Hart Stores: Value Trap?

In my last post on Hart Stores (TSE: HIS) here, we looked at some value measures that indicated their stock might be trading cheap. However, after pouring over the historic financial statements, it's clear that there have been serious signs of trouble brewing at the company. First, the operating margins are less than half of what they were in 2004. In 2004, the operating margins were 7.5% and are now around 3.2%. There are other indications of trouble including year over year sales dropping by 2.9% and same store sales decreasing by 4.2% in the same period. Net earnings, return on shareholders' equity and return on net assets have all been falling this past year.

As value investors, we like to buy good companies at low points in the business cycle, provided that business conditions return to normal during a better performing economy. Some of the problems I see with Hart stores started when the Canadian economy was hot. Operating margins started contracting in 2004 which is not something I would expect for a Canadian retailer. In their annual report, Hart Stores refers to increased competition from large retailers with superior buying power, and I think it is likely that this competition has put pressure on Hart Stores operating margins.

Hart Stores operate their retailing stores in Central, Eastern and Atlantic Canada and have strategically tried to differentiate themselves from other retailers through creating a more customer-friendly shopping experience and stronger customer service than the competition. Will this differentiation strategy be enough to entice consumers to continue shopping at Hart Stores as other big box retailers offer similar products at cheaper prices? I think this scenario becomes less likely as economic conditions weaken.

For the time being, I would be cautious in seeing Hart Stores as a value play until it's evident that their current problems are cyclical in nature and not indicative of more sinister secular problems.