After dropping for several years, retail stocks continue to rally big into the end of 2017. The SPDR S&P Retail (ETF) (NYSEARCA:XRT) is up 9% in the past month alone.
Why the big end-of-year rally?
Firstly, retailers are in the middle of their best holiday shopping season in recent memory. A slew of positive retail earnings reports, lots of healthy holiday sales guides, a ton of upbeat Black Friday/Cyber Monday sales commentary, and strong macro consumer spending data have come together to paint an unusually bullish picture of retail stocks this holiday season.
Secondly, corporate tax rate cuts are coming. That is big for retailers, who are normally big taxpayers.
But just because all of retail is in rally mode doesn’t mean all retail stocks will continue to rally into the foreseeable future. In fact, despite my overall bullish outlook on retail, I’m concerned about a few names that appear to have gotten ahead of themselves in this recent rally.
One name I’m concerned about is Guess?, Inc. (NYSE:GES). Here’s why.
Guess Stock Looks Fully Valued
Right before this big retail rally got started, GES reported quite ugly third quarter numbers while simultaneously delivering a disappointing holiday quarter guide.
GES stock got killed after that report. It dropped from $18 to $15.
But the recent retail rally has driven GES stock back up to $17, erasing almost all of those post-earnings losses.
Here’s the problem: the third quarter numbers showed that while the margin expansion narrative remains on track, sales growth is slowing. At $17, GES stock is more than fully valued as a slow sales growth, big margin growth retail company. Plus, the market appears to be already pricing in a high probability of tax cuts materializing soon.
GES revenue growth is tepid and slowing. The America business remains in free fall. The Europe business is slowing, and so is the Asia business. All in all, 4.9% revenue growth two quarters ago turned into 0.6% revenue growth last quarter. In U.S. dollars, revenues are expected to grow just over 6% this year. That growth rate is expected to fall to 4-5% next year.
Overall, given the slowing sales growth trends, it is likely that revenue growth over the next five years settles in around 3% per year. That puts revenues in five years at $2.71 billion.
The margin growth narrative at GES remains exceptionally promising. Margins have been in free fall for multiple years, but they are starting to rebound. Gross margins are trending up as promotions continue to peel back. Operating margins are expanding healthily from a depressed base.
Overall, management thinks that revenue growth and disciplined cost control can drive operating margins to 7.5% in the long term (versus 3.5% expected this year).
Let’s say GES nets 7.5% operating margins in five years with revenues of $2.71 billion. That implies operating profits of just over $203 million, or net profits of $132 million after applying a 35% tax rate. That equates to about $1.60 per share, assuming 83 million diluted shares.
Over the past several years, earnings have been around $1.60 multiple times, and each time, GES stock was awarded a low-to-high-teens multiple, with the average being around 15. Apply a 15x multiple to $1.60 earnings, and you get a $24 price target in five years.
Discount that back by 10% per year, and you get to a fair value of around $15.
But, let’s assume the tax rate does go from 35% to 21%. That would imply net profits of nearly $161 million in five years, or about $1.94 per share. Apply a 15x multiple to that, then discount back by 10% per year, and you get to a fair value of around $18.
Bottom Line on GES Stock
Even if tax cuts do come, I think GES stock is approaching the point of being fully valued.
As such, I don’t think there is much more upside in this name. GES stock is already priced for big growth.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.