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Insiders are bailing on specialty retailers
With valuations high and the chances of beating last year's stellar numbers low, execs at stores Chico's, Starbucks and Quiksilver are taking their profits now.
By Michael Brush
Specialty retailers are back as Wall Street darlings.
Its easy to see why these sellers of trendy apparel, food and other items are surging:
- Theyre hitting the style trends just right. Their T- shirts and denims for teens, plus their sensible outfits for moms, are flying off the shelves.
- Inventories are lean and clean. That means stores dont have to kill profit margins by slashing prices.
- An improving national economy has bolstered business. Some analysts believe the strong consumer spending trends could continue for the rest of the year. One helpful factor: the upcoming round of tax refunds.
Given these favorable trends, its no surprise that many specialty retail stocks -- including American Eagle Outfitters (AEOS, news, msgs), Aeropostale (ARO, news, msgs), Chico's FAS (CHS, news, msgs), surfwear retailer Quiksilver (ZQK, news, msgs) and Starbucks (SBUX, news, msgs) -- are now flirting with 52-week highs.
Not so fast
But are these stocks really poised to go higher?
Check in with the managers at the very top of these popular retail chains, and the answer is clearly No. Theyre not openly giving advice on whether to buy their stocks, of course. But if actions speak louder than words, theyre shouting Sell! at the tops of their lungs.
As of the third week of March, insiders at specialty retail companies dumped a near-record $850 million worth of their own stock so far this year. Top managers at Chico's FAS, who are consistently good at coming up with leading fashions for women over 35, have staked out the lead in insider selling, as well. Consider Chico's co-founders Marvin Gralnick and Helen Gralnick -- hes chairman, and shes senior vice president for design and concept. Together, the couple sold $23 million in the middle of March for as much as $46.70 per share. All together, Chico's insiders have sold an awesome $40.7 million in stock this quarter. Thats nearly three times the average over the past five years, and theres still a week left in this quarter to sell more.
Insiders at American Eagle dumped $9.62 million worth so far this year. Thats the most they have sold in a single quarter since the third quarter of 2001, says Kevin Schwenger, an analyst who helps track insider activity at Thomson Financial. American Eagles Michael Leedy, vice president in charge of strategic planning, sold over $4 million worth in early March for as much as $24.50 per share. And at Quiksilver, insiders sold $8.55 million, the highest in five years. Quiksilver CEO Robert McKnight Jr. sold $8.3 million worth for as much as $21.44 per share in the middle of March.
| Retailers ripe for selling |
Company | Recent stock price | 1st qtr. 2004 insider selling* | Avg. quarterly insider selling** | Projected annual earnings growth | P/E ratio | PEG ratio*** | | American Eagle Outfitters (AEOS, news, msgs) | $25.40 | $9.6 million | $26.4 million | 13% | 20.00 | 1.54 | | Aeropostale (ARO, news, msgs) | $34.90 | $23.8 million | $8.9 million | 23% | 19.83 | 0.86 | | Chico's FAS (CHS, news, msgs) | $43.10 | $40.7 million | $14.6 million | 24% | 29.32 | 1.22 | | Pacific Sunwear (PSUN, news, msgs) | $23.10 | $19.9 million | $4.3 million | 19% | 18.63 | 0.98 | | Starbucks (SBUX, news, msgs) | $37.10 | $49.2 million | $16.7 million | 19% | 42.16 | 2.22 | | Quiksilver (ZQK, news, msgs) | $21.30 | $8.6 million | $1.6 million | 17% | 17.04 | 1.00 |
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*as of March 17. **Over the past five years. ***P/E ratio divided by growth rate. Source: Thomson Financial
Despite the avalanche of selling, money managers enjoying the ride in these stocks dismiss the insider activity as insignificant. Its little more than natural profit-taking by insiders after some good moves in their stock, they say. The insiders still own huge positions in their own companies, they argue, so dont worry.
But history says worrying is exactly what you should do. In most cases, anyone still holding these stocks is likely to wish he had followed the insider cue and sold right now.
Here are the five main reasons.
Insider selling is near record highs
Despite what the bulls think, the selling so far this year is anything but normal. Insiders at specialty retail chains dumped $341 million in stock in January and $324 million in February. History clearly shows this is a red flag. Whenever selling goes above $300 million for a quarter, specialty retail stocks are typically a lot lower a few months later.
Bulls argue that insiders are selling in all sectors across the market, so whats the big deal? Well, its much worse at these retailers. The ratio of selling to buying, as tracked by Thomson Financial, stands at 231 to 1 over the past 90 days. That means for every dollar worth of stock purchased, insiders sold $231 worth. That puts specialty retailers in the top 25% of all sectors, ranked by this sell-buy ratio.
At two of the most richly valued specialty retailers, Chico's FAS and Starbucks, insiders were dumping shares at considerably more than twice the average five-year rate, according to Thomson Financial. Its the same at Aeropostale. These are compelling numbers that should make you head for the hills if you own these stocks.
Retailers face tough 'comps'
Why are insiders dumping so aggressively? One reason: Stores are coming up on some tough monthly comps. Thats industry jargon for sales gains at stores that have been in business for more than a year (so-called comparable stores).
Heres the problem: After hunkering down during the buildup to the invasion of Iraq a year ago, consumers went on a shopping spree once the Iraqi regime collapsed and tensions eased. That spree continued into the fall. Soon, retailers will have to beat those records set last year when the consumer bounced back. The crunch should start this summer.
