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EXECUTIVE SUMMARY:

• Economic data points to weaker retail sales.

• Retail stocks have been bid to lofty levels, creating a gap between reality and expectations.

• A weakening / retrenching consumer could be the driver for a sharp decline in select overvalued retail names.

• Three “luxury” retail names present opportunity as short sale targets (pending price action confirmation):

• Lululemon Athletica (LULU)
  
• Tiffany & Co; (TIF)
  
• Limited brands (LTD).

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Consumer retail is an attractive area for short candidates at present.  In addition to a wide gap between reality and expectations as reflected in the data, price action in the S&P retail Index (XRT) shows a sharp break in the trend, signaling a possible inflection point for the group.

As the consumer retail outlooks threaten to crumble under the weight of stubbornly high unemployment, increasing consumer tax burdens, and broad economic weakness, the following three retail short candidates offer strong opportunities.

Lululemon Athletica (LULU)

• This highflying Canadian retailer has created its own market.

• The yoga apparel craze smells of “fad”.

• At 30x earnings, LULU’s share price could decline significantly – and still be pricey.

LULU is a “designer and retailer of technical athletic apparel primarily in North America” (Reuters).

The yoga-inspired Canadian firm has expanded rapidly into the US.  Rather than generating sales through the traditional approach of capturing market share, however, Lululemon Athletica has literally created a new market for its high-priced athletic apparel.

The merchandise is typically made out of organic material, giving the company an eco-friendly reputation which has helped create an avid following and has propelled impressive growth.

Fad Alert

As is typically the case with trendy, new retail concepts, shareholders have latched on to the growth concept and have bid the stock sharply higher.

While the stock price was under significant pressure during the financial crisis, earnings continued to grow as management continued to open new stores in the US.  As retail stocks rebounded, LULU actually rallied 800% from its low in March of 2009.

But despite the strong performance of the company, it now appears that shareholders have gotten a bit ahead of themselves and the stock multiple has become excessive.  At the current price in the low $40’s, LULU is trading at about 37 times expected earnings for fiscal 2011 (the fiscal year ends Jan 31).

Analysts are expecting further growth in fiscal 2012 with consensus estimates of $1.43 – but even using these optimistic numbers, the stock is still trading at 30 times long-term expectations.  This multiple might be justified in a bull market, but LULU is not going to be immune to broader weakness in the retail area.

Premium Prices Create Liability

A quick browse through online prices for merchandise reveals a fairly expensive stable of items.  For instance, the cheapest top in the women’s section is priced at $48 with most items between $58 and $108.  (For whatever it’s worth, the $48 top is a simple form fitting white tee – not exactly “value” priced)

Of course LULU has built its brand around quality and needs to generate a premium price for this merchandise.  But with unemployment high and retail sales beginning to feel the effects, high-priced luxury items are likely to fall to the bottom of many consumer’s priority list.  And while that won’t put Lululemon out of business, it could have a significant effect on both forward earnings expectations and more importantly on the multiples that investors are willing to PAY for those forward earnings.

When consumer weakness catches up with LULU, management will likely have some very difficult choices to make.  The temptation to discount items in order to keep inventory moving will have the effect of reducing gross margins (which sends up a red flag to institutional investors).  Considering the excessive overhead costs associated with luxurious wide open retail floorplans, and the typical on-site yoga professional, a decline in average ticket price would be very concerning.

As an aside, excessive discounting of merchandise could have the effect of eroding the company’s brand image which holds a certain air of exclusivity…

On the other hand, if management decides NOT to discount in the face of weakening consumer demand, then sales growth will likely stall and inventory could quickly pile up.  A healthy balance sheet means that LULU won’t suffocate under the capital weight of inventory, but since the stock is priced for excessive growth, any unexpected increase in inventory levels would send a disturbing signal to growth mutual fund managers who would immediately begin to revise their models.

Fundamental Pricing (For When Fundamentals Matter)

Right now investors don’t give a hill of beans what the “proper” valuation of LULU’s stock should be.  It’s much more of a momentum play where managers are searching for exposure to the name regardless of what they have to pay for it.  But we’ve seen this story time and time again – and eventually the fundamentals DO matter.

