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A Turnaround Analysis of 3 Retailers

June 02, 2014 | About:
Vinay Singh

Vinay Singh

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Turning around a bad retail situation is a difficult task. The odds are very much against a broken store operator regaining its former glory, and a single management misstep could initiate a crisis that ends up in bankruptcy. On the other hand, shareholders can benefit greatly if a turnaround is successful. Even a stabilization of an under-performing retailer’s operations can provide good returns.

Cash: An Excellent Indicator of Turnaround Success

It usually takes substantial time to produce a successful turnaround. Having a sufficient amount of cash on hand is the best means for ensuring the company can achieve its revamp. However, as cash levels decline the chance of insolvency increases.

When funds become tight, retailers can go bankrupt due to vendor credit problems. Retailers usually receive goods from vendors on credit. This credit is offered on the belief that they will be reimbursed once the items are sold. When vendors fear they might not be repaid, payment is demanded up front.

This change in terms is usually fatal to a weakened retailer. They typically rely on a single major selling season to generate the bulk of their profits. Prior to that season, retailers don’t usually expect to have the amount of cash needed to purchase the required inventory. If the retailer doesn’t have the cash to acquire enough items to fill the shelves, they usually have to file for bankruptcy just to keep the doors open.

A useful indicator of a company’s cash resource is the amount of cash at year-end (which can be found on the firm’s balance sheet) relative to its additions to property and equipment (which can be found in the cash flow statement). A company is at increasing risk as this ratio dips near 1.0 times.

Here are three interesting retail turnarounds:

Best Buy (BBY)

Best Buy, the consumer electronics retailer, is in the middle of a well-publicized turnaround.

Best Buy initiated a restructuring in response to its meager sales growth and profitability decline. The company’s "Renew Blue" plan aims to increase online sales, optimize efficiencies and cut costs.

Best Buy looks to have sufficient liquidity for the next year with a cash-to-additions in property ∧ equipment ratio of 2.4x based on cash of $1.8 billion and expenditures of $742 million.

The company's fair business value, based on expected cash earnings times a market capitalization multiplier, seems to fall in a range of $27 to $31 per share. This is based on $49.6 billion in revenue and about $1.1 billion in cash earnings for the last year, with those earnings discounted 5% and using a conservative 9x-to-10x multiplier, versus the standard retail 12x-to-14x multiplier.

Staples (SPLS)

Staples is the world’s largest office products company. Its shares have a 52-week high of $16 and a low of $10.

This company is also facing a tough operating environment. Sales for the latest quarter were $3.3 billion, a decrease of 4%, when excluding an extra week of sales. Comparable-store sales, which exclude Internet sales, decreased 5%.

In response, the company is planning reductions across the board in its square footage in North American Stores, global headcount and high-interest bearing debt to help reduce operating costs.

Staples probably has sufficient liquidity for the next year with a cash-to-additions in property & equipment ratio of 2.2x based on adjusted cash of about $800 million (booked cash of $1.3 billion less $500 million for maturing debt) and expenditures of $350 million.

The company posted $24.4 billion in revenue and about $1.1 billion in cash earnings for its latest fiscal year. Based on a 5% discount to these earnings and a 10x-to-11x multiplier, mainly due to benefits from a recently announced merger between two major competitors, Staples' fair business value is around $15 to $17 per share.

Kohl's (KSS)

Department store operator Kohl's is a different turnaround situation. While not showing any meaningful sales decline, its operations have had little growth and inconsistent results. The shares have a 52-week high of $55 and low of $41.

Its latest quarterly revenues increased 5.4% to $6.3 billion, including one extra week. Excluding the extra week, net sales climbed 2.5% from the prior-year quarter to approximately $6.2 billion. Kohl’s comparable store sales increased 1.9% from the prior-year with an improvement in inventory levels.

The company's liquidity position is a bit muddled. It posted a negative cash-to-additions in property and equipment ratio with cash of about $537 million and expenditures of $785 million. But that seems mostly due to aggressive share buybacks of $1.2 billion last year and $2.3 billion in the previous year.

Given that Kohl's generated $381 million of free cash flow in 2012 and assuming that if it had refrained from using some $600 million for buybacks, its cash-liquidity ratio would be closer to an acceptable 1.4x.

The company also has a handy five-year, $1 billion senior unsecured revolving credit facility without any draws during 2012 or 2011. Considering these circumstances, the company's cash position is probably alright but should definitely be monitored.

In the past year, the company recorded $19.3 billion in revenue and about $1.3 billion in earnings. With a 5% earnings cut and a slightly discounted 10x-to-12x multiplier, Kohl's fair business value calculates to a range of $54 to $65 a share.

Conclusion

Revamping a retail operation isn’t easy. There is a real chance a company can go bust. But even a moderately successful turnaround may offer excellent returns. Keeping an eye on a retailer’s cash and valuation can help increase the odds that a speculative investment in this area turns out well.


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