Aeropostale is a retailer of casual apparel for young men and women. The company went public in 2002 and has been growing sales and earning almost constantly ever since. Throughout the recession performance was excellent ā net income for the year ended January 2010 was up 77.5% from the year ended January 2008. The āalmostā comes over the TTM period, where net income has declined for the first time since 2006.
That āalmostā has been a rough ride for ARO stockholders. The current price as of this writing is $10.52, down 62% from the 52-week high and down more still from its 2010 high in the low $30s. The past two quarters have been quite ugly, with earnings for the first six months of $19.3 million versus $88.9 million from the previous year (a 78.2% decline, in case you were curious).
Thatās a awful lot of ugly. So why, you may ask, am I recommending ARO? Because the current pricing represents an implicit bet that (a) ARO will collapse or (b) it will never approach anything even vaguely close to its previous level of profitability. I think those are intensely pessimistic bets, so thereās opportunity for value investors with the patience to wait the situation out.
[A quick note: I pretty much stick to first-quarter results as the āmost recentā quarter since itās the most recent quarter with a 10-Q available, but the trends regarding year-over-year gross margins and expenses apply to both, especially the disastrous second quarter.]
Corporate Health
Flip all that around and the first step to a positive ARO thesis is demonstrating that it isnāt a corporate zombie. Weāll start with liquidity. ARO burned $126 million in cash during the first quarter, which is unnerving until you look a bit closer. Operations and investments accounted for only $29 million of that combined, and the rest was spent on a large share buyback. Management clearly took a calculated risk with this decision (and frankly not one Iām thrilled about), but the first quarter cash flow numbers arenāt a sign of any impending trouble. Itās also worth noting that the company burned a small amount of cash last year during this period (also excluding financing cash flows for comparison) and that was during a period of normal profitability.
Receivables arenāt a factor due to the nature of the business. Inventories are higher, however, up from $123 million to $142 million. That works out to a 15.6% inventory increase on flat sales. I was put off by that number until I scrutinized it more. Days inventory actually declined for the TTM period compared to the year ended January ā11, down to 30.9 days from 34.9 days. This puzzled me until I realized that part of the higher inventory level reflected an increase in the price ARO was paying for its inventory due to higher raw materials prices (more on that later...).
Solvency is not really an issue here. ARO carries no long-term debt and has only store leases as a large fixed liability. Those could theoretically threaten its continued operation, but only if the company posted truly dismal results for an extended period of time. As weāll get to below, I think thatās very unlikely.
Historical profitability
Now that weāve established that ARO is worth evaluating as a going concern, the next step is to decide what degree of profitability investors can expect in the future. In the past ARO has been a highly profitable company, providing shareholders with excellent returns on their invested capital: 5-year average ROE of 49.6% and 5-year average ROA of 25%.
The present hasnāt had a lot of resemblance to the past, though. Recent quarters have seen a substantial decline in AROās profitability as competition and raw materials drove down gross margins. To figure out how well ARO will be able to regain its past returns we need to examine how much of that pressure will continue. The competition isnāt going anywhere, but there has been a large shake-up concerning a key raw material.
Cotton Prices
Cotton prices have been a big part of AROās recent woes. Hereās a chart of the price of cotton (National Cotton Council's "A" index) over the past five years:
This looks a bit like one of those āspot the one that does not belongā problems. Cotton prices during the past twelve months skyrocketed to enormous heights, almost tripling in the March 2010-2011 period. That took a toll on clothing retailers and you can see it in AROās margins. Gross margin for the first quarter was 29.1% compared to 39.4% for the same period last year.
On the other hand, declines in cotton mean gains for ARO. Cotton is already down almost 50% from its all-time high in March. Futures currently trade around $1.05/lb., so that should greatly reduce the raw materials pricing pressure theyāve been facing lately. Margin compression isnāt all attributable to cotton prices, but even a fractional improvement to gross margins would be a big lift to ARO. I canāt really predict the price of cotton with any certainty (nor would I want to try), but with another visual Iād like to point out what an immense aberration the price movement of cotton over the past twelve months has been compared to its overall history: http://www.tradingeconomics.com/commodity/cotton
Iāve seen articles mentioning that the record-breaking drought in the Texas area might push cotton prices back up if the crop suffers, but thatās only a short-term problem if investors are holding ARO as a long-term investment.
Valuation
Given that there is an imminent catalyst to improve margins, how much do they need to improve for investors to see gains and how much can they be expected to improve? Glad you asked!