I’m expecting the 2012 consensus estimates to be revised lower.  This expectation is simply based on the macro picture for the US consumer, and the challenges I expect the company to face as it tries to expand in an environment of flat to negative economic growth…

Let’s assume that over the next several months, analysts revise their 2012 projections a tad lower to $1.25 (I think we could see much deeper cuts but let’s consider a relatively optimistic scenario).  The negative revision would likely be a major surprise to investors who are conditioned to expect gradual increases in guidance and consensus numbers.  As a result, it would be difficult for managers to justify paying more than 20 times 2012 expectations – after all, the growth is no longer a “given.”

Obviously, a forward PE of 20 using earnings expectations of 1.25 would put the stock price at $25.00 – good for a 42% decline from the current range.

Timing will be critical as no trader wants to commit capital until the decline is imminent.  The company just announced Q1 earnings on June 10 and won’t report again until September.  However, analyst reports on “channel checks” along with broad retail reports could provide catalysts for the stock to begin to trade lower – of course a downgrade or negative earnings adjustment by sell-side brokers would also be likely to trigger some pink sell tickets.

Tiffany & Co. (TIF)

• TIF’s high-priced strategy is vulnerable to consumer belt tightening.

• At $2.8B in sales TIF faces significant size vs. growth challenges.

• Dividend repurchases and stock buybacks suggest stagnation / lack of growth.

• 17X earnings for this stagnant name could become 10-12X earnings in this global deflationary environment.

Nothing says “I Love You” like a shiny gift in a blue box and a five figure addition to the debt load…

Tiffany & Co. (TIF) has built a reputation around luxury retail – offering the very best in quality and craftsmanship with little regard for pricing.  This focus goes a long way towards cementing the company’s loyal and deep pocketed clientele base – but also creates difficulty in securing NEW clients during economically trying times.

With an internationally recognizable brand, Tiffany & Co. was one of the chief beneficiaries of expansion in emerging markets as upper class populations in all corners of the world looked for places to spend their newfound wealth.  The financial crisis of 2008 seems just a blip on the radar now as the stock has rebounded from its swoon to within striking distance of the high set in 2007.  And management proudly reported a 118% increase in profits during the first quarter of 2010 – forecasting a record earnings year for the company.

But despite the brave words and impressive statistical feat, TIF is likely to face significant weakness in the months ahead as a number of headwinds create difficulty.

• Emerging markets are hunkering down in anticipation of a decline in stimulus spending
• Austerity programs threaten to cut the spending power of retirees across Europe
• High levels of debt in the US and other developed nations pressure discretionary spending
• Currency translation dilutes dollar reported earnings while dollar-based costs remain high

Using the high end of management guidance, Tiffany is currently trading at about 17 times forward earnings.  That doesn’t sound excessive initially, but keep in mind that Tiffany is a large robust company – not a small nimble growth operation.  During the last four quarters, the company booked $2.8 billion in sales and has only seen revenue begin to grow on a year/over/year basis for the last two quarters.

There’s no getting around it… It’s tough as nails to GROW a company that already has that kind of critical mass.

But while investors are still pricing the stock as a growth stock, management is sending not-so-subtle signals that the company has reached maturation and is now much more of a “cash cow” than a full-fledged growth machine.

The company has an excessive amount of cash which management is struggling to find a use for.  Twice in the past year Tiffany has increased their dividend payout, and the board has approved a large stock repurchase program.  All of these things sound like positive factors, but they point towards stability and NOT towards expected growth.  If there was a strong potential for growing the franchise, management would be using cash to open new stores and increase distribution channels.  But instead, the company has little use for cash and is returning it to shareholders.

The Potential Short Return

Based on the long-term stagnation in growth – coupled with significant business risk in a globally deflationary environment, I would expect TIF to work its way down towards a “fair value” of 10 to 12 times forward earnings.  Using consensus expectations of roughly $2.60 this year, that would put the value of the stock somewhere between $26 and $31.

