A "Retail" David and Goliath

12/17/2004 12:00 am EST

Focus:

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer turns his technical and fundamental skills towards analyzing "a clash between a titan and an underdog" in the retail sector. Here's his assessment of this "David and Goliath" scenarioin this case, between retailers, Wal-Mart and Kmart.

"Whether they love their falling prices or hate their business practices, most Americans can agree that Wal-Mart Stores (WMT NYSE) is truly the Goliath of the shopping sector. With close to 5,000 stores and a market cap of almost $223 billion, WMT is the world's leading retailer and the #1 name in the Fortune 500. The firm grew its revenue by almost 5% during the last fiscal year to more than $280 billion and boasts a gross profit of $59.9 billion over the last 12 months. Kmart Holdings (KMRT NASDAQ), on the other hand, is not the retailer that John Q. Public would normally herald as the epitome of retailing success. The company just emerged from bankruptcy proceedings about 18 months ago. One of its most popular and lucrative brand names (the Martha Stewart line of linens and house wares) has been tainted by the incarceration of its creator. And in a move deemed questionable by many, the discount retailer has agreed to buy venerable retailing mainstay Sears in a deal valued at $11 billion, This will create Sears Holdings, the third-largest American retailer, and is expected to close in March 2005.

"And yet, as is sometimes the case in a battle of non-equals, to the smaller competitor may go the spoils. WMT is struggling on the technical front, with very little signs of an impending uptrend, while holiday sales projections have turned south. Despite these facts, analysts and pundits continue to favor the shares. Misplaced optimism can be a dangerous game, as continued weakness in the shares could catalyze a thundering jump off the bullish bandwagon. Since the beginning of this calendar year, WMT has dropped by 5%. In terms of relative strength, the shares have underperformed the S&P by 16%. In fact, the shares have been underperforming the market since September 2002. Meanwhile, t he press has continued to place the retailing behemoth on a pedestal. And as far as Street analysts are concerned, Zacks reports that 15 of the 20 analysts following WMT have named the stock a ‘buy’ or better, with just four hold ratings and a solitary outright ‘sell.’

"As for Kmart, the shares have soared 260% over the past 11 months. From a short-term perspective, KMRT is fresh from a new all-time high (achieved on November 17) and is shuffling atop support from its ascending 20-day moving average. A longer-term view reveals the benefits of tandem support from the equity's climbing ten-week and 20-week moving averages. Furthermore, the stock has recently surmounted psychologically significant resistance at the round-number century mark. Waiting in the wings to provide further fuel for a continued rally are the more than nine million KMRT shares sold short. This comprises nearly one-quarter of the equity's total float available for trading. If the stock continues to motor higher, bearish players could scramble to cover their positions, and would take almost a full week to do so at the stock's average daily volume.

"We'd also note that KMRT has earned little respect from the nation's press, unlike the much-ballyhooed WMT chain. Meanwhile, Wall Street has only mustered two analyst ratings, both of which are ‘holds.’ It is clear that KMRT shares are in an environment of strong price action amid a rather pessimistic backdrop. Meanwhile, WMT is producing lackluster shareholder returns amid disappointing fundamentals and optimism. With all of these factors aligned, it appears that, as far as the major discount chains are concerned, the road to profitability may be guided more by a blue light than a yellow happy face.

"Pessimism is swirling around KMRT as it pushes ahead with the merger with fellow retailer Sears. According to Zacks, only one analyst rates the shares, and KMRT was downgraded on yesterday's merger news from a ‘buy’ to ‘neutral.’ Short sellers have loaded up on bearish positions, as the number of KMRT shares sold short now accounts for more than 24% of the equity's float. With more than six days to cover these bearish bets, KMRT could benefit from a short-covering rally. On the technical front, the stock is up more than 330% since the beginning of the year, skyrocketing along the support of its ten-week and 20-week moving averages. In addition, the equity has handily beaten the S&P 500 Index (SPX) on a relative-strength basis during this time frame. This combination of heavy pessimism and technical strength has bullish implications from a contrarian perspective. We’d add that for options traders, our Options Advisor newsletter suggests buying the March 100 KMRT calls."

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