Hereās what margins have looked like during AROās time as publicly traded company:
The five-year average gross margin is 35.3% and the nine-year average (since IPO) is 33.4%. The five-year and nine-year averages for net margin are 8.7% and 8% respectively. Operating expenses as a percentage of sales have averaged 21.1% (five years) and 20.3% (nine years).
Comparing the current valuation to average net margins provides a starting point for valuation. Using the current market cap ($849 million) and estimating sales of $2400 (basically flat from last year), ARO sells for 4.1x ānormalizedā earnings if the five-year average net margin is used.
To make that a little clearer: $2400 * .0868 = $208.32 (net income); $849 / $208.32 = 4.1x
If the 9-year average net percentage is used to normalize earnings then it sells for 4.4x earnings. Not bad.
Investors might rightfully be skeptical that the company could get net margin even as high as its previous averages (much less to the heights of '10/'11) in the face of stiff competition. I share their concerns ā itās rough out there. The benefit of AROās current disaster-pricing is that it could provide investors with a compelling return by making a much smaller improvement. To help visualize that I built two matrices. The first compares a variety of hypothetical net margins and P/E multiples in terms of the resulting market cap ($M, using the same $2400 rough sales figure). The second table displays the resulting market cap as a percentage of the current market cap ($849). Green identifies higher values; red identifies lower values.
As you can see, thereās not a lot of red. If net margin gets above 4% (thatās half the historical average) then itās difficult for investors to lose money. Given that the price of cotton has declined so substantially in recent months I think that kind of modest improvement is definitely within reach.
Iām not a big fan of EBITDA as a valuation measure, but others are so I ran the numbers for that one as well. ARO is currently selling for 2.4x normalized EBITDA using five-year average EBITDA margin and 2.5x EBITDA using the nine-year average EBITDA margin.
I May Be Crazy, But Iām Not Alone
Several prominent value investors have taken positions in ARO at substantial premiums to the current price. David Einhorn and Chuck Akre both bought in during the second quarter at a price between $26 and $17. Granted, they might be reconsidering the timing of those purchases (at best theyāre down 39% so far) but thatās a vote of confidence on AROās survival and improvement from two excellent investors.
The Short Version (a summary)
ARO is the low-cost supplier in its market and saw its margins squeezed on both ends by competitor discounting and rapidly rising raw materials prices. Earnings fell off a cliff and the share price followed suit. The company is now priced for disaster, leaving investors with little downside and large upside potential on even a modest turnaround in its fortunes. With cotton prices falling off that same cliff (someone ought to put up a sign...) and taking pressure of their margins, I think the time for that modest turnaround has arrived.
That āalmostā has been a rough ride for ARO stockholders. The current price as of this writing is $10.52, down 62% from the 52-week high and down more still from its 2010 high in the low $30s. The past two quarters have been quite ugly, with earnings for the first six months of $19.3 million versus $88.9 million from the previous year (a 78.2% decline, in case you were curious).
Thatās a awful lot of ugly. So why, you may ask, am I recommending ARO? Because the current pricing represents an implicit bet that (a) ARO will collapse or (b) it will never approach anything even vaguely close to its previous level of profitability. I think those are intensely pessimistic bets, so thereās opportunity for value investors with the patience to wait the situation out.
[A quick note: I pretty much stick to first-quarter results as the āmost recentā quarter since itās the most recent quarter with a 10-Q available, but the trends regarding year-over-year gross margins and expenses apply to both, especially the disastrous second quarter.]
Corporate Health
Flip all that around and the first step to a positive ARO thesis is demonstrating that it isnāt a corporate zombie. Weāll start with liquidity. ARO burned $126 million in cash during the first quarter, which is unnerving until you look a bit closer. Operations and investments accounted for only $29 million of that combined, and the rest was spent on a large share buyback. Management clearly took a calculated risk with this decision (and frankly not one Iām thrilled about), but the first quarter cash flow numbers arenāt a sign of any impending trouble. Itās also worth noting that the company burned a small amount of cash last year during this period (also excluding financing cash flows for comparison) and that was during a period of normal profitability.
Receivables arenāt a factor due to the nature of the business. Inventories are higher, however, up from $123 million to $142 million. That works out to a 15.6% inventory increase on flat sales. I was put off by that number until I scrutinized it more. Days inventory actually declined for the TTM period compared to the year ended January ā11, down to 30.9 days from 34.9 days. This puzzled me until I realized that part of the higher inventory level reflected an increase in the price ARO was paying for its inventory due to higher raw materials prices (more on that later...).
Solvency is not really an issue here. ARO carries no long-term debt and has only store leases as a large fixed liability. Those could theoretically threaten its continued operation, but only if the company posted truly dismal results for an extended period of time. As weāll get to below, I think thatās very unlikely.
