Consider Debt When Bottom-Fishing Retail

• ByTim Melvin, RealMoney.com Contributor
• On Monday November 17, 2008, 1:41 pm EST

By any account, the retail sales report on Friday was awful. It was the largest drop in sales since the aftermath of 9/11. Auto sales were down the most, but spending was down in just about every category. It was the fourth month in a row that consumers spent less in the nation's malls and stores. Retailers are beginning to show some concern and have cut back inventories for the first time in over a year, resulting in the largest drop in business inventories in over three years.

Since retail activity is responsible for two-thirds of GDP, it looks like we will have a second quarter of negative growth. After the report, I saw a lot of discussion about this being the worst possible timing.

Since many retailers earn the bulk of their annual profits during the holiday season, I suspect it is far too early to bottom-fish the group. It is tempting, as many of the stocks look cheap, but the risks remain high. Sales are much worse than I ever expected, and I think they will be even worse in the fourth quarter than anyone foresees. It will be a bleak Christmas, I suspect.

When I look at the retail sector, I see stocks that I think are incredibly cheap. It is hard not to add stocks like Charlotte Ruse at these prices. There are some names that I think will do very well when the consumer returns, but until then, it could get quite ugly.

Earlier this year I took at shot at some names in the group, and although they held up better than many, I ended up selling at a loss. Charlotte Ruse is the only one I still have, and the proposed takeover would allow me to break even on the stock.

Every time I look at the group now, I hear the gravelly voice of Walter Schloss. "I don't like to lose money. I do not like debt." There is more pain ahead for this group, and those retail- and consumer-oriented companies with debt on the balance sheet will have a very difficult time surviving the downturn.

Consumer-sensitive companies with debt on the balance sheet could quickly see interest payment become a significant problem in maintaining profits. How much do sales have to decline for a company like Autozone to have a problem. With annual interest payments of $ 140 million and lease payments of better than $60 million, one bad quarter could cause an enormous drop in earnings. It night not happen, but why take the chance?

Nordstrom's just cut their estimates for the quarter by a larger-than-expected amount. With annual interest payments of $145 million and lease payments of $70 million, a prolonged slump could cause earnings to disappear. Again, it might not happen. But it could, which is why debt in retailers should be avoided. These are fixed costs that cannot be controlled and could easily turn earnings to losses in a bad environment.

Perhaps enough people will struggle with weight this holiday season that Weight Watchers will easily cover the $85 million of interest payments and $24 million of rent payments. But they might not, and the large cost of debt will eat into earnings and could cause the share price to drop quickly.

Estimates for auto dealer Group One are that the company will make about $40 million in net profits. If the auto business continues to decline at the current rate, the $30 million of interest payments have a huge impact on earnings per share. Why risk it?

We do not know how far the retail decline can or will go over the next several quarters. It depends heavily on housing prices and unemployment. Almost no one correctly predicted the steep decline in the economy, and I am not sure that I would give much weight to any forecast of when it is going to get better. I do know that if you are not spending all your cash flow in interest payments, you have a better chance of surviving the decline.

If you feel you have to buy an auto retailer, why not CarMax ? They have just $7 million of annual interest payments. There are literally dozens of retailers that have no debt. Companies like Joseph A. Banks may find it difficult to sell suits, but at least they do not have to worry about interest payments eating up their cash flow. The retail book business may continue to struggle, but at least Barnes and Noble does not have to worry amount mounting interest payments since they have no long-term debt.

I think it is probably a bit early to bottom-fish retail. However, it is worth looking into making a paired trade out of the group, buying the debt-free companies and shorting those with high debt as a percentage of total capital.