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Insider Action Flags Retail Paired Trade

Jonathan Moreland

I certainly am glad I did not act as negatively on retail as my top-down opinion would suggest. I'm on record as being concerned about the ability of U.S. consumers to keep going their profligate ways, given the group's high debt, low savings and the tall hurdle of energy prices, which are still high even if off the peaks. And if housing prices merely level off, it may be enough to put a systemic crimp in the ability of this nation of heavy spenders to fund purchases with new home-equity loans.

I just can't translate the continued strength of U.S. consumer spending as a signal that none of these negatives matters. What hasn't killed the U.S. consumer hasn't made him stronger. The U.S. consumer is more like a boxer at the end of a lengthy fight: still standing, but the struggle has made him more vulnerable, not more resilient.

However, consumer sentiment has bounced back recently, and there is talk that some retailers may post some decent Christmas sales. What has most affected my strategic moves in retail, however, has been the surprising amount of insider buying in retail names. I checked out Internet retailer RedEnvelope(REDE Quote) for a quick little profit back in September, and I still have a large gain in specialty consumer electronics seller Tweeter(TWTR Quote) despite the stock's recent pullback.

Restoration Hardware vs. Saks

But as I began entertaining buying yet another retailer, the top-down curmudgeon in me just couldn't stand being so heavily weighted in a sector with so much logic against it. Fortunately, negative insider activity at another company has opened up the opportunity for a sort of paired trade in retail. And so I recently bought Restoration Hardware(RSTO Quote) while shorting Saks(SKS Quote).

For sure, this is not a perfect pairing. Though both firms are technically in the same sector, Restoration sells home furnishings and fixtures, while Saks' upscale department stores have much more exposure to clothing.

I like the mismatch, though. With long-term interest rates threatening to not rise much more, the housing sector could end up being firmer than many think possible. That should help Restoration's business. At the same time, I see no end to the outlets available for consumers to buy brand-name and generally good-quality clothing at a discount.

Although Target(TGT Quote) has garnered many kudos for its merchandising, Saks' stock has outpaced Target's over the past five years. Saks also sports a much higher forward price-to-earnings multiple than Target, 28 vs. 17. That may be justified on growth percentages, but profitability-wise, Saks is a much poorer cousin.

Saks' return on equity is a third of Target's, and even half that of boring old Federated Department Stores(FD Quote). Comparing operating margins of these three is even less flattering to Saks. Saks seems to have done well selling itself to Wall Street thus far, but one can wonder if much of what's positive about Saks' prospects has already been priced into its stock.

Insiders at the Register

Saks' insiders seem to believe the present value of their firm's stock is good enough to cash in on. Seven of them sold more than 2 million shares in November at an average price of $17.50. Though mostly option-related, that mitigates the negative aspect of this large selling cluster only slightly.

The unanimity of the accelerated selling seems to indicate that this group does not feel it worthwhile to wait until Christmas sales numbers are released to reap these risk-free gains. This gives the impression that the numbers may not quite be all "ho-ho-ho" and "fa-la-la-la-la" -- especially because cashing out early next year seems better for tax purposes, as well.

Adding to the negative aspect of this selling is that it was done after the stock sold off more than 30% from its recent highs. Insiders selling into weakness is not a positive indication. That's when investors would expect to see insiders buy in, showing their faith in a stock's recovery.

In stark contrast, that is exactly what insiders at Restoration Hardware have been doing. With the stock now trading for about 30% of its 52-week highs as well, two insiders recently purchased nearly 300,000 shares between $5.47 and $6.38.

Director Glenn Krevlin is the major buyer. He represents investment firm Glenhill Capital, and has proven adept at picking up Restoration during its many dips. He was last active back in April, when the stock was also around this price. Between then and now, Restoration traded up to $9, and one insider took advantage of that strength to sell options heavily. Tellingly, that seller appears to be on the sidelines now, another indication that insiders feel positive about the stock's near-term prospects.

Back to Krevlin: He was also among the insiders whose buys guided me to that recent, profitable trade in RedEnvelope, a trade that I would have done even better with if I had held on longer. This time, he seems to be betting that Restoration can post EPS in the upper end of the expected range for next fiscal year (ending January 2007). From the 8 cents expected this fiscal year, analysts expect the bottom line to increase to between 17 cents and 45 cents. These estimates reflect the wide range of sentiment surrounding this and other retailers. Restoration would need earnings in the upper portion of the estimate range to justify buying now for fundamental reasons, and that expectation is what I read into the recent bullish insider sentiment.

Besides the insider activity, another interesting contrast between Restoration Hardware and Saks is the short-term technical strength of both. Restoration looks as strong in the short-term as Saks looks weak. If Restoration can break through the 200-day moving average it is now butting its head against, this paired trade should be profitable even if Saks recovers a bit.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider RedEnvelope, Tweeter and Restoration Hardware to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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