What Oroton can teach you about ‘hot’ stocks

In 2010-11, leather goods retailer Oroton was flying, with profitability as high as the hype surrounding its shares. Those days are long gone.

‘We’re about to open stores in Australia soon’ said the Michael Kors (NYSE:KORS) shop assistant.

To any other Aussie tourist visiting the famous LA shopping strip known as Rodeo drive in May 2010, such words would be considered harmless or perhaps exciting if you were a fan of the brand. For me, however, it caused alarm bells to ring.

Why? I’d recently been considering the investment merits of Aussie leather goods and handbag retailer OrotonGroup (ASX:ORL) — a market darling at the time.

During 2010, it seemed Oroton could do no wrong and it wasn’t surprising to see queues forming outside its stores. These queues, along with its high profit margins and return on equity over 80% were frequently cited by market commentators as signs of its quality.

The problem with success, though, is that it encourages competition and unless you have some form of competitive advantage, that competition leads to reduced profitability. If Oroton could maintain its success, then the $6.50 share price would prove cheap; if not, it would prove expensive.

Michael Kors did come to Australia, albeit three years after my trip to Beverly Hills, opening its first Australian store in April 2013. A number of other international retailers followed. What has happened to Oroton since then is a cautionary tale of getting caught up in the hype of a market darling.

In 2014, the first full year after the entry of Michael Kors, Oroton reported like-for-like sales growth of 8% and everything seemed well. However, if you looked closer at the results you'd have noticed that its gross profit margin had fallen to 62% compared to 71% in 2012.

In the face of its market becoming significantly more competitive, Oroton was forced to start discounting its products heavily. What’s worse, when they tried to wind back the discounting the year after, like-for-like sales actually fell 1%, meaning that customers had become used to the lower prices.

The competition has only become tougher and Oroton’s financial reports show that it has continued to suffer.

While gross margins have stabilised around 60%, its net profit margin (which was as high as 25% in 2012) is now 2.5% — a figure you'd expect to see for a ‘lowest price everyday’ style retailer. What happened to the much hyped ROE figure of over 80%? Well, it still starts with an 8, however, the decimal point has moved one place over to the left at 8.5% in 2016. What’s even worse is that its operating profit is now lower than it was 10 years ago and the share price is down 64% from when I looked at it in 2010.

Thanks to not getting caught up in the hype, a chance encounter in Los Angeles and following it up with my own research, I avoided a big loss. Few market commentators even discuss Oroton anymore; a similar fate will likely befall many of today's ‘hot’ stocks.