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As consumers continue to tighten their belts, a world of hurt is hitting retail businesses, wounding or even bankrupting weaker companies such as Sharper Image and Linens 'n Things.
For investors, it's time to play a real-life game of "Survivor." Identify the winners, and there's a chance to make a bundle.
"It's just a tough environment out there," says Keri Spanbauer, a retail sector analyst at Thrivent Financial for Lutherans. "Maybe the consumer pulls back, but if your competitor next door goes out of business, you can do well."
And finding those fittest companies, as well as their sickly competitors, may be as simple as doing a little balance-sheet reading, looking for companies not saddled by debt.
After doing a bit of that work, with help from a few money managers and analysts, I've decided in favor of:
- Barnes & Noble (BKS, news, msgs) over Borders Group (BGP, news, msgs), which is on the ropes financially.
- Wal-Mart Stores (WMT, news, msgs), Costco Wholesale (COST, news, msgs) and Kohl's (KSS, news, msgs), three big national chains with the financial strength to bury smaller regional competitors.
In one case, I'm betting on the underdog, Circuit City (CC, news, msgs), against Best Buy (BBY, news, msgs), in part because so many buyout offers are in the air. Likewise, Credit Suisse Group retail sector analyst Gary Balter, who has been guiding clients on how to play this trend in the retail sector for months now, thinks Office Depot could see upside as a take-out candidate.
The gain in more pain
Although there are some reports of the credit crisis coming to an end, and though consumers are starting to receive tax rebates from the government, it's not too late to place bets on the retail sector. Many analysts expect a long and slow recovery at best, which means more pain for the weaker retailers."If the economy is anywhere near as weak as everybody seems to think, we will see some more retail bankruptcies," says George Putnam, the editor of The Turnaround Letter, who as a value investor watches troubled companies closely in economic downturns for investment opportunities.
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"The future is one of pain and consolidation, and buying well-positioned, cash-rich retailers will be the way to win," Balter agrees.
Here's how the retail sector got into this mess: During the previous bout of economic good times in the late 1990s, many retail CEOs called a truce on price wars, making it easier for second-tier competitors to thrive, Balter says. Second-string retailers got another boost from the consumer-spending bubble created by the home-equity-loan boom and tax cuts. And low interest rates gave the retailers access to cheap money, which they used to open more stores.
Now as the consumer cuts back, the sector needs to shed its excess supply -- as expressed in square footage of store space -- after a period of excess. Balter expects many more retail sector bankruptcies over the next 18 months. When competitors go into bankruptcy, it's easier for them to get out of leases and close stores, leaving the field open for the stronger survivors.
Bed, bath & a bankrupt competitor
Bed Bath & Beyond has been duking it out with competitor Linens 'n Things in a price war for months. It was an uneven match from the start."With its stronger balance sheet, Bed Bath & Beyond was able to play the game much longer than Linens 'n Things," says Thrivent's Spanbauer. Bed Bath & Beyond recently had $224 million in cash and no debt.
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How retail chains are doingPatti Freeman Evans of Jupiter Research and Margaret Brennan of CNBC break down the mixed picture for April same-store sales.
Earlier this month, Linens 'n Things, a private company owned by Apollo Management, cried "uncle" and declared bankruptcy.
In the near term, Bed Bath & Beyond may take a hit if Linens uses clearance sales as it executes plans to shutter 120 of its 596 stores. But longer term, market-share gains will mean higher earnings for Bed Bath & Beyond.
Balter calculates that if Linens 'n Things disappears completely -- which he thinks is possible if consumer spending stays weak and competitors keep up the pricing pressure -- it could add 50 cents a share to Bed Bath & Beyond's annual earnings. That's significant: Analysts project Bed Bath & Beyond will earn $1.82 a share in the fiscal year ending in February 2009.
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