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Two
Easily Detected Red Flags
The last time
I looked, shares of discount retailer “99 Cents Only Stores” were
trading at $14 or so, down
around 60 percent from their summer 2003 mid-$30 trading range.
Translating that percentage loss into dollars, your shares would be
worth around $400 today if you had invested $1,000 at the peak.
But careful
investors who heeded two simple ‘red flags’ had plenty of time to
get out with little or no loss. I get into the details in a minute, but
first some background.
99 Cents Only
Stores sells name brand merchandise such as packaged food, beverages,
household goods and beauty aids. As its name implies, 99 Cents Only
sells everything for exactly 99 cents.
Founded in
1982, 99 Cents Only had grown to 153 locations by February 2003. Based
in the Los Angeles area, its stores were concentrated in Southern
California where 99 Cents Only enjoys a rock solid reputation for
providing quality products at rock bottom prices. Until last year, 99
Cents Only followed a steady growth path and had suffered few stumbles.
But with the
chain close to saturating Southern California, it had to look elsewhere
to maintain its mid-20 percent annual growth rate. 99 Cents Only had
already opened a few stores in other areas, primarily Las Vegas. But,
because it had no reputation in those markets and competition was keen,
its results were unimpressive.
Despite the
lack of success, 99 Cents Only decided that Texas was fertile territory
and decided to enter that market in a big way in June 2003.
Unfortunately,
other discounters were already well entrenched in the Texas market and
its stores failed to generate the expected results. As a result, its
earnings plummeted, sinking its share price.
But you
didn’t have to know anything about the Texas market to discover that
99 Cents Only was stumbling. Here’s how you could have figured out
that 99 Cents Only was risky business.
Red Flag
#1
In February 2003, 99
Cents Only, seeing that its Southern California growth rate was
faltering, reduced its earnings forecasts (guidance) for its March and
June 2003 quarters. Reduced earnings guidance almost always kills the
stock price. But company management figured that the Texas expansion
slated for later in the year would bail them out. So they kept forecasts
for the year unchanged at $1.00 per share.
99 Cents Only
management wasn’t intentionally misleading investors. Top executives
are optimistic by nature. They see faltering earnings growth as just
another problem that they can fix. But in my experience, once earnings
growth falters, things are just as likely to get worse as better in
ensuing quarters. It’s very unlikely that a company that reduced
forecasts will make up the lost ground in the same year (99 Cents Only
reported 2003 earnings of $0.79
per share).
Action
Item: Sell the stock if a company cuts earnings forecasts for the
next one or two quarters, but not for the whole year.
Management
usually announces changes in its earnings guidance in its quarterly
earnings report press release. If not, you can catch up on
management’s thinking on the topic by listening in on the conference
call that follows the earnings report. You can usually listen to the
conference call, either live, or recorded, via a link on the company’s
website.
Red Flag
#2
Declining operating
margins is one of the most reliable predictors of future earnings
shortfalls.
In case
you’re rusty on accounting terms, operating margins (operating income
divided by sales) measure profitability considering everything except
interest expenses and income taxes.
Faltering
operating margins usually signal that something is amiss. It could be
that the company is cutting prices to retain market share against
aggressive competitors, or that costs are spiraling out of control.
When you
analyze margins, compare the latest results to the same year-ago quarter
to rule out seasonal variations.
As a rule of
thumb, consider a 5 percent drop (e.g. from 20% to 19%) as a ‘yellow
flag’ advising caution, and a 10 percent drop (e.g. from 40% to 36%)
as a ‘red flag’ requiring immediate action.
99 Cents Only
reported its June 2003 quarter results in late July, when its stock was
trading in the low to mid-$30 range. Its earnings met expectations, but
its operating margin was 11.1%, down from 12.5% in the year-ago quarter.
That computes to an 11% drop, a red flag by my definition.
For
shareholders who missed that signal, 99 Cents Only gave them a second
chance when it reported its September quarter results in late October.
At that time, 99 Cents Only shares were still changing hands at $29 or
so. The firm reported disappointing earnings, but blamed the shortfall
on startup costs in Texas. However, that pesky operating margin red flag
was even worse this time. September quarter margins dropped to 8.6% vs.
the year-ago 12.0% figure. That’s a 28% drop.
Action
Item: sell a stock when its last quarter’s operating margins drop
10% or more from the year-ago margin.
You don’t
have to calculate operating margins. You can look up the last five
quarterly margins on Hoover’s Online (www.hoovers.com).
From the company’s Fact
Sheet page, select Financials
and then Quarterly
Financials.
Propelled by
an almost continuous string of earnings shortfalls, 99 Cents Only shares
dropped into the low $20 range in March 2004 and finally down to the low
teens in June.
Nothing
always works in the stock market. These two red flags sometimes give
false alarms. But their presence signals increased risk, tilting the
risk/reward balance against you.
published 9/19/04 |
