Low End to High End

01/14/2005 12:00 am EST

Focus:

Michael Ozanian

Senior Editor, Forbes Earnings Quality Report

Michael Ozanian looks beneath the surface of reported profits to assess "earnings quality", and what that portends for a company's future prospects. Here, he looks at a trio of retailers, from low-end dollar stores to high- end home products.

"Business has been sluggish recently for Dollar Tree Stores (DLTR NASDAQ), which offers merchandise ranging from housewares and toys to food and beauty aids for $1.00 at over 2,600 stores. Its main problem is higher home heating and gasoline costs that have crimped spending by low-income consumers, who are its primary customers. Although the past few months have been tough, we believe the company is on the verge of explosive bottom line growth because of its exceptional earnings quality. Specifically, DLTR has become an extremely efficient company, producing more cash than its reported earnings would indicate. And management has been dong a smart job of reinvesting its cash. With the stock badly beaten down, now is a great time to buy this cash-rich retailer. Our 12-month target is $37.

"Some analysts believe that Talbots (TLB NYSE), a retailer and catalog purveyor primarily of women’s classic apparel, has lost relevancy as a result of rising competition. In our view, the stock is at a bargain basement price. Talbots has lost some momentum recently, but over the years its management has shown the ability to produce robust growth. We believe Talbots' sales and earnings growth will start to climb back to their historical averages next year. Yes, competition is tough. But Talbots is a strong brand and has the financial muscle to support its expansion. For investors with a little patience, now is an ideal time to buy shares of Talbots. The company is trading for just 16 times this year’s expected earnings, much less than most other specialty apparel retailers. Our 12-month target price is $35.

"Williams-Sonoma (WSM NYSE) operates over 500 stores primarily under the Williams-Sonoma and Pottery Barn names that focus on high-end home furnishings and home cookware. In recent quarters the company’s performance has been top notch, as high-income shoppers have made their way back to stores quicker than middle-and low-income consumers. Analysts believe the company’s future earnings growth will come from Williams-Sonoma Home, which was introduced in catalog form in September and is on track to launch an e-commerce site and a few test retail stores next year. WSH will bring WSM out of the kitchen and into most other rooms in the home, including living room and dining room furniture. The company is virtually debt-free. WMS trades for a slight premium to the average stock, but given its consistently superior track record and excellent earnings quality we believe it is worth every penny. Our 12-month target is $44."

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