This review of Saks Inc.'s earnings quality is the last in a series of commentaries about specialty retailers listed in the S&P400 index and, specifically, retailers that have cash management issues. Previously I looked at Ascena Retail Group , Chico's FAS , and Fossil .
Earnings quality is reflected in the financial statements
The Motley Fool offers two databases -- EQ Scan and EQ Score -- that are used to uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But, a critical eye on these statements can often uncover trends that could be important for investors to understand before hard-earned money is lost.
The EQ Score database assigns an index rank to the company from 1 (lowest quality) to 5 (highest quality). As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward.
EQ trends for specialty retailers with cash management issues
EQ Score Jan. 2012
EQ Score Feb. 2012
EQ Score March 2012
|Ascena Retail Group (ASNA)||1||1||3||Up||Cash Flow|
|Chico's FAS (CHS)||4||4||1||Down||Cash Flow|
|Fossil (FOSL)||1||1||1||Flat||Cash Flow|
|Saks (SKS)||Not Ranked||Not Ranked||Not Ranked||Flat||Cash Flow|
Source: Fool EQ Score, week ending March 9, 2012.
Ascena's EQ score has trended up, Chico's is down, and Fossil and Saks have shown no trend. All exhibit cash management issues. Regarding Ascena, I recently commented that its income statement and balance sheet metrics were very positive, and its cash management and cash flow, while showing signs of improvement, have been holding this stock back until recently. Chico's inventory levels have outpaced revenue growth, which has put the company's gross margin into a downward trend. Moreover, Chico's year-long spending spree has artificially boosted EPS through common shares repurchases, while net income increased only $29 million for the year. Fossil's income statement metrics were positive, but the rate of change in these metrics was slowing. Fossil's inventories, DSI, and accounts receivable were all growing. The company's cash conversion cycle was an unhealthy 116 days at the end of FY11.
Saks: Where the wealthy shop, but not where they invest
Saks may be a great place to shop, but Saks is not a great stock to own. From the chart above, the stock price generally correlates well with net income. Saks operates "high-end" retail stores in the U.S. under the Saks Fifth Avenue (SFA) or Saks Fifth Avenue OFF 5TH (OFF 5TH) brand names. Its stores offer an assortment of fashion apparel, shoes, accessories, jewelry, cosmetics, and gifts. As of Jan. 28, 2012, the company operated 46 SFA stores and 60 OFF 5TH stores.
The second chart shows revenue, gross margin, and Saks' typical retailer inventory patterns. Inventory peaks prior to the seasonal holidays, with the revenue peaks lagging afterward. The gross margin moves between 38% and 44%, but generally these three metrics are range-bound. The company's revenue grew slightly YOY (7%), but inventory levels increased 8%. Inventory as a percentage of revenue, on a four-quarter average, is at 102%.
Saks is not as guilty of using stock repurchases to boost EPS as some of the other retailers discussed in previous commentaries, but the company used $28.9 million to repurchase shares last year.
Saks' days in inventory (DSI) metric (four-quarter average) is unacceptably high at 160 days, and its cash conversion cycle (four-quarter average) is 126 days. As a high-end retailer, Saks places great emphasis on customer service. Its customers will pay higher prices as long as they receive the extra attention they feel is warranted by the higher price points. Nonetheless, it takes a long time to move inventory out the front doors. Saks' general and administrative expenses are quite high, forcing operating and net income lower. This is counterintuitive, as one would expect higher prices at the register to translate into higher margins. Saks' cash flows are obviously affected by lower margins. As a result, operating cash flow minus net income is negative about half of the time, which underscores the company's problems managing its cash.
In addition, long-term debt is currently at $367.9 million, and there is another $152.6 million on the balance sheet as "other non-current liabilities." The company uses some cash to pay down on the LT debt, but also pays approximately $50 million annually in interest expense. The stock has fluctuated from its low of $6.60 on Aug. 30, 2010, to its current price of $11.45, which could provide plenty of downside if inventory levels remain elevated and hammer margins as a result of price cuts.
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