Description

I posted Stage Stores (STGS) over a year ago and it turned out to be an incredible investment. The company performed well and, as I expected, the stock tripled in a very short period of time. I sold the stock and have been watching it for a while now. I believe the stock is a tremendous bargain again, with very little downside.

If interested, I recommend you read my old write-up for some background on STGS.

UPDATE:

STGS has recently run into sales problems. Comps ran at 14% for 2001 as the company emerged from bankruptcy, closed under-performing stores and re-stocked open stores. In the first half of 2002 comps continued to increase, with high to mid single digit gains. Comps began to slow down in the third quarter, with “only” a 2.9% increase, and the stock fell swiftly from the low $30’s to below $20. Comps continued to deteriorate in the fourth quarter with a 6.8% fall, against a tough 8.4% increase the previous year.

WHAT’S WRONG?

1) The slowing economy. As with almost all retailers the economy has hurt sales and STGS is no different.

2) Competition. The problem for STGS is their big town markets. I understand their small town markets are doing well, as they always seem to. Their biggest problem recently seems to be a competitor named Foley’s. They are a division of May Company. For whatever reason, Foley’s has been on a rampage for the past several months with massive sales. They seem to have taken a lot of market share. I do not know what Foley’s plan is, but competitors have indicated to me that they don’t believe these promotions can continue for an extended period of time.

Also, in the last two years Kohl’s entered a couple of STGS's markets, including Houston. Although STGS’ overall sales held up well after Kohl’s first entered, they have had an effect on their sales.

Also, JC Penny who STGS has competed against forever and who has not really opened up any new competing stores, has been doing much better and has probably taken some market share recently.

3) Cutting back on credit card sales. STGS made a decision in 2002 to reduce their exposure to marginal credits, as management correctly anticipated a deterioration in consumer credit. Private label credit card sales represented 44.3% of sales for the first 9 months of 2002 versus 49.5% in 2001. This 10% drop has had a big effect on sales for the year, even though they probably avoided some credit problems. This credit tightening is a one time adjustment, not an on-going decline.

WHAT’S RIGHT AT STGS?:

1) Their small town focus is huge competitive edge. 77% of their stores are in towns smaller than 150,000 people and 56% are in town smaller than 50,000. STGS and its predecessors have been operating profitably in these small towns since the 1920’s. These stores have been insulated from large competition (like Kohl’s) for many decades and provide a very steady earnings base. Even during bankruptcy, with terrible inventory, the existing store base did not deteriorate dramatically.

2) Stock buy-back. STGS has been aggressively buying back stock (though not in the last 2 months, which I’ll discuss later) and bought back 5.5% of their outstanding in just 4.5 months. Management has 3.6 million options struck at around $15 and has the proper incentive to maximize shareholder value

3) New MIS. STGS just spent $24 million last year upgrading their MIS system. This already helped to reduced shrinkage for 2002, which helped margins last year and should help further this year with shrink and inventory management. Their previous systems were terribly old, so the upgrade could produce big benefits.

4) VALUATION.
STGS is trading at 4.9x last year’s earnings (net of cash), 6.3x free cash flow and 2.4x EBITDA.

This is incredibly cheap on an absolute basis and is the cheapest retail stock I know. Not only are all of the comparables trading at higher multiples than STGS, none of them has a balance sheet as strong as STGS. The average multiple for stores most comparable to STGS is about 11-12x next year’s earnings and about 6x EBITDA.

Price/share: $19
Estimated 2002 Year End Net Cash and receivables/share: $6.75
Fully Diluted Shares: 19.8

Equity Value: $378
EV: $235

Estimated Book Value/share: $19.00


EPS: $2.60
EBITDA: $104
Free Cash Flow/share: $3.00

2002
P/E: 7.3x
P/E (less cash and interest income earned on cash):
4.9x
P/FCF: 6.3x


EV/EBITDA: 2.4x
P/Book: 1.0x

ROE: 14%

These earnings were generated in an extremely poor retail environment and are cyclically depressed. Assuming Foley’s does not continue to act irrationally (which I believe is a fair assumption) and without any economic recovery (or an economic collapse either) I belive STGS's sales will stabilize and that earnings in 2003 could be similar to 2002. Due to the lower share count resulting from their share repurchases, earnings could fall 5% and STGS would still have the same EPS as last year. Obviously an economic recovery would allow for much higher earnings.

