Is Traditional Retail Structurally Challenged?

One of the key secular growth trends set to dominate retail over the next few years is the transition from bricks and mortar sales to online sales.  Another, more cyclical, theme relates to the unequal nature of the economic recovery.  Put simply, emerging market demand is pushing up the price of those goods that the lower income groups spend a larger part of their discretionary income on.  So with higher food and energy prices there will be less spend on consumer discretionary for lower income groups.

Putting these two themes together, it is not hard to see that businesses like Best Buy $BBY, Family Dollar $FDO and Dollar General $DG should be structurally challenged. Indeed, Best Buy gave Q4 results recently and it disappointed the market with its outlook and guidance. However, the likes of Nordstrom $JWN and Coach $COH (Japan aside) have been demonstrating good growth.  Moreover, companies like Amazon $AMZN and Walmart $WMT are key beneficiaries because they both can grab market share from the likes of Best Buy.

What Best Buy Earnings are Telling the Market

Best Buy gave numbers and guidance

• Full Year Guidance of $3.30-$3.55 vs. $3.56 estimates
• Q4 revenue decline by 2%
• Same stores sales decline of 4.6% partially offset by new store growth!
• Gross Margin expansion

Clearly, Best Buy has some issues to deal with and the company was quick to cite disappointing sales of higher margin TV sets and net book sales. Moreover, declining sales has had an effect on inventory and analysts were quick to focus on the rising inventory plus working capital requirements. High inventory is a problem because it implies a reduction in future margins (to shift slow moving stock) and it also raises question about the structure of the business.

 

($m)	2008	2009	2010	2011
Revenue	40,023	45,015	49,694	50,272
Inventory	4,708	4,753	5,486	5,897
Revenue/Inventory	8.50	9.47	9.06	8.53

So we see that the revenue/inventory ratio is rising. This is not usually a good sign.

The Case for Making Best Buy a Best Buy?

The positive case for Best Buy is best made with reference to its evaluation and restructuring program. The decline in sales could be seen as a result of an unfavourable product sales mix (TVs, net books, lack of new upgrade cycles for windows) and the difficulty of beating tough comparable sales. There is no doubt that Best Buy is generating huge amounts of free cash flow and it is capable of using this cash to generate EPS growth via share buy backs. Indeed, current analyst (and company) estimates do not account for buy backs. More importantly, Best Buy is generating the cash in order to restructure the business.

The restructuring program centres on shifting sales towards things like Best Buy Mobile, tablets and gaming. In addition, Best Buy is reducing the size of stores in the US so the possibility exists for an increase in sales per square foot as well as learning how to maximise sales in new stores.  Gross Margins rose in these results and the company has been aggressively controlling SG & A costs. Initiatives like ‘buy online pick-up in store’ are intended to differentiate Best Buy from online only competition and are reflective of how Best Buy is competing.

We can see these issues reflected in gross margin growth which has been in sequential decline.

($m)	2008	2009	2010	May-10	Aug-10	Nov-10	Feb-10	2011
Revenue	40,023	45,015	49,694	10,787	11,339	11,890	16,256	50,272
Gross Profit	9,546	10,998	12,160	2,793	2,918	2,983	3,943	12,367
Gross Margin	23.9%	24.4%	24.5%	25.9%	25.7%	25.1%	24.3%	24.6%

However, on a yearly comparison Q4 gross margins were actually up.  

Best Buy a Structurally Challenged Stock?

The negative case centres on the argument that-despite the cheap evaluation-Best Buy is structurally challenged and these issues will see a future decline in earnings and cash flow generation. For example, a comparable retailer in the UK is HMV (cds, dvds, games etc) and this company looked very cheap for a long time on traditional evaluation metrics. However, the share price continued to decline with ongoing structurally challenges. This is a significant point because Best reported that European sales growth and gross margins were negative.  As HMV went, so could Best Buy.   Indeed, many of Best Buy’s initiatives are focused on restructuring to face the online threat, but is the company capable of meeting these challenges?

For example, reducing store size is wonderful, but it implies reduced sales of ‘bulky’ products and these products tend to be those sold in store.  Retailers tend to buy IP based purchases online and it is this type of purchases  (mobile, tablet, gaming etc) that Best Buy think it can expand into. Furthermore, opening new stores when existing sales are in decline is usually a bad move in retail. It suggests that the company will be implementing more of a failing business model or sales mix.

Similarly, new technological developments like customers being able to scan barcodes and search online for cheaper alternatives will challenge Best Buy margins and sales growth. Moreover, online retailers specialise in ‘long tail’ provision, so if Best Buy wants to compete with them they will have to hold larger inventory and that will eat into cash flow generation.

