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Geoff Gannon Investor Questions Podcast #17: Should You Put a Discount on a Stock With a Seasonal Business?

July 04, 2010 | About:
Geoff Gannon

Geoff Gannon

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There is no reason for investors to put a discount on a stock with a seasonal business. If you would be happy buying the whole business, you should be happy buying the stock. Forty years ago, Warren Buffett was happy to buy all of See’s Candy. More than half of that company’s sales are made in November and December. Yes. See’s is a seasonal business. But it’s also a great business.

That’s why Warren Buffett bought See’s. And that’s why you should buy R.G. Barry. Because you think it’s a great business.

When you asked your question, you said slippers are a commodity business. So my guess is that you don’t think R.G. Barry is a great business. We’ll take a closer look at the business in a minute. But let’s put the whole seasonal issue to rest. It doesn’t matter. Whether or not you should buy R.G. Barry’s stock has nothing to do with when it sells slippers. A business that makes 100% of its sales in December is as valuable as a business that sells the same amount every day of the year.

http://investorquestionspodcast.squarespace.com/storage/investor-questions-podcast-episodes/IQP_0017_Should_You_Put_A_Discount_On_A_Stock_With_A_Seasonal_Business.mp3 Let’s talk about why that is. A few episodes back, I talked about unspoken assumptions. I’m going to harp on that point there. Always look at the unspoken assumptions you have about a stock.

The unspoken assumption behind those who say there’s something wrong with seasonal businesses is that a seasonal business depends too much on one thing. And depending too much on one thing is risky.

That sounds like common sense. But it’s really nonsense. Think about Warren Buffett’s decision to buy See’s back in the early 1970s. See’s depends on 2 months for almost all of its sales. It also depends on one state, California, for a lot of its sales. And almost all of the company’s sales come from the western half of the United States. The company’s attempts to cross the mighty Mississippi have thus far failed.

It’s a Western brand. And it’s a wildly successful Western brand. It’s one of Berkshire Hathaway’s all time best acquisitions. The company grew profits year after year without asking for more cash from headquarters. In fact, See’s was a cash gusher for Berkshire. It sent cash back to Omaha where Buffett was able to buy stocks and other businesses without having to worry about providing See’s with food for growth.

What does this have to do with R.G. Barry? Not much other than the seasonal part. My point is that relying on one product, one brand, one state, or one month is not any more risky than relying on one fortress. Yes. It’s better to have a whole ring of fortresses. But if the choice is between one stronghold and miles and miles of ditches, I’d feel safer behind the castle walls than on the other side of a hole in the dirt.

One super strong business is better than hundreds of weak businesses. It’s not just more profitable. It’s also safer.

Sometimes relying on one thing can be risky. Relying on just one technical advantage is risky. Relying on low cost labor is risky. Relying on one tariff is risky. Relying on one customer is risky. And relying on one genius to guide your company is risky.

None of those things has to be there. Most of them go away with time. All geniuses die. Cheap labor becomes more expensive as the local economy gets richer. Tariffs fall. Technology becomes outdated.

But Christmas comes every year. Think of all the changes in America since Warren Buffett bought See’s Candy. And think of all the candy he’s still selling. A lot of things have changed. But we still buy candy. And we still give candy. And we don’t look for the lowest price. We look for the best brand.

At least when it comes to chocolate. And that’s what Buffett saw in 1972. And he was right. If he had seen years of growth ahead for chocolate, he’d be wrong. The boxed chocolate business is not a growth business. The number of pounds sold has not kept up with the economy. There are a lot of reasons America is fat. Eating too much boxed chocolate is not one of them. We may be fatter than we were in ’72, but we aren’t eating more chocolate.

The key to understanding Buffett’s thinking is to think about stagflation. That’s a 1970s era word. But it describes the chocolate business perfectly. Stagflation is when an economy has both high unemployment and high prices. In other words: prices go up but companies still don’t hire new workers to make more stuff.

That’s oversimplifying things but it works for our discussion of chocolate. What happened with chocolate is that unlike most parts of the economy where one person could compete with another and thereby force prices back down whenever they started to rise, chocolate companies can’t do that. They can’t add new supply because one box of chocolate is not a good alternative to another box. Supply added by a no name competitor would fail to bring down prices for See’s candy. And See’s candy is so much more valued in places like California, that it can demand ever higher prices without having other chocolate companies swooping in and selling an extra pound of chocolate at a lower price.

What I’m saying here is that the risk in the chocolate business was completely the opposite of seasonality. See’s was successful and safe because it depended on just one thing. It depended on December, it depended on California, and it depended on its brand.