But we all know that stocks don’t typically hover in a flat line around “fair value” but actually rise well above what can be fundamentally justified during times of optimism, and when things get difficult, equities typically fall well below a fair fundamental assessment of the value of the company.

So quite honestly, once retail stocks begin their decent in earnest, I expect TIF to slide much lower than what I would deem to be a fundamentally justified price.  Panic selling could easily cause the stock to test (or even break below) the March low near $16.70 and while I would likely be aggressively covering a short at that level, this would represent a 62% decline from the current price near $45.

There’s certainly a short-shot for this non-growth luxury retailer, and catching the right inflection points along the way could set up a very attractive series of trades.

Limited Brands (LTD)

• LTD earnings have been eye-popping… but only coming off a base of 1 penny per share.

• Red hot growth expectations coming off a (nearly) zero base will be impossible to sustain.

• Debt loads are significant; any earnings shortfall could be punished harshly.

The parent company of Victoria’s Secret, La Senza, and Bath & Body Works has had quite a run.  Rallying more than 450% from the low printed in March 2009, the company has also seen its earnings ramp sharply higher in the last three reported quarters.

Part of the excitement surrounding the stock is the fact that the October quarter generated a year-over-year earnings increase of 100%, the January quarter featured a 49% increase, and earnings for the most recent April quarter was up an astonishing 3,400%

But before you go out and snap up shares of this “incredible growth company” (said in jest), you should note that the prior year base for both the October and April quarter was a mere 1 penny per share.  It’s not that hard to generate eye-popping percentage increases when you’re starting from close to zero!

Now that the economic recovery has pretty much been accepted as a given, the company will have more challenging comps and will need to work a little harder to perform the kind of earnings magic that was reported over the last few quarters.  These feats will be especially difficult considering the fact that Limited is still not seeing any material growth in sales.

• July Quarter, 2009 – 10% drop in revenue
• October Quarter, 2009 – 4% drop in revenue
• January Quarter, 2010 – meager 2% increase in revenue
• April Quarter, 2010 – finally a 12% increase in revenue

Keep in mind that during the 2009 and 2010 quarters, revenue was being compared to the very difficult “financial crisis” quarters so I would have expected a growing company to have turned in much better revenue growth over the past year.

Debt Weight

One of the most concerning issues with LTD is the heavy debt load shouldered by the company.  Interestingly, the company doesn’t put balance sheet information in their quarterly earnings releases (possibly in hopes that the debt level won’t come up during the conference call) but as of the end of the fiscal year (Jan 31, 2010) Limited had $2.7 billion in long-term debt and another $731 million in “other Long-term Liabilities.”

Just using the long-term debt classification, the company has a 125% debt to equity ratio – that’s a pretty leveraged company, especially considering the difficult environment for consumers and the potential for a significant “hiccup” in retail spending.

Limited isn’t going to go into bankruptcy anytime soon…  Management is holding onto $1.8 billion in cash which will more than cover interest and principal payments for years to come.  But servicing this debt could certainly be a drag on future earnings – especially if the company continues to be unable to grow sales in any material way.

Shareholders are currently paying 14 times expected earnings for this year – but the estimates appear high.  Analysts are expecting 2011 to feature a 45% increase in earnings, but sales continue to be lackluster at best and the company is generating earnings growth by cutting out expenses rather than growing the company organically.  So what happens when management runs out of expenses to cut?!?

My suspicion is that LTD will earnings will come in at 80% of expectations – or less, and that investors will respond by cutting the multiple and paying only 10 times earnings.  Under this scenario, the stock would drop below $15, and lose roughly 40% of its market value.

After a relatively low-volume spring surge higher, LTD has run into resistance and the pattern has become much more volatile and broken the established uptrend.  At this point, I’m waiting for a clear breakdown in the stock – at which time I’ll be actively shorting and managing the position to create an increasing amount of exposure while locking in profits and tightening my stops along the way.

Regardless of the strength of the Victoria’s Secret brand, Limited Brands will likely lose luster in the eyes of investors and offer active traders some exceptional short opportunities this summer and fall.