In the last few years, we've seen the demise of such retailers
as Bombay, Linen & Things and Circuit City. These firms were
ill-equipped to handle the duel pressures of a slowingeconomy and
the rising pressure of
and other retailers. And since retail spending continues to migrate
away from brick-and-mortar stores and toward the Internet, you can
expect to hear of a few more retail bankruptcies in the next few
But that doesn'tmean you shouldn't own retail stocks.
As I've said before
, retail stocks often make for excellent holdings coming out of the
clutches of a
. This is because, given the fixed-cost nature of retail, rapid
sales gains from increased consumer spending often lead to
substantial gains at the
. And this, in turn, often leads to big stock gains.
We already have a pretty good idea of which retailers will have to
close up shop. The
, devised by New York University Professor Edward Altman back in
1968, has an uncannily accurate track record of predicting
bankruptcies well before they happen. In his first set of tests,
Altman found that 72% of companies that were predicted to head to
bankruptcy within two years actually did. The methodology can be
applied to virtually any industry, but has been especially
prescient in the retail space.
Using this nifty tool can help investors get a handle on which
retail stocks are likely safe bets and which should be avoided or
considered ripe for short-selling.
How it works
The Z-Score looks at seven financial indicators found on the
, and then pairs them up in a set of five distinct ratios. These
ratios are then assigned a weighting, and when tallied up,
I recently did a Z-score calculation for more than 100
View the results here
Altman figured any retailer with a Z-Score above 3 could be
considered safe. Readings between 1.23 and 3.0 are in the "grey
zone," and any retailers that generate a reading below 1.23 are
likely headed for deep trouble. The charm of this analysis is that
you can make a spreadsheet (or use the one we've created) and
simply update the numbers every quarter. This will give you an
early read on retailers headed into distress and which ones are in
So which retailers appear to be in the most distress? Take a look
at this shortened version of my calculations below...
heads the list -- by a considerable
, likely because the retailer has roughly $800 million in
on the balance sheet. That's a past-looking metric and not really
all that helpful in determining future financial distress. The
company is trying to re-invent itself from a purveyor of open
source software to a full-fledged e-commerce site. Geeknet was
unprofitable in its former incarnation, and remains unprofitable
with its new initiatives. However, with $25 million in cash and a
small burn rate, the Z-Score rating may not be an accurate gauge in
Further down the list, a pair of companies caught my eye because
their business models look increasingly unviable. Both
are industry laggards in brutally competitive environments. It
wouldn't take much effort by
to put the hurt on Rite-Aid by kicking off more price wars.
Eliminating weakened rivals through aggressive pricing is a
long-standing retail industry trick, used by
Best Buy (NYSE:
to smother Circuit City and
Pier One Imports (NYSE:
to put the screws to Bombay. In a similar vein,
could make life miserable for OfficeMax, if it so chose.
Action to Take -->
You should keep tracking these retailers in order to keep tabs on
your long positions as well as hunt for potential
The Z-Score will be back in vogue if the
weakens anew. But the Z-Score is just a starting point. It
sometimes points to companies that are not truly on the cusp of
deep financial distress, but the methodology does have a clear
positive track record.
-- David Sterman
P.S. -- We've just identified six surprising events that could
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Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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