Insiders know very well that their stocks will sell off if they dont keep beating the comps. Judging by how quickly theyre selling their own shares, it looks like many of them dont want to take any risks. These guys are sitting there saying, I know I cant make my comps, so I am getting out of these stocks now, says John LaForge, a portfolio manager at First Albany Asset Management.
You might think that comps dont matter, because many of these hot retailers are getting a lot of their growth by building new stores. You would be wrong. Comp-store sales is a measure of the health of the store concept, says Jonathan Mueller, a senior stock analyst with Aim Investments. You can grow square footage for a while, but eventually it is not sustainable.
Valuations look rich
Starbucks looks the worst, by one basic valuation measure known as the PEG ratio. To get a PEG ratio, divide the price-to-earnings ratio of a stock by its projected growth rate. With a PEG ratio of 1, a stock is considered fully valued by many investors.
Starbucks has a PEG ratio of 2.2, and American Eagle has a PEG ratio of 1.5. Chico's FAS looks rich, too, even though its PEG ratio is a bit lower at 1.2. Thats because with a P/E of around 29, Chico's FAS is trading right up against its all-time high valuation of 30 times forward earnings.
The valuations of some of these really are stretched, says Neil Hokanson, president of Hokanson Capital Management. Starbucks and Chico's come to mind. If they have a glitch at all, they are going to get hit, he says.
Indeed, a mere analyst downgrade of Chico's FAS by Jefferies last week -- on the grounds that it looked too expensive -- immediately shaved several points off the stock. (It dropped nearly $4 a share to $42.25 by Monday.) Jeffries isnt the only sell-side shop starting to question the valuations on these specialty retail stocks. To justify the current price, Chico's FAS would need to achieve margin expansion of 2.5 percentage points from its current peak level of 23.8%, says Credit Suisse First Boston analyst Richard Baum. While Chico's FAS management is among the best in specialty retail, we question whether they can pull off such a feat.
The consumer may run out of steam
Thanks to low interest rates that sparked robust mortgage refinancing, consumers raised enough cash to keep spending right on through the recession. But now, the mortgage refi boom may be coming to a close. And its not clear to anyone that this recovery will spark enough new jobs to pick up the slack.
That may be why consumer confidence slipped in February, a month where hardly any new jobs were created. If the trend continues, that could spell doom for retail stocks. Consumers seem to be cooling their jets, so we are laying low, says Louis Navellier of Navellier & Associates. I have no exposure to retail. We have been sellers of all those stocks.
The high price of gasoline -- with oil trading at 13-year highs -- wont help either. Every penny increase in the price of gas diverts $1 billion annually from spending on other things -- like the products these retailers sell.
We need to see employment growth and real wage growth, because all of the possible stimulus is already out there, says AIMs Mueller. We are watching very closely, but we are not making a big bet on retail stocks right now.
Indeed, the nations manufacturing activity was at its highest level in 20 years during January, but it slipped in February, suggesting the rate of growth in this economic cycle may have peaked. (For more, see my column 12 stocks for the recovery's next phase.) And dont forget about the impact of the presidential cycle on the economy. As a rule, growth typically slows down after a presidential election: yet another warning sign for anyone holding these retail stocks.
The dreaded fashion miss is always lurking
Heading the list of potential risks is the dreaded fashion miss. This is a particular hazard for retailers catering to fickle teens, including American Eagle, Aeropostale and Pacific Sunwear (PSUN, news, msgs). Probably not coincidentally, these are companies where insiders have been selling heavily.
By definition, retailing is a fashion business, says Hokanson. People in the business realize that what is in fashion now wont be there forever. So they ring the bell and sell stock whenever they can, in case their lines go out of fashion.
Some stores thrive, but retail stocks can wait
To be sure, some of these companies dominate such a strong niche that they might just power through the challenges ahead. Bill McVail, a portfolio manager at Turner Small Cap Growth fund (TSCEX, news, msgs), steers clear of teen retailers such as American Eagle, Aeropostale and Abercrombie & Fitch (ANF, news, msgs) because they are competing for the same teen fashion dollar with lineups that have a fair amount of overlap.
But he argues that the Pacific Sunwear d.e.m.o. stores have just what he looks for in a retailer -- a highly differentiated offering catering to strong demand. Pacific Sunwear d.e.m.o. stores sell hip-hop clothes and accessories to suburban teens. Suburban teenagers see Jennifer Lopez in a video on MTV, and she has a certain Sean Jean look head to toe. And they walk into d.e.m.o. and say, I want to look like that, McVail says. They want to get all blinged out. And in suburbia there just arent a lot of options if you want that fashion.
Like McVail, Paul Ariano of Wall Street Associates thinks Hot Topic (HOTT, news, msgs) has a defendable turf, selling so-called goth and alternative clothes and accessories to teens. He also thinks Urban Outfitters (URBN, news, msgs), which sells 1970s-style clothes and accessories to modern-day bohemians, has a strong enough concept to keep growing. They can double their store base, he says.
But Hokanson, who likes growth stocks but only at a reasonable price, thinks its better to get out of any of the specialty retail stocks if you own them and simply wait for better buying opportunities in the future.
They are coming back to earth, so there probably will be some good buys at some point, he says. But not yet.
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