Historical profitability
Now that weāve established that ARO is worth evaluating as a going concern, the next step is to decide what degree of profitability investors can expect in the future. In the past ARO has been a highly profitable company, providing shareholders with excellent returns on their invested capital: 5-year average ROE of 49.6% and 5-year average ROA of 25%.
The present hasnāt had a lot of resemblance to the past, though. Recent quarters have seen a substantial decline in AROās profitability as competition and raw materials drove down gross margins. To figure out how well ARO will be able to regain its past returns we need to examine how much of that pressure will continue. The competition isnāt going anywhere, but there has been a large shake-up concerning a key raw material.
Cotton Prices
Cotton prices have been a big part of AROās recent woes. Hereās a chart of the price of cotton (National Cotton Council's "A" index) over the past five years:
This looks a bit like one of those āspot the one that does not belongā problems. Cotton prices during the past twelve months skyrocketed to enormous heights, almost tripling in the March 2010-2011 period. That took a toll on clothing retailers and you can see it in AROās margins. Gross margin for the first quarter was 29.1% compared to 39.4% for the same period last year.
On the other hand, declines in cotton mean gains for ARO. Cotton is already down almost 50% from its all-time high in March. Futures currently trade around $1.05/lb., so that should greatly reduce the raw materials pricing pressure theyāve been facing lately. Margin compression isnāt all attributable to cotton prices, but even a fractional improvement to gross margins would be a big lift to ARO. I canāt really predict the price of cotton with any certainty (nor would I want to try), but with another visual Iād like to point out what an immense aberration the price movement of cotton over the past twelve months has been compared to its overall history: http://www.tradingeconomics.com/commodity/cotton
Iāve seen articles mentioning that the record-breaking drought in the Texas area might push cotton prices back up if the crop suffers, but thatās only a short-term problem if investors are holding ARO as a long-term investment.
Valuation
Given that there is an imminent catalyst to improve margins, how much do they need to improve for investors to see gains and how much can they be expected to improve? Glad you asked!
Hereās what margins have looked like during AROās time as publicly traded company:
The five-year average gross margin is 35.3% and the nine-year average (since IPO) is 33.4%. The five-year and nine-year averages for net margin are 8.7% and 8% respectively. Operating expenses as a percentage of sales have averaged 21.1% (five years) and 20.3% (nine years).
Comparing the current valuation to average net margins provides a starting point for valuation. Using the current market cap ($849 million) and estimating sales of $2400 (basically flat from last year), ARO sells for 4.1x ānormalizedā earnings if the five-year average net margin is used.
To make that a little clearer: $2400 * .0868 = $208.32 (net income); $849 / $208.32 = 4.1x
If the 9-year average net percentage is used to normalize earnings then it sells for 4.4x earnings. Not bad.
Investors might rightfully be skeptical that the company could get net margin even as high as its previous averages (much less to the heights of '10/'11) in the face of stiff competition. I share their concerns ā itās rough out there. The benefit of AROās current disaster-pricing is that it could provide investors with a compelling return by making a much smaller improvement. To help visualize that I built two matrices. The first compares a variety of hypothetical net margins and P/E multiples in terms of the resulting market cap ($M, using the same $2400 rough sales figure). The second table displays the resulting market cap as a percentage of the current market cap ($849). Green identifies higher values; red identifies lower values.
As you can see, thereās not a lot of red. If net margin gets above 4% (thatās half the historical average) then itās difficult for investors to lose money. Given that the price of cotton has declined so substantially in recent months I think that kind of modest improvement is definitely within reach.
Iām not a big fan of EBITDA as a valuation measure, but others are so I ran the numbers for that one as well. ARO is currently selling for 2.4x normalized EBITDA using five-year average EBITDA margin and 2.5x EBITDA using the nine-year average EBITDA margin.
I May Be Crazy, But Iām Not Alone
Several prominent value investors have taken positions in ARO at substantial premiums to the current price. David Einhorn and Chuck Akre both bought in during the second quarter at a price between $26 and $17. Granted, they might be reconsidering the timing of those purchases (at best theyāre down 39% so far) but thatās a vote of confidence on AROās survival and improvement from two excellent investors.
The Short Version (a summary)
ARO is the low-cost supplier in its market and saw its margins squeezed on both ends by competitor discounting and rapidly rising raw materials prices. Earnings fell off a cliff and the share price followed suit. The company is now priced for disaster, leaving investors with little downside and large upside potential on even a modest turnaround in its fortunes. With cotton prices falling off that same cliff (someone ought to put up a sign...) and taking pressure of their margins, I think the time for that modest turnaround has arrived.