Cap Ex: Maintenance Cap Ex is only about $9mm. So free cash flow is about $0.40 cents higher than earnings, or about $3.00/share.

At year end, STGS will have about $140 in cash and in credit card receivables. STGS uses its excess cash to fund credit card receivables, so there never appears to be any build up of cash on the balance sheet. I believe many investors do not fully appreciate this fact when doing Enterprise calculations.

CATALYST
The most important recent event, however, aside from the attractive valuation is recent rumors about their credit card operations. Rumors have been circulating that STGS is trying to sell/outsource their credit card operations. I have done a lot of field checks on this and I believe the rumors most likely have substance.

Several retailers have done this over the past few years (notably SAKS and JC Penny). Gottschalks (GOT) is the most recent I know of (they very recently filed an 8-K detailing their transaction). GOT sold their receivables to Household for par and will receive an on-going participation in all finance charges. This transaction immediately liquidates all receivables held by GOT, freeing the cash to be used as they please and allowing GOT to focus on their core business. The beauty of this transaction is that in addition to all the liquidity they receive, GOT believes the transaction will be neutral or even positive to earnings. GOT will benefit from Household’s credit card and marketing expertise and their low cost of funds.

If STGS does this, which I believe is a decent bet, STGS will be left with a full $6.75 in net cash (estimated 2002 year end) and no debt and probably a similar earnings level of $2.60/share.

STGS stopped repurchasing shares in mid December. It’s possible that this transaction is the reason for this. They had been very aggressively buying stock at prices higher than the current price, including over $25/share in their most recent purchases in December. If they were pursuing this transaction they would likely be prohibited from repurchasing shares.

If this transaction happened, based on their previous actions, STGS would most likely look to return their excess cash to shareholders, via a massive repurchase or some kind of tender or dividend.

TARGET

STGS should trade at about 5-6x EBITDA and about 12x earnings. This would be a slight discount to comparable retailers, due to recent poor performance. This would indicate a price of over $31/share

DOWNSIDE

I do not believe there is any significant downside at this level. STGS’ stock performance in the last few weeks in a terrible market is good evidence that STGS has hit a floor. At $16/share STGS would be trading at only 3.7x earnings, net of cash, 1.6x EBITDA and 85% of tangible book value. I cannot imagine a scenario where this would be justified. Despite the tough retail environment and recent deterioration in results, it is hard to conceive of a scenario that would justify a stock price much lower than it is currently.

Due to bad weather recently in the south, STGS may have another month or two of bad sales ahead of it, but comps start to get easy in the middle of the year. Obviously, if sales continue to deteriorate, earnings will suffer.

Catalyst:

The main catalyst here is simply valuation. Rarely do you get a chance to buy a stable business that has been around for almost 80 years at 4.9x cyclically depressed after-tax earnings (net of cash) and at tangible book value (of which 35% is cash).

The most timely catalyst is the possibility of STGS selling/outsourcing their credit card receivables. This would free a massive amount of cash and would make STGS’s cheap valuation too obvious to ignore.

Continued reinvestment of excess cash and free cash flow in share buy-backs and selective new stores openings will help realize the value here.

Catalyst

The main catalyst here is simply valuation. Rarely do you get a chance to buy a stable business that has been around for almost 80 years at 4.9x cyclically depressed after-tax earnings (net of cash) and at tangible book value (of which 35% is cash).

The most timely catalyst is the possibility of STGS selling/outsourcing their credit card receivables. This would free a massive amount of cash and would make STGS’s cheap valuation too obvious to ignore.

Continued reinvestment of excess cash and free cash flow in share buy-backs and selective new stores openings will help realize the value here.