Stock Interest List Update

In this time of flux and lack of clarity in the directional pull of the stock market 2outof4 asks more than ever for its readers to offer up their ideas for the Stock Interest List. Surely reader interaction can provide more interesting ideas and dialogue than one man alone. You are encouraged to speak up and let your ideas be tested!

The following idea is interesting to me because Wall Street does not seem to follow the Company. Despite a couple of large mutual funds having greater than 10% positions in the firm, the eponymous CEO does not seem to have more than a 0.76% stake in the Company. So besides being a small cap, I'm at a loss as to why the Company is so under followed. Any information is welcome, as always.

The Cato Corporation (ticker: CTR) is a 1,330 store retailer of value-oriented (2outof4's kind of clothier) women's apparel under the storefronts "Cato" and "It's Fashion". The stores are located in 32 states and from the geographies that I am familiar with it seems like the stores are located near "smaller" cities and near interstate highways. Although, it does look like there is a sizable presence near Dallas and Houston http://www.catofashions.com/locator_results.cfm?state=TX&type=Cato. I may have to rely on the inlaws for some more field research!

In my view the sales growth, same store sales growth an store growth have been reasonable over time, but at a much lower pace the last couple of years. So I do not have a strong sense of what the growth plan looks like, but one service I have access to suggests FY10 sales estimates (whose estimates, I have no idea) of over $880 million from $845.7 million in FY08.

Clearly, it is not growth that attracts me to this Company/Stock. However, the returns on invested capital by CTR are in excess of 50%. Average net income margin for the last 10 years, adjusted for the two best years is 4.9% and there is a ton of cash on the balance sheet, which CTR can either use to grow or return to shareholders.

When one constructs a price to earnings ratio (P/E) using Enterprise Value (market cap plus net debt) divided by sales (EV/S) as the numerator and 10 year average Net Income Margin as the denominator, one calculates a trailing twelve month (TTM) P/E of just 8.0x (0.39/0.049). That seems reasonable for a business that should theoretically benefit for consumers looking for bargains.

At 5.6x trailing twelve month's EV/EBITDA there is also quite a high margin of safety in place because of CTR's strong cash generation. I can apply the average 10 year free cash flow (FCF) as a starting point to a discounted cash flow model, apply zero growth and a 12% weighted average cost of capital (WACC) and still have slight upside to today’s share price. By the way, plugging in last year's FCF to the same model gives one 30% upside to today's share price.

So what is the catch? Is the stock just under followed and therefore undervalued in today's market or is there something that we do not know about that makes CTR reasonably valued. I do not have the answers. But based on prior operating performance, the fact the retailer serves a need in today's economy, and attractive valuation characteristics and cash flow, CTR is added to the Long Interest List. A thorough reading of past SEC filings is my suggested way of understanding wher ethe Company has been and where it wants to go in the future.

As always, thoughts and comments are welcome.

-2outof4