Retail stocks: Where the smart money is
Investor Daily: The outlook for retailers isn't good. Here's one way pros are separating the winners from losers.
NEW YORK (Fortune) -- A chill has descended on America's shopping malls. With credit markets frozen, the Dow plunging and consumers buying less, retailers are bracing themselves for one of the worst holiday seasons in nearly two decades.
Linens' n Things, Steve and Barry's and Sharper Image are among the retailers to file bankruptcy this year, double the usual pace. Ailing retailers at risk of a similar fate are likely to make it through the holiday season, but restructuring experts predict a fresh wave of bankruptcies come January.
Most at risk are apparel and furniture sellers, where consumer spending has been especially weak. As long as banks continue to limit lending, retailers that need fresh capital in 2009 are also vulnerable.
Betting on which retailers will survive isn't easy. For those loath to pore over quarterly filings or who, like me, have an aversion to math, the rating agencies are a good place to start. But as the housing crisis has shown, Moody's and Standard & Poor's have made terrible calls in recent years. Dozens of highly rated mortgage securities based on loans to low-income homeowners turned out to be little more than junk.
One useful tool the pros use is credit default swaps, which are unregulated insurance policies that investors or lenders buy to protect themselves should a company default on its debt. A lender, for example, might pay $30,000 to insure $10 million in debt. As the risk - perceived or real - of default increases, the swaps become more expensive. Credit default swaps, or CDSs, have been blamed for the collapse of AIG, Lehman Brothers and Bear Stearns.
CDSs aren't an absolute indicator of risk, but they offer useful clues as to how the overall market views a company's health. A quick look at CDSs for the retail industry shows a spike in CDS prices beginning in September, when monthly sales data were lower than expected and fears of a global recession slammed markets worldwide.
Consider Dillard's (DDS, Fortune 500), a Southeastern department store chain embroiled in a nasty battle with shareholder activists. The company's controlling stockholders are an entrenched family that has been slow to shore up the sagging business. Its shares, at $4.52, are off 80% from a year ago. As of Monday, Dillard's swaps were trading at $1.6 million per $10 million of coverage, up nearly threefold from $400,000 in late summer. Typically, alarm bells in the retail sector go off when a company's CDS spread reaches about $700,000 per $10 million of debt. Investors are clearly nervous.
Sears Holdings (SHLD, Fortune 500) is another company that has been dogged by liquidity fears. Although the company has plenty of cash and credit available, its market share is declining, stores are dilapidated and its boy-wonder financial backer, Eddie Lampert, has yet to articulate a sensible turnaround strategy. Sears' shares, at $48.61, are less than half their level a year ago, and its CDSs (which trade as Sears Roebuck Acceptance Corp., a wholly owned finance subsidiary) have soared to $1 million, more than three times their level of late August. Investors beware.
Not all retailers are getting walloped by investor fears. Wal-Mart (WMT, Fortune 500) is a fairly safe bet, with a AA credit rating from Fitch. It stands to benefit from tighter consumer spending.
Although Wal-Mart swaps have risen to $98,300 per $10 million in coverage, up from an average $30,000 in the previous six months, they're still pretty cheap. Wal-Mart is also one of the few retailers whose stock, at $51.35, is trading above year-ago levels. Similarly, rival Costco's (COST, Fortune 500) swaps are trading at a healthy $87,200 (although its shares are down 21% in the last year).
To be sure, credit default swaps aren't perfect predictors of where a stock is headed.
Macy's, for example, is a favorite of liquidity bears. The company operates in the highly-competitive middle ground of retailing, is still struggling with the 2005 buyout of the May Company, and has seen sales at stores open at least a year decline. What's more, the retailer has $1 billion in debt coming due over the next year. It's CDSs have jumped to $530,000 from $137,000 in August.
But analysts say those fears are overblown. Macy's has $740 million in cash on its balance sheet and a $2 billion revolving credit facility that runs through 2012. After meeting with Macy's management recently, Charles Grom, an analyst with J.P. Morgan, assured clients that the company "isn't a going concern risk."
CDSs can be useful, but they aren't the only one tool. Investors still need to do some homework (and maybe even a little math) before placing a bet.
Has the beating the market's taken got you wondering about how to invest now? Let us know what you'd like us to address in our next Investor Daily. E-mail Fortune. 
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