Thriving in the Land of Giants

The last two years have certainly been a retailer's dream. Profits flooded in as consumers, laden with newfound wealth, casually flashed their credit cards. The S&P Retail Stock index rose 43% in 1997 and 61% in 1998, while the wider S&P 500 index climbed 31% and 27% in 1997 and 1998, respectively.

But will the shopping spree continue, or will consumers start stashing cash under their pillows? The retail index has given back most of its gains for the year and is up only 3% year-to-date, far less than the 11% increase of the S&P 500. And retail stocks typically underperform the market during the second half of the year. Merrill's retail analysts suggest that investor uncertainty about e-commerce sales may also trigger a brick-and-mortar selloff, even though the Internet will account for a fraction of 1% of general-merchandise sales this year and less than 1% for several years thereafter.

We decided to play it safe. So we screened for retailers with low debt and high growth prospects that might be less vulnerable to a slowing economy. If you're an East Coaster, the name Shopko Stores (SKO) may not ring any bells. But this scrappy Green Bay, Wis., discount chain has a niche merchandise strategy, a balance sheet brimming with cash and a sorely undervalued stock.

Shopko is a dwarf compared to the big, bad giants knocking on its door. And other regional discounters such as Caldor (which went out of business earlier this year) and Bradlees (BRAD) have been casualties of the so-called Big Three -- Wal-Mart Stores (WMT), Kmart (KM) and Dayton Hudson's (DH) Target. But it would be a mistake to think that it's just a matter of time before Shopko is vanquished, says Merrill Lynch analyst Daniel Barry. "Shopko is not hiding in Wisconsin, hoping that its turf is not invaded by the Big Three. It has already been invaded." And armed with its cleaner, brighter stores and differentiated products, Shopko is beating back the mass merchandisers.

The ammo is no rocket science. Instead of taking on the brawn of the Wal-Marts of the world, Shopko is kicking them in the Achilles' heel. The company, says Skip Helm of William Blair & Co., has repositioned itself as a "customer-lifestyle-driven specialty discounter." Shopko has largely dumped its commodities lines (auto parts, fishing gear, and so on), which don't stand a chance against the retail giants, in favor of lifestyle items, and it sells more upscale brands such as Nike (NKE) and Reebok (RBK). Shopko differentiates itself from traditional retailers by offering fewer types of products, but deeper selections within carefully chosen categories, such as active and casual apparel and home furnishings that cater to its key female customers. In a recent move to bolster its "softer" lines, the company formed a partnership with Payless ShoeSource (PSS). Payless will operate the shoe departments in Shopko stores under its own brand name.

Meanwhile, Shopko is expanding its health business, which represents 20% of total sales and profits, by building up its in-store pharmacies and vision centers and offering a wide array of vitamins and supplements. A subsidiary also offers health care benefit-management services.

At the same time that Shopko is learning to maneuver around the big guys, the company is also fattening itself up on smaller rivals that operate in less congested neighborhoods. Last month, Shopko completed the purchase of the 152 small-store discount chain Pamida Holdings. Operating in small Western communities of under 20,000 people, the multipurpose stores face virtually no local rivals.

While many retailers have choked on overly ambitious expansion strategies, Shopko's purchase of Pamida should provide a "whole new leg of growth," says Helm. Not only has the acquisition doubled Shopko's store size and increased its square footage by 28%, but it will immediately add to earnings. And Shopko will use the proceeds from a recent stock offering to pay down Pamida's expensive debt load.

The Pamida purchase may be just the preface to a larger expansion story. "Shopko feels that it understands the small-town customer, it has built the infrastructure to serve that customer, and can allow smaller retailers throughout the country to leverage this expertise. Therefore, we think that the Pamida acquisition is only the first in a series of acquisitions," wrote Barry in a note. The analyst points out that Shopko has expanded its square footage at the same rate as Wal-Mart and Target, and more quickly than Kmart and Ames Department Stores (AMES). Management, which plans to continue increasing square footage by 8% to 10% a year, recently announced that it would spend $70 million on expanding its distribution capacity in order to support that growth.

Over the last five years, the chain has boosted earnings by 11.9%, surpassing the growth rates of both the discount retail industry and the S&P 500. In the most recent quarter, earnings jumped 19% to 32 cents a share, while revenue rose 29% to $869 million. Sales in stores open a year or more, a good measurement of retail performance, were up a more-than-expected 9.2%. This year, analysts are expecting 18% earnings growth.

Declining gross margins have contributed to recent stock-price weakness, but Banc of America Securities analyst Thomas Tashjian says investors are overreacting. While margins have steadily eroded this year because of increased promotional spending and a rise in less profitable sales through its benefits subsidiary, the analyst thinks Shopko will be able to improve its product mix and margins as it completes the clearing out of old inventory at Pamida stores.

With earnings projected to grow by at least 15% over the next five years, or more than double the rate of the S&P 500, you have to wonder: Why is Shopko so darn cheap? The stock is trading at only about 11 times estimated fiscal 2000 earnings, while discount retailers as a group trade at an average forward price-to-earnings multiple of 22. And Shopko trails the industry's average P/E-to-growth-rate by 55%.

One answer may be that Shopko was until recently a stranger to the Street. Retail analysts didn't focus on the health care side of the company, and weren't much inclined to make the trip up to Green Bay, Wis., says Helm. But that's changing. Since Shopko spun off a 65.5% stake in its pharmacy-benefit management subsidiary, ProVantage (PHS), last month, two more analysts have started bullish coverage of the stock. By squarely focusing on its retail business, which contributes 85% of earnings, Shopko has unlocked shareholder value, says Helm. The stock hit an all-time high of 40 5/8 just three days after the ProVantage IPO.

But ProVantage has recently fallen victim to the IPO-selloff contagion, as well as to the increasing likelihood that President Bill Clinton's Medicare drug plan won't make it through Congress any time soon. The stock is down about 33% from its offering price of $18, and Shopko shares have sagged along with it. Still, ProVantage's earnings and sales (65% of which flow through Shopko's balance sheet) continue to outperform management's targets, as the company fills ever more prescriptions through its network pharmacies and increases mail-order sales. Wall-Street Journal All-Star analyst Jeffrey Feiner of Lehman Brothers also notes that ProVantage represents a "key differentiator" and insulates Shopko against a potential economic downturn.

Now that Shopko is a pure-play retailer and ProVantage has come out from hiding, analysts say the stock should begin to realize the full growth potential of both businesses. While Feiner sees the shares trading at 40 over the next 12 months, Merrill's Barry thinks Shopko shares deserve to trade at at least 18 times forward 2000 earnings, which implies a share-price target of $54.

If shoppers do start penny-pinching, only the fittest will survive. Shopko may not have the brawn of a Wal-Mart, but the truly nimble can thread their way between the feet of giants without getting stepped on.