I recently wrote about a report about another specialty retailer, The Buckle, Inc. I want it to be understood that I am not favoring a specific industry because of macro trends or my outlook for the sector. I will continue to make decisions based on individual companies and the inherent economics they possess, rather than where I believe the most economic growth will occur. You may see some similarities between my report on Buckle and this one on Aeropostale.
I first noticed the superior fundamentals of Aeropostale in my review of the specialty retailers in Value Line. I am familiar with the stores, but I had no idea the level of profitability they possessed. At the time I reviewed the Value Line report, the company was trading far higher than I would be willing to pay, so I passed on it, but made note of it being one of my favorite specialty retailers. A few friends of mine then kept mentioning that ARO looked undervalued. I disagreed fervently because I remembered the VL issue, but then checked the current price. It had fallen almost 4o% since the report was written and it interested me enough to take a closer look.
Aeropostale, if you’re not familiar with them, caters to kids 14-17 years old in a similar target market to American Eagle and Abercrombie & Fitch (also owns Hollister). I am currently reading a book on monopolies and the importance of owning a specific space within an industry. Aeropostale’s “space” is lower prices for similar styles offered by their competitors. They offer many more sales, discounted items, and lower overall prices than their competitors. They try not to compete as much with the best overall quality, but this lower-priced arena is far less-competitive. This gives Aeropostale a monopoly; they may or may not be the lowest-cost producer, but they possess a monopoly on this niche for teens looking to dress well at a lower price. This can be easily competed with by American Eagle or Hollister lowering their prices to similar levels, but that would undermine their corporate image of providing high-quality, branded, fashionable clothing. People make a statement when buying Hollister or Abercrombie, but it’s not necessarily that way with Aeropostale. I don’t see their competitors lowering prices because Aero’s are so low. They are all comfortable where they are and are more focused on each other than on Aero’s position in the market. Aero is roughly the same size as their competitors, having 950 stores vs. 1,000 on average for AEO & ANF. Also, one key measure of efficiency and market share in this industry is sales per square foot. For mall-based specialty retailers, the average is about $400. Aeropostale’s sales/square foot has increased every year from $456 in 2002 up to $624 in 2010, the highest of any mall-based apparel retailer. This continual increase has shown their gain in market share, as well as efficiency in their stores, over the decade. Their margins have also increased; it wasn’t a result of offering more discounts.
So, at 950 stores, it is considered one of the larger specialty retail stores and is mostly saturated in the U.S. Therefore, they need new places to reinvest their cash flow. Management has found two ways to grow today. The best part? They are very conservative in their expansion initially, but once they know the concept works well, they ramp up growth quickly. Aero sales have grown 26% per year the last 5 years.
The first is international expansion. After exhausting most opportunities domestically, they moved stores into Canada and recently opened up a new store in Dubai, UAE. In 2010, ARO has already opened 8 stores in Canada, bringing the count up to 52. They also opened a third distribution center, this one in Canada as well, to help increase the speed-to-market up North. A new distribution center can only mean one thing; even more expansion into Canada. It is not stated exactly how many stores management wants to open abroad, but their ability to continue to grow profitably in the past leaves me hopeful.
The second growth opportunity is the “P.S. from Aeropostale” stores. This is catered to kids 7-12 years old and is looking to compete with Abercrombie & Fitch’s “Abercrombie” stores, as well as Gymboree and Gap Kids. This is not the first time Aero has tried opening another concept outside their typical competence. Three years ago, they opened up 14 “Jimmy Z’s” stores to try out the concept, and after a year or so of testing it out, they closed it completely. Jimmy Z’s was a surfer & skateboarder store with higher price points and more upscale than the parent company. Their initial store count was 14 and they didn’t open any additional stores; management realized that the concept wasn’t working. The same thing occurred again with these P.S. stores, opening 14 for a full year to try them out in 2009. After reviewing the results, management believes strongly in the concept and has been rolling out quite a few in the last 7 months; they’re now at 39 P.S. stores. Management expects them to hit 500 stores in the next few years and that it will do quite well. I haven’t visited any of these P.S. stores, but I am familiar with regular Aero stores and I believe the parent company knows what they’re doing.
