Top 10 Turnaround Candidates for 2002, Part 2

The stock market is sending a clear message to investors: The ramp in liquidity, the drop in interest rates and the benign backdrop in energy and inflation will lead to better times in 2002.

My favorite part of the economic cycle is when times are tough. It's not just because equity bargains are plentiful, although they are. It's because companies trim every ounce of fat from their expense structure. When the cycle turns, and it will, the leverage to margins and earnings is at peak levels.

So it's time to get positioned ahead of the economy's turn. Waiting for the economy to improve before committing to equities is a mistake. In every recession in the past 100 years, without exception, the market rallied well in advance of the recession's end.

The purpose of my turnaround columns is to highlight stock ideas of companies that are unreasonably underpriced in advance of a turn in their fundamentals. This is my second installment of the five-part Top-10 Turnarounds for 2002. (Check out the first part here.)

Dillard's

Whether a money manager allocates capital to 10 stocks or 100 stocks, virtually every money manager has a favorite stock. I consistently signaled to readers that Office Depot (ODP) (up 115%) was my favorite turnaround in several columns early this year. If I had to pick a favorite of my Top 10 for 2002 turnarounds, it would be Dillard's (DDS).

A Steady Decline for Dillard's But changes at this retailer position it for a credible rebound

Dillard's operates about 340 department stores, mainly in the South and Midwest. Unlike most other department-store retailers, Dillard's owns most of its stores -- about 75% of them. I've gone through a myriad of different calculations to determine the private market value of Dillard's; without going into detail on the calculations, suffice it to say the private value of Dillard's far exceeds the public market value.

It's not enough to just buy cheap when buying turnarounds. Too often, cheap is just cheap -- and it stays cheap. Before investing in a turnaround, you need to identify catalysts that will unlock value. Here are a few catalysts that will help unlock the value in Dillard's:

• Supply-chain management: Dillard's has overhauled the management of inventory, improving controls on markdowns, slower-moving inventory and vendor discounts. The results are impressive: Inventory levels are down 14% year to date, amid a very tough retail environment.

• More private-label brands: Private labels carry high margins. At Dillard's, they only represent 15% of sales, so there's plenty of opportunity to grow this line. Also, private labels give Dillard's better command over its supply chain, leading to operational improvement.

• Valuation: The valuation gap between Dillard's and its peer group is remarkably wide. Dillard's doesn't deserve a similar valuation to Federated (FD) or May Department Stores (MAY) right now. It may take a couple of years, but if and when Dillard's returns to historical norms in terms of margins, this $15 stock will trade north of $30 per share.

• Same-store-sales trends: The key metric to watch is same-store-sales comparisons. Recent trends suggest that a turn may be under way, as both absolute and relative (to peers) measures have been looking better since this past June.

Manpower

I first mentioned my next turnaround pick, Manpower (MAN), in an August column. Manpower is a temporary-staffing company whose stock hasn't made any progress in the past six years. Meanwhile, the company continues to forge ahead: Revenue and net asset value have more than doubled in the past six years.

It's not surprising that Manpower stock is depressed during the current economic contraction. History provides guidance on how Manpower will perform in the new cycle. The stock has traded recently at trough levels on par with the 1990-91 recession, in terms of revenue, cash flow and earnings. Historical peak levels suggest a valuation of twice the current quote of about $33 when the good times return for Manpower. For that sort of appreciation, I don't mind waiting for the good times to roll.

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