Beating the Street (25 page)

So what was wrong with this picture that would have justified a fivefold decrease in the value of Toll Brothers shares? I read the recent reports to find out. Debt had fallen by $28 million, and cash was up $22 million, so the balance sheet had improved during these hard times. So had the order book. Toll Brothers had a two-year backlog of orders for new homes. If anything, the company had too much business.

The company had expanded into several new markets and was well positioned to benefit from a recovery. You didn't need a terrific housing market for Toll to post record earnings.

You can imagine my excitement at finding a company with very little debt and enough new orders to keep it busy for two years, its competitors dropping by the wayside, and its stock selling for one fifth its 1991 high.

I put Toll Brothers at the top of my
Barron's
list in October, expecting to recommend it at the panel in January, but in the meantime the stock quadrupled to $8. (By the time the panel convened, it had reached $12 again.) Here's a tip from the prospectors of year-end anomalies: act quickly! It doesn't take long for bargain hunters to find the bargains in the stock market these days, and by the time they're finished buying, the stocks aren't bargains anymore.

More than once I've identified a likely winner that's been beaten
down by the tax sellers in the fall, only to see it soar in price before I could get its name published in
Barron's
two months later. In 1991, the price of the Good Guys, a chain of appliance and electronics stores, rose dramatically between January 14, the day of the
Barron's
meeting at which I recommended the stock, and January 21, the day the magazine was scheduled to hit the stands. On January 19, the editors and I had a conversation about this predicament, and we decided to delete the Good Guys from the text.

Obviously, I wasn't the only investor who discovered the Toll Brothers bargain in the fall of 1991. Frustrated that others were screaming their Eurekas before I had a chance to mention it in print, I turned my attention to other companies that I imagined would benefit in subtler ways from the overblown crisis in real estate. The first that came to mind was Pier 1.

It didn't take a clairvoyant to figure out that people who moved into the houses they bought, new or used, were going to need lamps and room dividers, place mats and dish racks, rugs and shades and knickknacks and maybe a few rattan couches and chairs. Pier 1 sold all of these items at prices that customers on a budget could afford.

Naturally, I'd owned Pier 1 in Magellan. It was spun out of Tandy in 1966, and the virtues of this home furnishings outlet with a Far East flavor were pointed out to me by my wife, Carolyn, who enjoyed browsing through the Pier 1 located on the outskirts of the North Shore Shopping Center. This was a great growth stock in the 70s that ran out of steam, then had another great run in the 80s. Investors who'd bought these shares during Pier l's latest renaissance were well rewarded until the Great Correction of 1987, when the stock price dropped from $14 to $4. After that, it bounced back to the $12 level, where it remained until the Saddam Sell-off, when it was struck down once again—to $3.

When it came to my attention for the third time, the stock had rallied all the way to $10 and then faded to $7. At $7, I figured it might be undervalued, especially in light of a probable recovery in housing. I opened up my Pier 1 file to refresh my memory. The company had had 12 years of record earnings before it got hurt in
the recession. At one point, a conglomerate called Intermark had owned 58 percent of the stock and prized it so highly it allegedly rejected an outside offer to sell these shares for $16 apiece. The story on Wall Street was that Intermark was holding out for $20, but later, when Intermark was strapped for cash, it was forced to sell all its Pier 1 shares for $7. Subsequently, Intermark went bankrupt.

Getting the huge overhang of Intermark shares out of the way was a promising development. I talked to Pier 1's CEO, Clark Johnson, in late September 1991 and again on January 8, 1992. He brought up several favorable factors: (1) the company had made money in 1991 in a very difficult environment; (2) it was expanding at a rate of 25–40 new stores a year; and (3) with only 500 stores in the U.S., it was nowhere close to saturating the market. The company also had managed to reduce expenses, in spite of having added the 25 new stores in 1991. Thanks to Pier 1's devotion to cost-cutting, the profit margins had continued to improve.

As for the old reliable indicator, same-store sales, Mr. Johnson reported that in the regions hardest hit by the recession sales were down 9 percent, but in the rest of the country they had increased. In a recession, it's not unusual for same-store sales to decline, so I took this report as a modest positive. I'd be more worried if the same-store sales had declined in a period of general prosperity for retailers, which this was not.