I’m now going to move into the financials. Retail is one of the easiest industries to take a quick glance at to see their consistency and a few metrics of profitability. I like to see margins around 35% gross and 15% operating unless there is high inventory turnover, and have them be consistent year after year. ARO’s margins are consistently at:
- 30-40% gross
- 12-15% operating
- 7-10% net
These margins have been improving consistently over the decade as the company has grown from 180 stores to 950. I think some of this can be attributed to being more in the public’s eye as a large, popular retail outlet, and partially due to economies of scale. In looking at the return on deployed capital (read my article on the blog if you want more info on deployed capital), ARO is at about 50-110% every year. Therefore, we know that the business does not require a giant bank account to operate. All of the money generated from operations has been used to open additional stores or buy back stock. They still haven’t paid a dividend! I would much rather them increase value for me that isn’t taxed, so reinvestment in the company or repurchasing stock is very tax-efficient and still increases the value of my stake in the company. Also, I made a Du Pont Model to show their profitability the last 5 years and where it came from:
As you can see, the return on equity is quite high and it does not stem from leverage. The company actually employs no debt; all the leverage comes from current liabilities, which are easily covered by their profitability. The return on assets figure shows it all; I look for an ROA of at least 12% to constitute a “reasonable rate of return”. Above this is where you find most great businesses that, for one reason or another, sport higher profitability than their competitors or just the general stock market. This increase to 29% is not something I see as sustainable; Aero sells clothing at lower prices than all competitors, so it is not hard to imagine them improving their sales and returns during the recession. I’d say 20% or so, perhaps slightly higher, can be reasonably expected going forward if they don’t face any competition. You can see that their net margin is not anything spectacular, and that their high profitability stems from high turnover of assets, in other words the dollar of sales generated from each dollar of assets. This means that the business generates a lot of sales from the amount they have as hard assets to operate. It is a great model for expansion because you will grow at about the same rate as your ROA- especially when it is derived from the asset turnover. This model should show you just how consistent this company is in making improvements on their profitability. As a side note, the huge rise in 2007 on the ROE came from buying back a lot of stock that year (it decreases the equity by a large amount). The model should also show you that Aero has above-average financials, especially when compared to its industry.
So, at this point, I hope I have shown that Aeropostale sports above-average profitability and is very consistent, even through one of the worst recessions in the last 100 years. Now I would like to value it to answer the question, Is it cheap? In looking at the business model, it is still growing through opening the P.S. stores, as well as the international expansion. Because of this, and because ARO’s growth is very profitable (consistently increasing margins, ROA, etc…), I like to value the growth of the company. Therefore, I would value this on an operating cash flow basis (read my article valuation if you want more explanation). Aeropostale had an operating cash flow of $334 MM in 2009. I would value this now on a yield to market cap; it is at $2.25 B ($24.30), so the yield is approx. 15%. Aero is growing at 25% per year, although perhaps at lower rates for the future since it is already pretty large. Its capital expenditures are at 50-80 MM per year, used to open new stores, and the rest is distributed to shareholders vis-à-vis share buybacks. The buybacks consume the rest of cash generated and, after going through and seeing their average repurchase prices, I can say that management has done a great job in buying back at good price-to-value situations. I wouldn’t be surprised if they started paying dividends when the stock price got too high. They didn’t buy back any stock in 2008 because most of the year was at pretty high prices. The yield for the company, based on buybacks, is at an average the last 5 years at about 11% cash flow yield. I bought in at $23.33 a week or two ago, which is at a 15.7% cash flow yield. If it falls below this price, I plan on adding to my position.
You may be wondering why the stock fell 40% since I read the VL issue. Specialty retailers issue sales reports on a monthly basis, in addition to your expected quarterly and annual reports, so whenever these don’t compare well with the previous year in the same month or they don’t meet analysts expectations, the stock is sold off. Aero reported lower same-store-sales figures in August 2010 by 1%; hardly a large drop in profitability. This caused the main sell-off. Besides August, the past 5 years have consistently increased in the same-store-sales figure. It’s not easy to keep up with the continual increases in efficiency & market share. The net sales increased, even with a slight decrease in same-store-sales, because Aero opened new stores since last August that are now posting sales. So far in 2010, the company is about the same as it was last year on a same-store basis, but the net sales have increased a good amount because of the increased number of stores.
So the selloff, in this case, is because everyone has a very macro-oriented view of the economy and believes that retail is hurting. I believe all of this macro-crap is completely unfounded and that Wall Street, yet again, is completely wrong. Even the S&P analyst covering Aero, Marie Driscoll, knows about the P.S. store potential of about 500, and about the increase of profitability during the recession. The business is far more consistent than competitors, so I feel as though Ms. Driscoll is just looking to not stand out against other analysts covering the industry. Nobody has taken the time to review individual companies, in fact, Aero improved through the recession.
It is unique situations like this that allow the intelligent investor to coldly and rationally assess a situation and profit off of Wall Street’s folly. We are being offered, at a reasonable price, a great business that is still growing. I titled this article “growth at a reasonable price” because a 15% yield on op. cash flow isn’t something to put every cent you have into, but it is a situation I plan on making a solid return out of over time as the business grows. The best part of owning great businesses is that you can hold them for a long time. So, unlike most companies that you would sell once they reach fair value, you can hold this for a long time and wait until something newer and better comes along. I know Li Lu, for example, bought into Timberland and held it far beyond its fair value because it continued to grow. He made 7X his money in a few years just from “sitting his ass” on a great business. I’d give the same advice here; for Aeropostale, just sit on your ass. And of course, continually update your analysis as the company heads forward into the future. Complacency will get you into trouble as a business owner.
Click here for pdf version: Growth at a Reasonable Price