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Wall Street Gets It Wrong—Again

I remember Wall Street’s infatuation with gargantuan stores such as Toys R Us, Bed Bath & Beyond, and even Barnes & Noble. Believe it or not, they were the darlings of the early 1990s.

But now we’re witnessing the death of these Category Killers. 

I was reminded of this while running errands over the weekend when I saw that one of my favorite sports retailers, CitySports, a Boston institution, had closed its local store—I later learned it had shuttered all 26 locations. These hip, big box retailers were just the place to find a Gore-Tex running jacket that would keep you warm in subzero temperatures and look fashionable. And CitySports carried every conceivable brand.

Then on a trip to the supermarket I saw a giant 50% Off banner on a nearby Sports Authority store. After missing recent interest payments, the private company announced it will close about one third of its 450 stores. (I’m not that broken up about Sports Authority, to be honest. I get lost every time I shop in one of its chaotic stores and end up buying Gatorade gum at the checkout because I’m so parched from roaming around.)

Nasty Breakup

Wall Street’s love affair with mega-retailers, as with most love affairs, worked until it didn’t. In the harsh light of day, that sexy growth stock can look like an ugly value trap. We’ve all seen the embarrassing downgrades in the oil sector where the “smart money” is lowering a $50 price target to $20 on a stock that’s already trading at $5.  

Investors are wise to take heed and try to poke holes in stories that seem ironclad, which is what I do in my Profit Catalyst Alert service, and which brings us back to beaten-down, big box retailers.

It’s not just large sporting good purveyors that are withering. Toys R Us, another retailer drowning in debt, announced it was closing its Times Square store. Besides the obvious gamble of opening a store with an indoor Ferris wheel in the country’s highest rent district, this toy company’s profitability is withering like Barbie at a National Organization for Women convention.

The bigger the retailer the better was the mantra. Walls of Yankee Candles and K-Cup flavors, floor-to-ceiling displays of athletic shoes and a dizzying maze of Under Armour gear racks were expected to entice customers to stay longer, buy more and never leave empty-handed. For a while this worked, but an oversupply of stores and the rise of online merchants have slowly eaten away at this model.

Certainly, Amazon’s lightning-fast delivery took a chunk of business from these retailers. However, many smaller stores have been able to survive and even thrive despite online retailers expanding. What’s killing big box retailers is the simple math of a giant footprint.

Bed Bath & Beyond stores can be as large as 50,000 square feet. The average Barnes & Noble is 26,000 square feet. For comparison, a football field is 48,000 square feet. The rent on these stores is enormous and can be a crushing cost, like NFL salaries. When the brand is performing, this model can work, but just a small drop in revenue or an increase in markdowns can jeopardize profits.

Big box retailing feels like a broken model for now. Overbuilding of these huge stores led to oversupply. New mall formats favor smaller stores, and the Internet is the ultimate enabler of the low-inventory model. Many stores offer free shipping for an item out of stock, keeping customers happy despite having fewer goods on hand.

Ignoring the Obvious

These examples bring to light two important lessons. The first is that Wall Street often ignores obvious risks to popular operating models. As we’ve seen countless times, Wall Street’s love affair with businesses such as 3D printing, shale drilling and mortgage-backed securities can quickly turn to loathing when unexpected crises emerge.

The second is how critical revenue growth is to earnings production. When revenue is rising, many operating blunders can be hidden. When revenue is slowing or declining, profit margins shrink rapidly as covering fixed operating expenses and interest payments becomes more difficult if the company has taken on debt to fund its growth. This is often called reverse leverage.
When analyzing names for Profit Catalyst Alert, I spend a lot of time looking for companies with rising revenue, whether it is due to new products, acquired businesses or a secular trend driving revenue.

That said, I stress-test my models for periods of sluggish growth. Management must show the ability to control expenses and limit debt to reasonable levels. If it can’t, I’ll skip that stock and let the smart money deal with the inevitable meltdown.

 


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