Essentially, new technologies and ‘convergence cannibalisation’ (ex cameras, computers, phones, ipods merging into a single device) from companies like Research in Motion $RIM and Apple $AAPL are challenging retailers like Best Buy. Unfortunately, this comes at a time when discretionary spending in middle income America is being pressured by high food and energy costs.

Whilst Best Buy Mobile sales growth is good, this could be seen as being driven by a cyclical uptake of things like smart phones of which Best Buy is not particularly well positioned to take advantage of for follow up sales.

Is Best Buy a Stock to Buy?

On balance, I think not. The stock trades at $29.22 and has an EV of $13.45bn.  I think that history shows us that despite the superficial attractions of a high free cash flow yield (above 10%) and low P/E ratio of 8.8x  the structural trends against this business are significant. I would look for a fall in comparable sales to revenues ratios before considering a long term purchase of this stock. For short term investors, I suspect that given improved macro-economic fundamentals there is some upside here because investors will like the evaluation-after all every stock has a price- but I think the challenges for Best Buy will accelerate and, I place little confidence in the forecast estimates.

Wabtec is a Good GARP Stock Exposed to Increased Rail Spending

 

Wabtec $WAB is the sort of stock that should be bought in these uncertain times. The company is a provider of a range of products to the freight and passenger transit rail markets. As such, its demand drivers are increased car load traffic and the new production of railcars. The former is usually caused by increased economic activity and the latter by new investment in rail and/or new investment in railroad infrastructure.

Wabtec is the only company on the New York Stock Exchange which has seen its share price rise, every year, for the last ten years. It is highly cash generative and boasts an impressive track record, combining cycle growth and the ability to cut working capital in a downturn. Over the last few years Wabtec has used its cash flow generation to make accretive acquisitions and the business has longer term prospects to expand internationally and benefit from emerging market growth.

Within the last few years in the US, freight has grown strongly whilst transit has been flat and this is largely a consequence of budget issues at transit agency customers. Obama has been asking for additional funding and has been aggressively pushing plans for high speed rail. That said, it is probably better to think of these initiatives (high speed rail etc) as potential upside rather than baking them into forecasts

Wabtec Long Term Growth Drivers

Firstly, increasing urbanisation (particularly in emerging markets) should fuel growth in intercity rail investment. Similarly, greater globalisation and production shifts will encourage the necessity for increased mobility in both transit and freight markets.

Secondly, railways are a more energy-efficient way to move people around. The US is such a huge consumer of gasoline partly because it was built on highways rather than railroads.

Thirdly, railway infrastructural spending is a great way to secure job growth and also encourage greater efficiency in transport.

Fourthly, Wabtec's freight demand should see increases with the expected growth in transport of bulky materials like grains and coal in the US. Not only are food and energy requirements growing, but the US looks set to export more (wheat etc) and this requires transportation to external hubs.

Finally, there is a clear need for ongoing infrastructure investment in railroad networks in emerging markets.

Wabtec is well placed in the service, renewal and replacement market and the continued global expansion of rail networks should see increases in the global fleet. A quick look at sales and earnings growth over the last few years reveals that margins have grown well...

(m)	2006	2007	2008	2009	2010	2011E	2012E
Sales	1,088	1,360	1,575	1,402	1,507	1,690	1,840
growth		25.1%	15.8%	-11.0%	7.5%	12.1%	8.9%
Gross Profit	197	370	427	393	449	490	534
Gross Margin	18.1%	27.2%	27.1%	28.1%	29.8%	29.0%	29.0%
Net Income	85	110	131	115	123	141	165
EPS	1.76	2.23	2.67	2.39	2.56	2.94	3.44
growth		26.7%	19.7%	-10.5%	7.1%	14.8%	17.0%

Source: Company Results, Analyst Estimates, Earnings View

...and as discussed previously, Wabtec does a great job in cash flow conversion...

(m)	2006	2007	2008	2009	2010	2011E	2012E
Operating Cash Flow	151	143	159	162	176	200	234
% Net Income	178%	130%	122%	141%	143%	142%	142%
Capex	21	20	20	18	21	25	27.6
Free Cash Flow	130	122	140	144	155	175	207
growth		-6.1%	14.4%	3.1%	7.8%	12.8%	18.0%

Source: Company Results, Analyst Forecasts, Earnings View

Wabtec Evaluation

 Any stock needs to be evaluated on a risk/reward basis and it is no different with Wabtec. However, this stock represents a relatively safe way to acquire an earnings and cash flow stream. It should be compared to a US ten year note and a risk premium attached to it. That said, if Wabtec hits targets than there is a strong case for it being fairly valued at present...