A chocolate company with lots of different brands sold in all 50 states in equal amounts all 365 days a year is actually a riskier business than See’s.

If you look at what chocolate companies have done in the last 40 years, you’ll see they’ve tried to be more like See’s. They’ve tried to depend on one thing whenever possible.

Some companies have even limited where their chocolate is sold. Instead of selling their chocolate anywhere and everywhere, they use their own retail stores and their own catalogs to control the customer’s experience and put some distance between themselves and their competitors.

Even in the grocery store aisle, chocolate looks a lot different today than it did 40 years ago. Everyone is trying to be special. Even the most general players like Hershey (HSY) are offering products that depend on selling a specific experience to a specific kind of customer.

That doesn’t mean that selling something every day of the year to everyone you can is a bad idea. That’s what Coca-Cola (KO) does. And Buffett made a lot of money on that investment too. But it wasn’t because Coke was or was not seasonal. It was because Coke offered something that was almost impossible to copy. Well, one company was able to copy Coke. And Buffett would’ve done just fine if he’d bought that company’s stock instead of Coke.

But let’s go back to this idea of risk. Is depending on one thing a risky strategy?

Not necessarily. In fact, it’s not as risky as most investors think. There are lots of risks investors ignore. Seasonality is not one of them. But it should be. Christmas comes every year. Customers can betray you. But the calendar is forever faithful.

Now let’s talk about the stock you mentioned: R.G. Barry.

The first step, as always, is to check the stock’s vital signs. The 4 vital signs are: a stock’s Z-Score, F-Score, 10-year free cash flow margin variation, and 10-year real free cash flow yield.

R.G. Barry’s Z-Score is 42.61. Anything over 3 is safe. So there’s nothing to worry about there. Mostly because the company has almost no debt. Next is the F-Score. R.G. Barry’s F-Score is 5. F-Scores can range from 0 to 9. An F-Score of 5 is average.

So the stock looks fine until we get to free cash flow. R.G. Barry’s 10-year free cash flow margin coefficient of variation is 6.77. That’s very high. And very bad. The 10-year average real free cash flow yield is also bad at 1.68%.

So the balance sheet is fine. This company isn’t going bankrupt. But it’s free cash flow numbers suck.

Or do they?

The long-term free cash flow numbers are not good. But the short-term numbers are good.

If we looked at just the last 3 or 4 years, we’d get a free cash flow yield of 10% or better. That’s good. Anything above 7% is better than the average yield on U.S. stocks over the last 130 years. The stock market isn’t cheap right now. So a free cash flow yield over 10% stands out.

But that free cash yield is based on just the last 3 years. When we looked at the 10-year yield it sucked. It wasn’t even 2%. That’s not good. And you can lose a lot of money if you buy stocks with free cash flow yields in the low single digits. That’s like buying a stock with a P/E of 50. Bad idea.

So which number paints the truer picture?

In this case, it looks like the short-term number. I almost never say that. A 10-year average is better than a 3-year average. But this is one case where the company probably won’t revert to the mean.

The issue here is that R.G. Barry completely changed its business in 2003. Data from before 2004 is really data about a different company. Back then R.G. Barry was in 3 businesses it’s out of today. The company owned a thermal products business. It had a European footwear business. And it did its own manufacturing.

Today R.G. Barry doesn’t manufacture the slippers it sells.

That’s not unusual. Most American shoe companies outsource all of their manufacturing. American workers are expensive. Shoes are cheap. Expensive workers making cheap shoes is a recipe for disaster.

Warren Buffett knows that well. He bought a company called Dexter Shoe. It was the biggest mistake he ever made. The company turned out to be worthless once foreign competition kicked in.

You can’t make shoes in America. You’d be crazy to try.

The trend in the footwear business is entirely in the other direction. All the successful companies focus on their brands. Some also focus on distribution. They are vertically integrated. That’s a fancy way of saying the companies stay with their product each step of the way. The one step they skip is manufacturing. They design the shoe. They advertise the brand. They sell the shoe. But they don’t build the shoe. That’s outsourced.

Which is the way it should be. Buyers don’t care about how well built a shoe is. They care a little. But only a little. They care more about price. And they care about the look. And the brand.

So you have a couple companies like Brown Shoe (BWS) and Collective Brands (PSS) that follow that pattern. There are other companies that just do the distribution part. They focus on selling. Others companies focus on design.

But nobody focuses on manufacturing. That’s done overseas by companies that don’t own the brands. They just make the shoes.

