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James Li
James Li
Articles (764)  | Author's Website |

Competition in Retail Industry Gives Rise to Potential Value Traps

Online retail companies like Amazon and eBay are taking over the market

June 17, 2016 | About:

The customized “Value Trap Screener” listed several retail companies that are potential value traps including Macy’s Inc. (NYSE:M) and Abercrombie and Fitch Co. (NYSE:ANF). As these two companies experience decreasing gross margins and operating margins, these stocks become potential sell targets.

The dreaded value trap: some potential warning signs

Value traps could potentially destroy an investor’s capital if they are not considered carefully. Such companies tend to trade at relatively low valuation ratios, suggesting there is value in buying the stock. However, despite these low valuation ratios, the company’s value continues declining, indicating a potential loss of capital.

One warning sign of a potential value trap is declining profit margins, according to a research article. To screen for potential value traps, GuruFocus users can implement the All-in-One Guru Screener and select the required criteria based on the research article. A sample “Value Trap Screener” contains the following filters:

  • Operating margin growth rate less than -1%.
  • Gross margin growth rate less than 1%.
  • Five-year EPS growth rate less than -6%.

Among the nine stocks featured on the “Value Trap Screener,” eight of them have negative gross margin growth rates. Two of these companies also have five-year EPS growth rates between -20% and -30%: Abercrombie and Fitch and Guess? Inc. (NYSE:GES).

Online retail takes over the industry; brick-and-mortar stores weaken

In the late 1900s, brick-and-mortar retail stores like Abercrombie and Fitch and Guess? dominated the retail company. Both companies experienced expanding gross margins during the late 1990s and early 2000s. However, as online companies like Amazon.com Inc. (NASDAQ:AMZN) and eBay Inc. (NASDAQ:EBAY) enter the retail industry, the brick-and-mortar stores begin losing customers and competitive power. As these companies lose market share to online retail companies, brick-and-mortar stores experience weakening margins, leading to reduced financial strength and profitability.

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Among the brick-and-mortar stores that flourished in the late 1990s, Abercrombie and Fitch had the highest gross margins, peaking near 67% in the early 2000s. However, the retail company had decreasing gross margins since 2009, suggesting that the company is losing profit share to online retail companies. Guess?, incorporated in 1981 and once known for its women’s shoes, also experienced declining gross margins in recent years, a warning sign that its business model is weakening.

One likely reason why Amazon and eBay have increasing gross margins is because customers are selling their Guess? shoes and other apparel products on these online websites.

Well-known retail company falters as margins decline

Like Abercrombie and Fitch, Macy’s has experienced weakening gross margins in recent years. Incorporated in 1985, Macy’s sells a variety of merchandise products: men’s and women’s apparel, cosmetics, home furnishings and other consumer products. The company historically had increasing gross margins; however, according to its 15-year financials, the company’s gross margins have decreased since 2011. Additionally, Macy’s operating margin decreased 2.4% during the first half of 2016 despite having expanding operating margins in the past three years. This suggests that Macy’s is losing its competitive power and experiencing a potential downward spiral.

In its recent 10-K, the management at Macy’s discussed its challenging fiscal year 2015: many of its key financials including net sales, operating income, diluted EPS and ROIC decreased during 2015. One likely reason for the decrease in net sales is overall weak consumer spending: according to the 10-K, the company’s operations are highly impacted by consumer spending levels and “competitive pressures from department stores” and online retail channels like Amazon and eBay. As these online companies take over the retail market, the retail company loses profit share, resulting in decreased gross margins.

The company currently is in gray zones based on its Altman Z-score of 2.13, suggesting that if the margins continue to decline, Macy’s may face bankruptcy risk. Although the company’s Z-scores have slightly increased during the past five years, they have been volatile, indicating an unpredictable company. Additionally, despite having strong Piotroski F-scores in the early 2010s, the company currently has a modest F-score of 5. With a Beneish M-score of -1.95, Macy’s appears to manipulate its assets and earnings.

Beware: Macy’s could be a value trap

The company has a trailing 12-month P/E ratio of 10.68, a P/B ratio of 2.46 and a P/S ratio of 0.43. Although the P/S ratio is higher than 65% of companies in the global retail industry, the current P/S ratio is near five-year lows. Additionally, the P/B ratio is near three-year lows. With relatively low valuation ratios, Macy’s appears to be a good buy. However, a deeper analysis of Macy’s competitive power and profit margins suggests otherwise. Like Nokia (NYSE:NOK) in 2012, Macy’s is one good example of a value trap: despite the low valuation ratios, the company is losing competitive power to other retail companies, especially Amazon and eBay.

Many gurus trimmed their positions in Macy’s in the previous quarter, likely because it may be a value trap. Ray Dalio (Trades, Portfolio) and Steven Cohen reduced their positions in the company by 68.76% and 40.28%. With this transaction, Dalio decreased his portfolio by 0.24%. Additionally, Pioneer Investments (Trades, Portfolio) completely wiped out its position in Macy’s. Despite many gurus selling Macy’s, David Einhorn (Trades, Portfolio) currently has the highest ownership in the stock: the investor from Greenlight Capital currently owns 7,056,400 shares after increasing his Macy’s position by 4.80% in the recent quarter.

See also

For more information on how to avoid value traps, read the following article. You can also use the All-in-One Screener to create your own “Value Trap Screener” by selecting the financial metrics that define a value trap.

Start a free seven-day trial of Premium Membership to GuruFocus.

About the author:

James Li
I am an editorial assistant and researcher at GuruFocus. I have a Master's in Finance from SMU, and I enjoy writing reports on financial trends and investor portfolios. Follow me on Twitter at @JamesLiGuru!

Visit James Li's Website


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