Published: September 13, 2010

Every Monday, I like to look at all the stocks that saw fresh rounds of insider buying in the previous week. Such so-called insider buying can alert you to undervalued stocks before most investors take note. That's because insiders (defined as any officer or director of a company, or any investor that owns more than 5% of the company's stock) have deep insights into how a business performs. Insiders must file a copy of their activities with the U.S. Securities and Exchange Commission. Several websites, including insiderinsights.com and edgar-online.com, track these transactions.

Most weeks, I am lucky to find one or two intriguing insider purchases that merit further research. But I noticed an unusual cluster of buying last week. At least two separate insiders stepped in to buy up large chunks of stock at three different retailers. Taken together, insiders at these companies snapped up more than $8 million in stock in last week. Investors have been selling off retail stocks throughout the summer, and these retailers seem to have been especially hard hit. Let's take a deeper look to see which one of these stocks holds the most appeal right now.

The gap is understandable. While both retailers generate 27% to 28% gross margins, Staples does so with a vastly more efficient overhead and can generate solid 8% operating margins, whereas Office depot hasn't been able to generate positive operating margins since 2007. (Though the company would have generated about $200 million of operating profit in 2009 were it not for some one-time charges.)

But changes are afoot, which explains why the company's insiders bought a collective $1 million in stock last week. There is little that Office Depot can do to improve sales until the economy improves and unemployment drops, but management can certainly squeeze more profits out of the business. And that process has already started.

Gross margins have risen in each of the last four quarters and are up more than 100 basis points from a year ago. Operating expenses are on track to drop about $300 million this year, which should push EBITDA from around $200 million last year to around $300 million this year. Analysts at Citigroup expect further costs cuts to boost EBITDA to around $400 million in 2011 and $500 million in 2012. The company is valued at about 2.5 times that 2012 forecast.

And while the company generated negative free cash flow in June, 2009, free cash flow improved to $62 million in the most recent quarter. Office Depot used to generate more than $400 million in annualized free cash flow, until a disastrous acquisition in Europe sapped all those earnings. These days, free cash flow is likely to be in the $100 million to $200 million range, but could perk back up above $300 million once the economy starts to add jobs. As the entire company is valued at just $1.2 billion on an enterprise value basis, $300 million in free cash flow translates into a free cash flow yield of 25%. It will take a few years to get back to that free cash flow level, but will require only a small rebound in sales and continued operational streamlining. You can understand why insiders are so bullish, even if investors are not.

American Eagle Outfitters (NYSE: AEO)
This retailer has also played second fiddle to a rival, which in this case is Abercrombie & Fitch (NYSE: ANF). While Abercrombie has a reputation for premium clothes, American Eagle is seen as a value-focused retailer, and has weaker profit margins to show for it. And teens have been cool to the company recently. Sales growth routinely exceeded +20% annually in the middle of the last decade, but have turned flat over the last few years and few analysts expect sales to rebound in the near-term, while the economy remains in a funk.

In its favor, American Eagle has nearly $600 million in net cash ($3 a share), which helped fuel a 10 million share buyback last quarter. Shares trade for a very reasonable 3.6 times projected 2011 EBITDA -- roughly -20% less than its peers. It's also noteworthy that the company's Chairman, Jay Schottenstein, just bought nearly $7 million worth of stock with his own money.

But it's hard to get excited about the company's near-term outlook since it doesn't trade at such a sharp discount to rivals. Down the road, that mega-purchase is likely to make the Chairman a lot of money, but insiders often arrive early to a party with their bullish buying activity. In this case, Mr. Schotttenstein looks to be early by a couple of years.

Collective Brands (NYSE: PSS)
This operator of Payless ShoeSource and Stride Rite shoe stores reported quarterly results on September 1st that badly lagged forecasts, pushing shares down to a 52-week low. Demand for shoes has been very weak, and sales are unlikely to rebound sharply until the economy turns up. The shares were likely oversold, and have risen for five straight sessions -- likely propelled by investors that have noted the recent $600,000 in insider purchases.

Even as management can do little to boost sales right now, it can improve Collective Brands' financial performance. The company acquired the Stride Rite business in 2007 in hopes of gleaning real synergies. Payless would gain access to Stride Rite's impressively lean wholesale shoe operations, and Stride Rite would benefit from Payless' solid logistics and real estate expertise, according to analysts at Morningstar. Those gains have been elusive, but they should still be evident in time and help boost margins.

"With integrated retail and wholesale operations, Collective Brands more closely resembles competitors like Brown Shoe (NYSE: BWS) and Genesco (NYSE: GCO). These footwear companies have benefited from scale advantages and multiple distribution channel opportunities associated with vertical integration, and Collective Brands is poised to do the same, in our opinion," wrote analyst R.J. Hottovy last week.

If he's right, then shares of Collective Brands have considerable upside. Shares trade for about seven times trailing free cash flow (which translates into a 14% free cash flow yield). Brown Shoe, the company's closest rival trades for more than 10 times free cash flow. And as noted above, Collective Brands has several paths to improved financial results, which should fuel higher free cash flow, even if sales growth remains anemic.

Action to Take --> While insiders at American Eagle Outfitters appear to need a lot of patience to make their big bet payoff, Office Depot and Collective Brands may start to win back investors by delivering improved expense control and higher cash flow. Office Depot looks to have considerable upside, perhaps +100% or +200% if management can stay focused on squeezing out costs.

-- David Sterman
Staff Writer
StreetAuthority