In the last few years, we’ve seen the demise of such retailers as Bombay, Linen & Things and Circuit City. These firms were ill-equipped to handle the duel pressures of a slowing economy and the rising pressure of Amazon.com (Nasdaq: AMZN), Wal-Mart (NYSE: WMT) and other retailers. And since retail spending continues to migrate away from brick-and-mortar stores and toward the Internet, you can expect to hear of a few more retail bankruptcies in the next few years.

But that doesn’t mean you shouldn’t own retail stocks. As I’ve said before, retail stocks often make for excellent holdings coming out of the clutches of a recession. This is because, given the fixed-cost nature of retail, rapid sales gains from increased consumer spending often lead to substantial gains at the bottom line. And this, in turn, often leads to big stock gains.

We already have a pretty good idea of which retailers will have to close up shop. The Z-Score, devised by New York University Professor Edward Altman back in 1968, has an uncannily accurate track record of predicting bankruptcies well before they happen. In his first set of tests, Altman found that 72% of companies that were predicted to head to bankruptcy within two years actually did. The methodology can be applied to virtually any industry, but has been especially prescient in the retail space.

Using this nifty tool can help investors get a handle on which retail stocks are likely safe bets and which should be avoided or considered ripe for short-selling.

How it works
The Z-Score looks at seven financial indicators found on the balance sheet and income statement, and then pairs them up in a set of five distinct ratios. These ratios are then assigned a weighting, and when tallied up, yield a Z-Score.

I recently did a Z-score calculation for more than 100 publicly-traded retailers. View the results here.

Altman figured any retailer with a Z-Score above 3 could be considered safe. Readings between 1.23 and 3.0 are in the “grey zone,” and any retailers that generate a reading below 1.23 are likely headed for deep trouble. The charm of this analysis is that you can make a spreadsheet (or use the one we’ve created) and simply update the numbers every quarter. This will give you an early read on retailers headed into distress and which ones are in good shape.

So which retailers appear to be in the most distress? Take a look at this shortened version of my calculations below…

Geeknet (Nasdaq: GKNT) heads the list — by a considerable margin, likely because the retailer has roughly $800 million in shareholder’s deficit on the balance sheet. That’s a past-looking metric and not really all that helpful in determining future financial distress. The company is trying to re-invent itself from a purveyor of open source software to a full-fledged e-commerce site. Geeknet was unprofitable in its former incarnation, and remains unprofitable with its new initiatives. However, with $25 million in cash and a small burn rate, the Z-Score rating may not be an accurate gauge in this instance.

Higher-profile distress
Further down the list, a pair of companies caught my eye because their business models look increasingly unviable. Both Rite-Aid (NYSE: RAD) and OfficeMax (NYSE: OMX) are industry laggards in brutally competitive environments. It wouldn’t take much effort by CVS (NYSE: CVS) or Walgreen (NYSE: WAG) to put the hurt on Rite-Aid by kicking off more price wars. Eliminating weakened rivals through aggressive pricing is a long-standing retail industry trick, used by Best Buy (NYSE: BBY) to smother Circuit City and Pier One Imports (NYSE: PIR) to put the screws to Bombay. In a similar vein, Staples (Nasdaq: SPLS) could make life miserable for OfficeMax, if it so chose.

Action to Take –> You should keep tracking these retailers in order to keep tabs on your long positions as well as hunt for potential short selling ideas.

The Z-Score will be back in vogue if the economy weakens anew. But the Z-Score is just a starting point. It sometimes points to companies that are not truly on the cusp of deep financial distress, but the methodology does have a clear positive track record.

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