So that’s the approach R.G. Barry has moved to. They were late to the game. Barry owned Mexican manufacturing as late as 2004. Most American shoe companies had given up on manufacturing by then.

R.G. Barry moved too slow. And we can see that in the numbers. From 2000 through 2004, business was bad. If Barry was the same company in 2010 that it was in 2002, I’d tell you to stay away.

But it’s not. This is a turnaround story. And as Warren Buffett likes to say: “Turnarounds seldom turn.”

I agree. But that’s good advice before the turnaround. Not after.

Also, this is a special kind of turnaround. Most turnarounds are built on the promise of fixing something. This turnaround came from selling something. Those are the best kind of turnarounds. Selling stuff you’re bad at is safer than doubling down. Most turnarounds are about doubling down. This turnaround was about something else. It was a strategic retreat. And it was a smart move.

So should you buy the stock? I don’t know. I can’t tell you not to. The stock’s vital signs are not good. But that’s only because they include some very bad years the company has put permanently behind it. At least that’s what we hope.

And I think we’re right to have a little hope here. R.G. Barry has a couple years of success under its belt. If the future is like the past 3 years, the stock is clearly cheap. But it’s not clear that the future will be like the past 3 years.

Like you said, this is a commodity product and that worries me. Price is important. These slippers sell for between $5 and $30. A lot of them are bought as gifts. And a lot of those are impulse buys.

Let’s face it, these are not carefully thought out gifts. As much as the company makes a big deal about its brands, this is not See’s Candy. Slippers are not something people pay up for.

We’re not talking about buying a box of chocolates for your wife. We’re talking about buying some slippers for Dad. R.G. Barry just doesn’t have the kind of mindshare great businesses have.

The person who buys the gift isn’t worried about the name on the slippers. They’re worried about the price. And they’re worried about getting something at the last minute.

On the other side of the scales, I do see some stuff here I like.

Most importantly: the business is seasonal. A lot of investors think seasonality is a big minus. Here, I think it’s a big competitive plus.

We just talked about vertical integration in the shoe business. An example I gave was Brown Shoe, which owns both shoe brands and shoe stores. That’s just one example. There are tons of others. And I wouldn’t be surprised if the industry kept moving in that direction.

What does that mean? It means competition in shoes will have a lot to do with distribution. With how you get the shoe to the customer. With where the customer buys the shoe.

Fine. But what about slippers?

That’s the beauty of the seasonality. People don’t buy slippers in shoe stores.

That means shoe companies aren’t eager to compete with R.G. Barry. Shoe companies want to sell shoes to shoe stores. R.G. Barry wants to sell slippers to all kinds of stores. The shoe companies want to sell shoes year round. R.G. Barry wants to sell slippers right before Christmas.

And that’s a niche. It’s not a great niche. I still think the long-term risk from foreign competition is real.

Slippers are a commodity product. But maybe slipper companies aren’t commodity businesses. Maybe they have a different way of getting their product to the customer. Maybe they can sell it in different places. Maybe they can sell it at a different time of year.

Maybe.

I don’t know. But R.G. Barry looks safe enough. The stock might even be cheap enough. The only issue is the short history. That’s a weird thing to say about a company that’s been around since the 1940s. But R.G. Barry has only been in its current (factoryless) form for about 5 years.

That’s not long. Analyzing a stock like this is kind of like analyzing a start-up. But the industry has been around. We know how slippers are distributed. We know where and when slippers are sold. And I think we know slippers can be a decent niche.

That niche is never going to provide amazing profits. Price is a big concern for customers. And brands don’t matter that much. I know the company says otherwise. But I’ve seen enough old brands hurt by new competition to know brands fade in the face of low prices when customers aren’t interested in paying up for your product.

So, yeah, I think there are risks here. But I also think you can buy the stock. It wouldn’t be my first choice. But, if it’s your first choice, go ahead and buy it. And don’t worry for a second about seasonality.

That’s all for today’s show. If you have an investing question you want answered call 1-800-604-1929 and leave me a voice mail. That’s 1-800-604-1929.

Thanks for listening.

About the author:

Geoff Gannon
Geoff Gannon


Rating: 4.4/5 (7 votes)

Comments

halis
Halis - 3 years ago
As far as RG Barry goes, too risky for me. It's lost money for 7 out of 10 of the last years. But what you said about companies relying on one thing. Is it risky?

Read "Focus" by Al Ries and it will change your entire view of things. He actually makes the argument that the companies that focus on one thing are actually the greatest companies in the world. He also cites many examples of companies that try to focus on too many things and they destroy value.

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