Luxury department stores did well in December with both Saks (NYSE:SKS) and Nordstrom (NYSE:JWN) beating analyst same-store sales estimates. Unity Marketing's Pam Danziger suggests that, "Luxury consumers are the heavy lifters in the economy, so it makes sense that businesses like Nordstrom and Saks will benefit from their excess spending." While true to a point, Saks has more going for it then just wild spending by its customers. Savvy investors will see this and get on board while the price is right. (For related reading, see Analyzing Retail Stocks.)

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Same-Store Sales

In the key holiday period of November and December, Saks delivered an increase of 7.1% on top of a 9.4% increase in the holiday season in 2010. These are strong numbers. In fact, if you combine this year's holiday numbers with last year's, Saks averaged 8.3% compared to 7.4% for Nordstrom. Its above-average performance has been carrying on for some time. The last negative month for same-store sales growth is November, 2009. That's 25 consecutive monthly increases year-over-year, through the end of 2011. In terms of same-store sales growth, 2011 was its best year of sales increases since 2007. Despite this picture of business health, its stock is down around 22% in the past 52 weeks through Jan. 13. Thankfully, not everyone's ignoring the disconnect between how the company is performing and its share price.

Mason Hawkins

The founder of Longleaf Partners is one of the biggest value investors anywhere. His firm's been managing money since 1975, with the singular goal of buying well-managed companies when their stock price is cheap and selling when it's dear. In the third quarter, Longleaf's Small Cap Fund acquired roughly 13.2 million shares of the luxury retailer. In its third quarter report it said this about Saks: "The company has a unique mix of assets including the owned New York City flagship store which represents approximately 20% of sales and is a square block of premium real estate." In an interview Jan. 10, CEO Stephen Sadove suggested it's actually 22%. In the trailing twelve months (TTM) ended Jan. 29, 2011, its revenues were about $2.78 billion. This means the Fifth Avenue store's contribution was approximately $611 million or around $927 a square foot.

It's not quite Lululemon (Nasdaq:LULU) territory at $1,880 a square foot, but considering the size of the store, it's more than fine. Obviously impressed by Saks business affairs, Longleaf picked up additional shares in the final quarter of the year and now owns 11.1% of Saks, making it the top mutual fund holder, according to Yahoo! Finance. Considering the Longleaf Small Cap Fund's annual turnover is just 17%, expect Hawkins to hang on to the shares for some time. (To learn more about this investing strategy, check out Value Investing: Introduction.)

Third Quarter

Let's look at a couple of things from its third quarter report in 2011, compared to its third quarter in 2007. Although revenues were 13% lower at about $692 million in 2011, from just over $796 million in 2007, Saks closing stock price in 2007 was $20.76, around 129% higher than its Jan. 13 closing price of $9.06. On a price-to-sales ratio, if you annualize the third quarter in both 2007 and 2011, you'll see that its ratio today is 35% lower at 0.65. Put another way, a Saks investor back in 2007 was willing to pay more for the same dollar in revenue. It appears to me that either investors were overpaying back then, or underpaying today. While I don't pretend to be able to read minds, how much do you want to bet Longleaf's exit point is somewhere around the $20 mark? Any takers?

The other point I'd like to address is operating cash flow (OCF). For the first nine months of 2007, Saks operating cash flow was negative $35.3 million. Flash forward four years and it was $119.0 million. Saks has been focusing on operating profitable stores and closing the rest, therefore, its capital expenditures today are about half what they were in 2007, the net result being higher free cash flow (FCF). In fiscal 2007, Saks finished the year with operating cash flow of $71.5 million, capital expenditures of $141 million and negative free cash flow of $70 million. No matter its market cap at the time, its cash return (free cash flow plus interest expense divided into enterprise value) would be negative. In 2011, it's currently around 9.7% and likely to go higher. Financially, Saks appears stronger than it's ever been. (For addtional reading, see how to Analyze Cash Flow The Easy Way.)

The Bottom Line

I can remember going to the Fashion Valley Mall with my family during a vacation in San Diego in 2009. I couldn't believe how many department stores there were: JC Penney (NYSE:JCP), Macy's (NYSE:M), Nordstrom, Bloomingdales and Neiman Marcus. It's an incredible mall, but that was overkill. In July 2010, Saks closed its store there to focus on better performing locations, only to be replaced by Forever 21. It was, in hindsight, a great move. Saks should only be where it's not an after thought. Management's hit upon a great plan and if they keep working it, the stock price won't be cheap much longer. (For related reading, see The 4 R's Of Investing In Retail.)

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.
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