 

Ratio	2006	2007	2008	2009	2010	2011	2012
P/E	32.7	25.8	21.5	24.1	22.5	19.6	16.7
FCF/Sales	12.0%	9.0%	8.9%	10.3%	10.3%	10.4%	11.2%
FCFYield	4.7%	4.4%	5.1%	5.2%	5.6%	6.4%	7.5%
FCF/EV	4.5%	4.2%	4.8%	5.0%	5.4%	6.1%	7.2%

Source: Company Reports, Analyst Forecasts, Earnings View

...and ‘fairly valued’ is fine because if it hits earning forecasts then the stock price should be able to ‘do its earnings’.

Wabtec was added to the portfolio at $56 with a $64 price target.

Nice Systems Benefits from Increased Regulatory and Compliance Requirements

Nice Systems $NICE is a, err, NICE way to play the growing trends towards regulation and security management within financial services. Nice gave results recently and announced an acquisition which was well received by the market. With the implementation of Dodd-Frank and the increasing needs for firms to manage security and work flow optimisation, Nice looks set to grow strongly.

Nice Systems helps companies to extract insight from interactions, transactions and surveillance. The information is gathered from a wide range of different sources, from emails and phone calls to video surveillance. Nice should see good growth as financial firms start to spend again to support expansion and deal with mounting compliance and regulatory issues. For example, the Dodd-Frank legislation is expected to lead to many more firms being regulated.

Furthermore, financial firms and Governments are under increasing pressure to protect themselves and the company from internal and external security threats as well as ensure that work flow is being properly managed. These words sound abstract, but consider Nick Leeson and Jerome Kerviel, both of whom benefitted from lax monitoring and compliance controls.


Nice Systems Results

Turning to the recent results

• Q4 Revenues of $187m vs. $180m estimates
• EPS of 51c vs. 49c estimates

Guidance

• Q1 Revenues of $179-$183m vs. $179.3m
• Q1 EPS of 43-27c vs. 45c estimates
• Full year Revenues of $775-800m vs. $768.5m
• Full Year EPS of $1.96-2.06 vs. $2.02 estimates

It should be added that the guidance includes the impact of the CyberTech acquisition ($25m to full year revenues) which is expected to complete at the end of March. Nevertheless, the guidance for Q1 is an upgrade and Nice beat Q4 estimates handsomely.


CyberTech Acquisition and Nice Systems Position

 Essentially, Nice Systems is positioned at the high end of the Work Flow Optimisation market. As such, Nice tends to offer relatively expensive large scale solutions to the enterprise market. Whilst this leaves them exposed to cheaper competitors chasing Nice's installed base when they come to upgrade or renew, it also ensures that Nice offers a comprehensive best in class solution.

The CyberTech acquisition is intended to give Nice some complimentary solutions and also allow Nice to offer sales with a lower Total Cost of Ownership (TCO). In particular, CyberTech offers compliance recording solutions and has a good position within European financial services firms. CyberTech is not only a good technology fit but also a good geographic one too, as Nice's current strength is in the US and Asia. Buying CyberTech will also allow Nice to make inroads into the previously uncharted SMB territory.

One area of possible concern is public sector end demand, but it is probable that this is an area whereby Governments will be highly reticent to cut. Work Flow Optimisation gives a tangible return on investment and much of Nice end demand is regulatory and compliance led. Another cause of worry could be an increase in the demand from organisations for their WFO solutions to be sold by their contact center infrastructure provider. Although, Nice is focused on the high end so this trend is unlikely to have a great affect.


Nice on a Nice Stock Evaluation?

With a stock price of $35.36 Nice has a market cap of $2.22bn and an Enterprise Value of $1.92bn with a highly cash generative business model. The current PE ratio is 35.36/1.85=20.2x and Nice trades on 17.5x forward earnings. Turning to free cash flow Nice just generated $133.3m which puts the company on a FCF/EV= 6.9% which is very good. With some back of envelope calculations it is not unreasonable to expect Nice to translate the forecast $129.5m in net income into around $145m in free cash flow which would put the company on a forward FCF/EV of 145/1920=7.5% but it should be noted that the forecast tax rate for 2011 is only 17-18%

If you-very conservatively-adjust the numbers for a 30% tax rate the reduction could come to around $19m which would give an adjusted FCF/EV of  126/1920=6.6% approximately. If investors want to buy a stock on a forward ratio of 5.5% then this would give a of around $42.2

I bought some with this target in mind.