Get Ready for Screaming Bargains to Emerge in this Sector

You don’t want to be loading up on retail stocks right now. Signs are emerging that the back-to-school shopping season will be lackluster, and the mid-term outlook for the end-of-year holiday shopping season is likely to be equally sobering.

The dim outlook has already been discussed by an increasing number of Wall Street analysts. Earlier this week, for example, Deborah Weinswig, retail analyst for Citigroup, lowered her 2012 profit forecasts for Kohl’s (NYSE: KSS), Macy’s (NYSE: M), J.C. Penney (NYSE: JCP) and Target (NYSE: TGT). Look for more estimate cuts from other analysts in coming weeks and months.

Yet you may want to keep a very close eye on this sector, because a curious phenomenon is likely to happen again. Whenever investors begin fleeing retail stocks, they often punish them far too much — at least by one key measure.  I’m talking about their market value in relation to their assets — especially inventory. On occasion, investors push a stock down so far that it is actually worth less than a company’s merchandise. This sets up the bounce back trade as value investors go hunting.

Off-price retailer Tuesday Morning (Nasdaq: TUES) is a great example. The company carries more than $200 million in inventory on its books, and at the start of 2012, the entire company was valued at just $125 million. Investors eventually spotted that anomaly and shares are up more than 80% since late January.

In a similar vein, I noted the unusual price action in electronics retailer Conn’s (Nasdaq: CONN) in this column  from June 2011. Shares have risen 177% since then.

In the past few trading sessions, Conn’s rival hhgregg (NYSE: HGG) has entered into the same “well below inventory” territory. The retailer recently warned that 2012 profit targets would not be met as sales had slowed. This retailer’s market value stood at roughly $600 million in late 2011, but is now just $255 million. In their zeal to dump the stock, investors have pushed the company’s value below the $282 million in inventory that stood on the books at the end of March.  Add the fact that hgregg also has roughly $60 million in net cash, and the valuation gap becomes especially stark. The $359 million tangible book value for this retailer is 40% higher than the market worth. Value investors will likely eventually spot this disconnect and bid shares back up from a recent $7 toward the $10 mark.

Other examples include:

Ingram Micro (NYSE: IM) This reseller of office equipment carries $3.2 billion in inventory and has $700 million in net cash. Tangible book value stands at $3.36 billion. (All figures are prior to a recent announcement that the company will acquire cell-phone distributor Brightpoint (Nasdaq: CELL) for $650 million).  Yet Ingram Micro is valued by investors at just $2.48 billion.

Office supply chain retailer Office Depot (NYSE: ODP) is also trading at a deep discount. Its $550 million in book value is just a fraction of the $1.1 billion in inventory.  Tangible book value stands at $718 million.

Risks to Consider: As noted, retail stocks could fall a bit further as second-quarter results — and the forward outlook — are digested, so this is a good time to prepare for the compelling values to come.

Action to Take –>  Office Depot, Ingram Micro and hhgregg are current examples of balance sheet bargains. With pillars of value in place, these stocks have limited downside as this point with potentially robust upside once the near-term retail doldrums abate. Look for other retailers to join this list in coming weeks. As the examples of Conn’s and Tuesday Morning highlight, considerable gains may lay ahead for these beaten-down stocks.