From some of the commentary on my previous article, I have found some serious resistance to some of my thoughts. Comments included:
- Overly optimistic future expectations and earning power estimates
- Ignoring idea of value destruction by management
- Wrongly believing past results are indicative of future growth
Rather than comment individually, I figure I’d write another article, addressing these concerns with some thoughts.
First, I want to thank you guys for keeping me honest- it’s helpful to have criticism and allow me to reassess my thinking. It’s also interesting to see the stock drop even further and to have me question my analysis/do some soul-searching here.
I’ve gone back and done what I should have previously- listened to last 2 quarters of conference calls to make sure management’s views lined up with my own. My thoughts are as follows:
2010 Q4 earnings call:
- First indication of inventory & merchandise problems
- Men’s comps flat, Women’s down 4% (down 3% for quarter comparable sales)
- Talked about increased costs in 1st half of 2011 of 3-5%, and 10-15% for 2nd half of 2011; going to try to pass along to customers
- Overly optimistic/serious tone, looking forward to fall season already
2011 Q1 earnings call:
- Men’s up 2%, Women’s down 10%, issue was their knitted tops which is one of Aero’s staple products
- “Clearly disappointing” results, somber & apologetic tones
- February was good, March & April were affected more severely than expected
- Main problems were merchandise, didn’t have women’s assortment that customers wanted
- Having challenging inventory clearance, overhang from Q4 inventory and now Q1 is overhanging to Q2- not having Q2 results like they’d want/expect
- Still sees significant cost inflation for back half of 2011
- Very specific merchandise issues in comparing good sellers to bad sellers; using words like “crystal clear”, “absolutely”, and “confident” about the changes that need to be made, getting back to roots
- If they didn’t know the problems, it would be a serious problem, but they know exactly what to change and really believe they can fix the problems
From listening to both conference calls, I get the sense from Q4 that management just started to see problems but wasn’t waking up to them yet (they had said in Q1 that February was strong and things turned in March/April, this call was March 10).
So, Q2 is suffering still from the Q1 inventory overhang and they’re clearing it through as quickly as possible. In both the Q4 and Q1, they were very optimistic about the fall & back half of the year. I think that is the inflection point. We may very well see then if the problem is a brand issue (which management vehemently denies/disagrees with) or a shorter-term merchandise issue. I’m not worried in just listening to management, and although they’re very optimistic all the time, they really seem to be getting back to roots from Q1.
So, this will hit margins this year. Fortunately, Q1/Q2 are the less-important quarters for the business, comprising 17-20% of sales each quarter the last few years. So, I want to update my thoughts on earning power.
First, you must realize I didn’t subtracting capital expenditures when analyzing the business for the original article. While they are remodeling stores as part of the expense, it costs much less to remodel a store than it does to open a new one, and these new store openings are still driving growth. Don’t focus on the last two quarters as an indication that growth isn’t working- it just happens that existing stores have had some issues in selling less than they previously did, whereas new store growth kept sales flat the past few quarters. I would say capital expenditures for store remodels are likely in the range of $10-20 MM, so I’ll take that off my initial earning power estimation.
In addition to this $10-20 MM being taken off, I will point out historical earning power vs. what can perhaps be expected for the future:
As you can see, gross margins have been as low as they were in Q1 (29.1%) last in 2003, where they were 29.5%. While I do not expect that margin for the full year, I do expect it for Q2. As a result about 40% of 2011 sales will be at 29.5% GM’s and it is unclear as to what to expect for Q3/Q4. With SG&A at 21% of sales (management said to expect flat SG&A for the year), this indicates an 8.5% operating margin for the first half of the year. On sales of $2.5 B (my approximation, one commentator believes closer to $2.4 B but with more store openings I think $2.5 is pretty accurate), this would lead to $85 MM in operating earnings for the first half of 2011.
One note to the above paragraph, because I’m sure someone will check & see there is only a 5.8% op. margin for Q1 2011, is that SG&A is a relatively fixed expense, and sales are lower in Q1/Q2 than in Q3/Q4. This gives a larger SG&A as a percent of sales in quarters 1 & 2 vs. the back half of the year. I’m assuming a fixed percentage of sales for the full year, rather than a monetary amount for each quarter separately to make the analysis simpler.
If you want to go by management’s confidence in getting back to it’s roots and clearly identifying the problematic merchandise, then you will agree with my margin expectations for the 2nd half of the year. It seems that in 2003, when there was a GM of 29.5% for the year, the operating margin was 9.4%. If it were to increase to 31% for the year, you’d expect closer to 10% operating margins, which is what I’m going to expect. That would mean the remaining 60% of sales that come in Q3/Q4 would need GM’s around 32.5%. I think that’s perfectly reasonable considering management’s commitment to improving results in the 2nd half of the year. Therefore, I expect operating margins at 10%, indicating operating earnings at $250 MM.
Cash flows, adjusted for working capital, typically come in some $60 MM below operating earnings, so I’d expect close to $190 MM in 2011 owner earnings. As discussed above, there’s the $10-20 MM also in store remodeling to be subtracted, so owner earnings for 2011 will come in perhaps at $175 MM, a far cry from my original article at $300 MM where I believed it was conservative. My apologies.
As for this merchandise issue, I’d consider it a shorter-term problem that management believes they can fix. Therefore, just as with Noble Corporation (my favorite holding currently) where earning power is depressed shorter-term, the current earnings should not provide the only basis for valuation. I believe once these problems are fixed with merchandising, earning power will return to mid-cycle levels around 12-13%. Paired with that are the margin-increasing licensing agreements abroad and P.S. store growth. Therefore, although 2011 earning power should have 10% operating margins, I’m going to value it at 12% operating margins once the merchandise problems are fixed.
At $2.5 B in 2011 sales, this indicates $300 MM in operating earnings, or $250 MM in op. cash flows adjusted for WC changes, meaning $240 MM in owner earnings. At $1.4 B (77 MM shares outstanding at $18.25/share), this indicates an 17% earnings yield for a growing business with potential margin upside if problems abate. I will say I think this business is worth somewhere between $2.75-$3.25 B, again if current problems are merchandise-related and not brand-related, which is a far cry from today’s prices.
Shareholders should focus on the next earnings call and see what management is seeing from their first month in the back to school season. If things are going as planned, we could see a turnaround in the 2nd half of the year. If problems are still arising and there is additional inventory overhang, owners should start to worry. For now, I’m happy owning the stock and welcome additional share repurchases (4.2 MM this past quarter).