Move over, Hot Topic ( HOTT). There's a new bad boy on Wall Street. Investors would do better to heed the sentiments of Hot Topic's thinning customer base and steer clear of the retailer rather than bet on its turnaround plan. The company will soon log its second straight year of profit declines, and its disappointing 8.4% drop in February comps extended its streak without a positive same-store sales gain to 11 months in a row. It's nearing time to cue up the lyric once sung by fatalistic rock legend Jim Morrison, "This is the end." The mall-based specialty retail chain, which once held sway with countercultural teenage rockers, isn't likely to restore its mojo anytime soon. There's a new wave of momentum developing on Wall Street for a mall-based retail chain connecting with the coveted teen demographic. Investors directing their flow toward Zumiez ( ZUMZ) these days are the new "Riders on the Storm." While Hot Topic was reporting its latest sales drain, Zumiez was logging a 28% jump in February same-store sales, a key retail metric gauging sales at stores open at least a year. That came on top of a 10.8% comp-sales increase in the same month last year. The purveyor of clothing and gear for young extreme-sports enthusiasts will report its fourth-quarter earnings next week, and analysts have high hopes. "We regard Zumiez's robust February sales results as further evidence that the concept is one of the best-positioned and well-differentiated retailers in the teen space," wrote McAdams Wright Ragen analyst Sara Hasan in a recent research report. With her buy rating on shares of Zumiez (her firm has an investment-banking relationship with the retailer), Hasan is one of the four out of five analysts covering the retailer who are bullish on the stock.
Since the initial public offering last May, Zumiez shares have soared 160%. The chain logged a 13.7% jump in same-store sales for the recently ended fiscal year on strong demand from surfers, skaters, snowboarders and BMX bikers. That kind of performance, with its support from the sell-side research community, gives it all the earmarks of a trendy, fashion-driven stock, which are notorious for big price swings based on momentum trading. Just as the shares get pumped up after a stretch of good results, any shift in the fashion winds can result in a wipeout. But a look at Zumiez's long history off Wall Street makes it difficult to write off the company as a shooting star. The retailer has been operating since 1978, and 26 of its 27 full years in existence have seen positive same-store sales. Its only negative sales year came in 2002, a recession period, and it has been profitable in every year of its existence. William Blair analyst Sharon Zackfia notes that in the five years before it went public the company logged nearly a threefold increase in its store base, an average annual same-store sales gain of 10%, and a 36% increase in average annual store volumes to $1.2 million. Over the same time frame, its systemwide sales more than tripled and its operating profit grew nearly fourfold. Trading around $53.75, the company was recently valued at 45 times earnings estimates through 2007. That's a rich valuation even in the red-hot teen fashion space, where Abercrombie & Fitch ( ANF) and Pacific Sunwear of California ( PSUN) trade at 11 times estimates and American Eagle Outfitters ( AEOS) trades at 12 times estimates. But analysts argue that Zumiez's growth potential is such that it needs to be valued differently. Zackfia estimated in a research note that the extreme-sports market has exploded into a $12 billion industry, driven by a surge in interest after ESPN's first X Games in 1995 and the addition of snowboarding as an Olympic event in 1998.
The increasing popularity of snowboarding was apparent at the recent Winter Olympics in Turin, Italy. Relatively new events, like the half-pipe competition and the snowboard cross, drew some of the largest crowds of the games in person and on television. Zackfia, whose firm makes a market in shares of Zumiez and has an investment banking relationship with the company, estimates that the company "can expand its store base nearly fivefold to approximately 800 units, implying nearly a decade of growth at the current rate of expansion." Furthermore, she sees off-mall opportunities for Zumiez that could boost its ultimate store potential closer to 1,000 locations. If those expectations are even remotely realistic, then Zumiez looks to be nearing a sweet spot in terms of growth when compared with Wall Street's more mature specialty concepts. With only 174 stores, it's well behind Abercrombie, with 466 stores. Hot Topic boasts 661 stores, Aeropostale ( ARO) has 659, PacSun has 798 and American Eagle has 868. Zumiez opened 35 stores in 2005, and it plans to open 42 in 2006. If it can manage to keep its cachet with the youngsters intact while it grows to Wall Street's liking, today's rich valuation could be tomorrow's bargain. The company sells both hard goods, like skateboards and helmets, and soft goods, like sneakers and apparel, which could give its brand more sticking power than its fashion peers have. Of course, contrarians may want to look to Zumiez's only dissenter on Wall Street, Ivan Feinseth, director of research at Matrix USA. Feinseth, who works for an independent firm with no investment banking business, holds a sell rating on the stock on the basis that it's overvalued. "They've had a good performance, but it's fading, and all the growth expectations in the world are already more than priced in here," Feinseth says.
He avoids traditional accounting measures of performance when evaluating a stock. He bases his analysis on a methodology called EVA, or "economic value added," which looks at a company's return on capital minus its cost of capital. Feinseth rates stocks using a screening system that combines various operating performance, risk and valuation factors. By his calculations, Zumiez averages a 10.2% return on capital and an 8.3% cost of capital. That indicates a decent performance, but he notes that its return on capital posted a steep decline in 2005 from 13%. "Sales have increased, but capital investment has also increased and there's evidence that their ability to generate economic value for shareholders is deteriorating as they grow," Feinseth says. "At this valuation, the stock could eventually collapse if the economic profits do not improve." If Zumiez's valuation has run out of whack, it may take a glitch in its sales numbers to provoke a selloff and force investors to take a more sober look at the stock. If, like Hot Topic, Zumiez should lose its alternative edge with its core customers in its pursuit of mainstream growth metrics, shareholders could find themselves singing "Roadhouse Blues." By then, a new bad boy will undoubtedly be coming on the scene through Wall Street's revolving doors of perception.