This commentary originally appeared on Real Money Pro at 9:29 a.m. ET on Thursday, Dec. 24. Click here to learn about this dynamic market information service for active traders.
The proposed takeout transaction of Pep Boys (PBY) highlights the valuation inconsistencies that now prevail in the retail sector.
PBY undoubtedly has unique strategic merit to the parties bidding for it. But the fact remains that it's a pretty poor retailer, with a low return on equity and a weak return of invested capital. The chain looks like it'll sell for 12x EBITD or so, depending on when a deal closes.
Meanwhile, retailers with much better business models are trading at below 6x of trailing-twelve-month EBITD. These include Bed Bath & Beyond (BBBY), Best Buy (BBY), Dillard's (DDS), Kohl's (KSS) and Macy's (M). Even Nordstrom (JWN), a superior retailer by any measure, is trading at 6x -- which explains why Neiman Marcus is unable to return to public markets.
All of these retailers generate significant amounts of free cash and remain highly profitable. That's true even though they currently face tough sales conditions (largely weather-related) and the threat of market-share loss to Amazon (AMZN).
But as good as Amazon is, it can't "eat" everyone. And the threat Amazon poses to bricks-and-mortar retailing mean's there's little if any new-store construction, while low inflation means firms need negligible capital for current assets (i.e., inventory and accounts receivable/payable).
In short, given today's low interest rates, you couldn't conjecture a more favorable opportunity for mergers or private-equity activity in a sector.
Privately held retailers' values are already well in excess of publicly traded ones' market multiples. I think it's only a matter of time before we find out by how much.
That's partly why I remain a buyer of Macy's, Bed Bath & Beyond and Best Buy. I'm also adding Best Buy to my "Best Long Ideas" list at $30.60. It joins BBBY and M as retailers on the list.