RealMoney Silver - Saks Looks Priced for a Perfect Turnaround

Saks Looks Priced for a Perfect Turnaround
By Bill Trent
RealMoney.com Contributor
4/30/2008 8:59 AM EDT

Looking at its stock performance, you'd never guess that fiscal year 2008 (which ended in February) was a banner year for Saks (SKS) .

Management crowed on its year-end conference call that "our operating margin's 4.2% doubled the 2.1% generated in 2006. This performance exceeded our targeted performance for 2007 and was driven by our comp-store sales increase of 11.7%, 50 basis points of gross margin expansion, 70 basis points of SG&A leverage and 100 basis points of leverage on other operating expenses."

The Best-Laid Plans ...

At a presentation on Tuesday, Saks CEO Steve Sadove outlined the company's plans for long-term operating improvement; its goals include increasing operating margins to 8%. The plan requires:

outsized comparable-store sales growth;
gross margin rate improvement; and
cost-effective infrastructure.

That strong comp-store performance came to a screeching halt. According to a recent 8-K filing, same-store sales are down 0.1% for the two months ending April 5, and 2.9% for the five weeks ended April 7. In other words, the decline is accelerating. With analysts currently estimating 4.4% sales growth for the 2009 fiscal year, the fabled second-half recovery is going to have to be rather strong to keep those estimates intact.

At the presentation, Sadove said that luxury consumers were responding to promotions and added that "you're going to see more promotions over the course of the first part of this year" as retailers look to clear excess inventory. That likely means shrinking gross margins going forward, thus knocking the second leg out from under management's plan.

Indeed, the 2008 plan is now forecasting flat operating margins, mid-single-digit comp growth, modest gross margin declines and modest SG&A leverage. As I noted earlier, positive comps are looking like a stretch goal so far. At this point, I expect earnings to be closer to the 42 cents in fiscal 2008 than the 46 cents currently predicted by analysts.

That 46-cent consensus estimate has already fallen from 59 cents three months ago, and the 2010 estimates have fallen from 80 cents to 65 cents over the same time frame. John Hussman of Hussman Funds (quoting James Montier at Societe Generale) noted the problem earlier this week: "The chart makes it transparently obvious that analysts lag reality. They only change their minds when there is irrefutable proof they were wrong, and then only change their minds very slowly."

Click here for larger image.

Being slow to adjust estimates for the S&P 500 earnings (or for that matter the mid-cap 400 index to which Saks belongs) starts with being slow to adjust the earnings of each component.

No Bargain

Even if Saks does manage to grow earnings at the 8% level that Zacks Research Wizard says analysts are predicting for the next three to five years, it is tough to see how the stock would perform particularly well. Its price-to-book ratio, at 1.6 times, is double the department-store industry average, despite Saks' below-average return on equity and average net margin.

Macy's (M) is already showing the performance levels that Saks is only striving toward, and its price-to-book ratio is just 1.12 times. If over the next five years Saks' valuation drifts to Macy's level, the stock would give up 6.8% per year. Add on the 8% expected growth, and you get to a target expected return of just 1.2% annually. Hopefully, they'd at least start paying a dividend, to bring the return in line with Treasuries.

Seen another way, that forecast leads me to a five-year price target of $14. If I wanted to earn 10% annually, I'd need a starting price of $8.75 to get there. In other words, it would take a 33% decline from today's price to make the potential returns look enticing.

Normally, I'd look for the free cash flow to provide a floor estimate, but unfortunately Saks doesn't have any. Its operating cash flow in 2008 was $71.5 million, while $141 million in capital expenditures drained the cash balance to $100 million. With another $125 million in capex planned for fiscal 2009, it looks increasingly likely that the company will soon be tapping the capital markets for funding.

I believe management has been executing its turnaround strategy well so far. Unfortunately, it looks to me that the turnaround plan is fully priced into the stock, even though it is likely to run into some economic roadblocks in the next year or two. It's just not the place I'd like to be right now.