I think shorting a basket of retailers represents good risk/reward from here. Remarkably, retail group has been one of the best performing groups this year, with XRT near all-time highs. There was an excellent short recommendation on XRT by natey back in ’08. Many of the arguments still apply today. While it may be foolish to bet against US consumers over the long term, I think shorting retail here represents an excellent bet/hedge -- retail as a group trades a sizable premium to market and is arguably priced for perfection, which struck me as odd as many people (Hussman, ECRI) believe we are close to/in a recession. Note this is not purely a top down process. I have followed around 100 retailers fairly regularly over the years and historically a big part of my portfolio is retail. Yet today I only have a half position in one name (KIRK), and most names I look at strike me as better from the short side. I suppose when one cannot find good long ideas, maybe it is time to look the other way.

Rather than proposing shorting XRT, I am recommending shorting a basket of names, which I believe are trading at peak multiples on peak margin. Most of these names are not momentum shorts based on valuation, so I think risk on the upside is also well contained (maybe naïve thinking on my part). Below is a short thesis on each name, and I’d be happy to follow up in details. Love to get some discussion as I know many on this board follow retail closely.

FDO (16x ’12): Dollar store group has been a favorite over the last few years for good reasons. Driven by strong SSS and buy-out news, FDO is trading at 16x ’12 on peak gross margin. SSS is slowing with tough multi-year compares coming up. Consumables should drive sales but hurt gross margins. The industry backdrop is arguably less favorable, with all players ramping up new store openings significantly and banking on consumables to drive sales. FDO was under pressure from activists to make earnings, and the quality in recent quarters have deteriorated significantly. FCF has lagged Net income badly. I think FDO will start missing numbers soon and multiple should contract to 11-12x, based on its low single digit sqft growth potential.

SHLD: I realize this is a controversial name given the majority owner. I have followed the SHLD story with great interest over the years and attended several shareholder meetings. While it may not be smart to bet against Mr. Lampert, I think the bull case on the story is clearly broken and there is no valuation support for the stock. The bull case was either Sears and Kmart turn around or there is great real estate value to be unlocked. I happen to think Sears and Kmart are structurally broken and are worth very little as going concerns. The real estate angle is also hurt dramatically by the emergence of online retailing. Arguably we are going to see an over supply of big box stores by numerous struggling retailers with no apparent buyers. The FCF/buyback story is close to an end, as the gap between D&A and capex is narrowing, and Sears/Kmart will soon be losing money on an operating basis. Even Sears Canada is struggling. This stock just bounced 50% from the low one month ago for no apparent reason.

HOTT: This stock has started to crack, and it remains a mystery to me why the stock hasn’t fallen more. Maybe it is the dividend holding the stock, but this is clearly a concept that has run its course. This company sports an EV of $240M but hasn’t generated over $30m EBIT in 5 years, and I doubt it will ever break $20m again. It does have some cash on the balance sheet, but I suspect it will be slowly bleeding to death. SSS has turned negative once again.

LTD (14x ’12): A company with two great brands, extremely shareholder friendly. International potential. What’s not to like? The problem is LTD has two completely saturated brands both operating at peak margin. SSS, while still strong, is starting to miss lofty expectation and compares are tough. Merchandise margins are starting to trend down again. This is 2007 all over again, when the extremely bullish investor meeting in late ’06 marked the peak of the stock. Aggressive buyback via issuing debt is also going to hamper mgmt’s flexibility on capital allocation going forward. I think normal EPS is $2 at best for this company.

LULU: ($8B mkt cap): This is the only name I recommend purely on valuation. Note this is a name that has been written up in the past on VIC, but I expressed my reservation back then as the company was about to deliver several strong quarters. I was blown away by how well the company has executed, but more importantly the stock arguably ran up even more. Now LULU sports a cool $8B market cap. For context, LULU with 150 stores has almost the same market cap of ANF/AEO/ARO combined. I have seen some expensive stocks, but this one pushes “expensive” to a whole different level. The bull case is that the US stores will hit similar sales productivity as Canadian stores. I think current valuation is already pricing in that scenario and discounts flawless execution for 5 years, which is something I am very comfortable betting against in retail land. The company is facing tough compares, and street model is largely modeling LULU sustaining this year’s peak gross margin for ever, which is crazy considering how little markdowns LULU had this year as they were short of inventory. I have a small short position and will pile on at the first sign of crack.

BKE: (14x 12): This one is the lowest conviction name for me. Consistent execution, special dividends ever year, and decent fundamentals. Yet I cannot get over the fact that the company is at peak productivity/margin selling jeans. Why should they keep 20%+ op margin when peers all struggle to get 10%? I don’t know when it will break, and frankly there is no sign of it breaking any time soon, but I felt the same way about ARO, and boy did it crack in a hurry ($25 to $10 in 4 months). It is this potential payoff that keeps me interested in the name. 

SSI (15x ’12): This stock has also cracked from where I shorted it ($16), but why should a fully saturated concept with no apparent competitive advantage trade at 15x ’12 at peak gross margin? There used to be a FCF angle to the story, but mgmt has chosen to lever up to buy back stock over $15 at peak gross margin. So even though headline EPS is growing YoY, underlying EBIT is down 20% YoY, with continued weak SSS in core stores. Now, mgmt suddenly found this wonderful idea of launching an off-price concept. Rather than experimenting with a few stores, they decided to bet big by committing to a schedule of store openings. Well, if TJX and ROST had so much difficulty launching AJ Wright and dd’s, I think it is safe to assume the odds of SSI succeeding is very low. Off-price is a model that requires a different kind of skill set and scale in buying personnel. This will be a money sink for SSI for quarters to come if not years.