Whenever I'm evaluating a retail enterprise, in addition to the factors we've already discussed I always try to look at inventories. When inventories increase beyond normal levels, it is a warning sign that management may be trying to cover up the problem of poor sales. Eventually, the company will be forced to mark down this unsold merchandise and admit to its problem. At Pier 1, the inventories had increased, but only because the company had to fill the shelves in 25 new stores. Otherwise, they stood at acceptable levels.

Here was a fast grower with plenty of room to grow more. It was cutting costs, improving its profit margins, and making money in a bad year; it had raised its dividend five years in a row, and was perfectly positioned in a part of the market that was bound to get better: housing. Plus, a lot of Carolyn's friends are very fond of Pier 1. The bonus in the story was Sunbelt Nursery.

In 1991, Pier 1 sold 50.5 percent of its Sunbelt Nursery chain in
a public offering. Of the proceeds of $31 million, $21 million was used to reduce the company's debt and the other $10 million was returned to Sunbelt to help finance Sunbelt's renovation and expansion. Overall, Pier 1's debt was reduced by $80 million in 1991, to about $100 million. A stronger balance sheet made it very unlikely that Pier 1 would be going out of business anytime soon, which is what frequently happens to more heavily indebted retailers during recessions.

The $31 million that Pier 1 received for selling half of Sunbelt was $6 million more than it had paid to acquire all of Sunbelt in 1990. You had to figure that the other half of Sunbelt retained by Pier 1 was also worth $31 million, which represented a valuable hidden asset to the company.

At the time I was looking into all this, Pier 1 stock was selling for $7 with a p/e ratio of 10, based on earnings estimates of 70 cents a share for 1992. With the company growing at a 15 percent annual rate, the p/e of 10 was a promising number. When I flew to New York in January to meet with the panel, the stock price had risen to $7.75. Still, I regarded it as a good buy, both of its own merit and because of the Sunbelt “kicker.”

Every month, a few more of Pier 1's biggest competitors in home furnishings, mostly local mom-and-pops, were closing their doors and going out of business. Major department stores were dropping their home furnishing sections to concentrate on clothes and fashion accessories. When the economy turns around, Pier 1 will have a huge share of a market in which nobody else seems to want to compete.

Perhaps I'm a frustrated matchmaker. Whenever I get interested in a company, I try to imagine what other company might want to acquire it. In my daydreams, I imagine that Pier 1 would be a logical acquisition for K mart, which was moderately pleased with its earlier acquisitions of a drug chain, a book chain, and an office supply chain, and is always looking for new ways to expand.

About 10 seconds after I put away the Pier 1 file, I pulled out Sunbelt Nursery. Often one stock leads to another and the devoted stockpicker
is sent off on a new path, the way the trained hound follows his nose and picks up a new scent.

Sunbelt is in the retail lawn and garden business. It occurred to me that the lawn and garden business would benefit from a rebound in housing just as much as the lampshade and dish rack business. Every new dwelling was going to need trees, shrubs, window box flowers, etc., to enhance its appearance.

It also occurred to me, as I pondered this further, that the nursery business was one of the last of the mom-and-pop enterprises that had not been supplanted by franchises or chain stores. In theory, there was a great opportunity for a well-managed regional or national nursery chain to do for flower beds what Dunkin' Donuts had done for the donut.

Could Sunbelt become that national chain? Operating as Wolfe Nursery in Texas and Oklahoma, Nurseryland Garden Centers in California, and Tip Top Nursery in the Arizona region, Sunbelt already had established itself in 6 of the 11 largest lawn and garden markets in the U.S. According to a Smith Barney research report that found its way to my desk, the company was trying to cater to “the upscale, quality-conscious lawn and garden customer seeking a broader range and quality of plants and supplies as well as a higher level of service than is generally associated with discount-oriented retailers.”

Originally, Sunbelt was spun out of Tandy, along with Pier 1. My first introduction to the independent entity came in August 1991 when Sunbelt management visited Boston in a road show to sell some of the 3.2 million shares that Pier 1 was putting into the market. At this meeting, I picked up a copy of the prospectus, alias the red herring, which gets its nickname from the bright red lines used to highlight the dire warnings that are sprinkled throughout. Reading a prospectus is like reading the fine print on the back of an airline ticket. Most of it is boring, except for the exciting parts that make you never want to get on an airplane or buy a single share of stock again.

Since initial public offerings are often sold out, you have to figure a lot of investors are ignoring the highlighted paragraphs. But in addition to those, there's useful information in a prospectus that shouldn't be overlooked.

The initial offering for Sunbelt went off successfully at $8.50 per share. Thanks to these proceeds, the company began its independent
life with a strong balance sheet—no debt and $2 a share in cash. The plan was to use the cash to remodel the best of its 98 lawn and garden centers, thereby improving their profitability, and to shut down a few of the duds.

These stores had not been remodeled since the Vietnam War, so there was plenty of room for improvement. The most important renovation was enclosing a portion of the nursery space so that plants and flowers could survive into the colder months and wouldn't be left to freeze to death and be reincarnated as mulch.

Pier 1 was still the major Sunbelt shareholder with its 49 percent stake, a factor that I viewed as very favorable. I already knew that Pier 1 knew how to run a retailing business, so it wasn't like an insurance company having a majority interest in a paper company. Moreover, Pier 1 had already done its own remodeling, and I thought Sunbelt could benefit from Pier 1's experience. The management of both operations owned a lot of shares, which gave them a substantial incentive to make Sunbelt a success.

By the time I got around to considering Sunbelt as a possible
Barron's
selection, the year-end tax selling had dropped the stock price to a tantalizing $5 a share. After a single disappointing quarter, mainly caused by a string of natural lawn and garden calamities (premature frost in Arizona, 14 inches of rain in Texas), Sunbelt had lost half of its market value.

What a bonanza for the investors who had the courage to buy more! This was the same company that had come public at $8.50 two months earlier. It still had the same $2 in cash, and its renovation plans were still intact. At $5 a share, Sunbelt was selling for less than its book value of $5.70, and with 1992 earnings estimated at 50–60 cents, its p/e ratio was slightly less than 10. This was a 15 percent grower. Other lawn and garden retailers were selling at twice book value and had p/e ratios of 20.

One way to estimate the actual worth of a company is to use the home buyer's technique of comparing it to similar properties that recently have been sold in the neighborhood. Multiplying the $5 share price by the number of Sunbelt shares, 6.2 million, I arrived at the conclusion that the market value for the entire company and its 98 lawn and garden centers was $31 million. (Normally in this exercise you have to subtract the debt, but since Sunbelt had no debt, I could ignore this step.)

Checking other publicly owned nursery companies, I discovered
that Calloway's, which operates 13 Sunbelt-type stores in the Southeast, had 4 million shares outstanding and its stock was selling for $10. That gave Calloway's a market value of $40 million.

If Calloway's with 13 stores was worth $40 million, how could Sunbelt with 98 stores be worth only $31 million? Even if Calloway's was a superior operation that made more money per store than Sunbelt—which it was—Sunbelt had seven times the number of outlets and five times Calloway's total sales. All things being remotely equal, Sunbelt should have been worth as much as $200 million, or more than $30 a share. Or all things not being equal—for instance, if Calloway's was overpriced and Sunbelt was a mediocre operation—Sunbelt was still cheap.

By the time my Sunbelt tip got into print, the stock had bounced back up to $6.50.

Though I didn't plan it this way, 1992 was the year that Lynch specialized in greenery. The same way Pier 1 led me to Sunbelt, Sunbelt led me to General Host.

You'd never guess that General Host had anything to do with plants. This once was a rather eccentric conglomerate that owned anything and everything—which may explain the name. At one time or another, it had owned Hot Sam's Pretzels and Hickory Farms stores and kiosks and American Salt. It owned All-American Gourmet TV dinners, Van De Kamp's frozen fish, and Frank's Nursery & Crafts. It had owned Calloway's Nursery before Calloway's was spun off in the public stock sale mentioned above.