The Source Of Campbell Soup’s Competitive Advantage: Weight

I like to get creative when I study companies. Whether it’s getting inside management’s head as it relates to allocation of capital, or simply reading the footnotes to the financial statements, I often connect data points that can point out interesting conclusions.

One thing in particular that I am looking for is any indication of a competitive advantage that goes beyond your everyday cost cutting, corporate synergies, or oft-touted metrics by management. This is in part due to Warren Buffett’s quote:

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”

As this relates to Campbell Soup Company, one we are all familiar with, I have an idea to put forward.

If you ask most people, they will tell you Campbell’s has a recognizable brand and as a result achieves superior economics. This is partially true, but in my studies of Porter’s Five Forces Model (new entrants, substitutes, suppliers, buyers, competition), every major theorist is unanimous in believing that new entrants are by far the biggest threat. So if a firm has high barriers to entry, it is near-impossible to take them down. And while Campbell’s brand is a barrier to entry, I don’t think it’s the main one that’s keeping them in business.

Their main advantage is simple: what they sell is heavy. Really heavy, in fact, for how much you pay for it.

Because Campbell’s sells a lot 0f their product for very little, and because it weighs a lot, they’ve invested heavily in their own regional manufacturing and distribution facilities. In the U.S. alone, they have 13 states with manufacturing capabilities. This investment of $2.3 billion is a major hurdle for any company entering the soup business.

If I were to come up with a list in my mind of the heaviest items per dollar spent, this is what I’d come up with (dollars per pound, roughly as prices aren’t readily available online):

  • Coca-Cola (on a 12-pack basis): $0.62
  • Budweiser (on a 20-pack basis): $1.42
  • Campbell’s Soup (on a 1 can basis): $1.62
  • Bricks: $0.07
  • Cinder blocks: $0.06
  • Aggregate: $0.005

These are the prices per POUND. Less than $1 is pretty significant, even less than $2 is still a ridiculous amount of product to move.

What I have identified here are a list of businesses that require sophisticated, low-cost, large-scale distribution to earn a reasonable return on their capital. And this is so expensive and low-return that Coca-Cola even separates this out into a separate public company. But as far as advantages go, not only would you have to compete with Coke or Campbell’s or Budweiser’s brands, you’d also have to come up with something to the tune of $21 billion for Budweiser. And this is just so that you can sell each item for $1-3 a piece. Not an easy task, indeed.

I also included some building materials businesses because I think they are relevant as well. I have seen some very talented value investors checking out aggregate and brick companies and I never stopped to think why. But selling 1 ton (2,000 pounds) of aggregate for $10-11 means nearly all the value captured is through economies of scale for shipping. It provides a regional competitive advantage and virtually guarantees nobody else can compete. I do remember reading a few years ago that the aggregate companies were consolidating; a quick check showed me just two large ones remain: Vulcan Materials and Martin Marietta. I’m going to start looking for more of these both domestically and internationally to see the economics, as well as the advantages they possess.

You’ll have to forgive me if I took this from a book, I cannot remember if I figured this out or I read it somewhere. Either way, I think it’s highly useful for starting to conceptualize hidden competitive advantages.

Happy hunting.

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Mohnish Pabrai is BACK

I attended my first Mohnish Pabrai hedge fund shareholder meeting in the Fall of 2010, two years roughly after getting interested in the stock market. When I went, I was enamored with Mr. Pabrai and believed him to be a superinvestor, much like Mr. Buffett describes.

However, upon entering the meeting, I received an annual report which showed current Dalal Street holdings. And I was not impressed. Following his presentation, he opened up to Q&A, which I took advantage of, at 19 years of age. The reactions by the crowd were interesting, to say the least. The transcript is below.

Q: I’m Andrew Schneck. I’m from Pittsburgh. I know we’ve been asking you a couple questions now about your allocation of your capital within the specific positions. In looking at the Kelly formula that you use, especially back earlier in the decade, it seems like the odds that you’re playing right now with your two percent or five percent bets are the same as a casino if you’re playing 52 percent in your favor, 48 percent against.

It seems almost that you’re more concerned with preserving your wealth than you are in going forward and trying to actively grow it. I’m just curious if you’re almost less sure of yourself with this whole downturn in 2008 and 2009, or if it’s more just that you feel that there are many more ideas out there now that you really can diversify into? Thanks.

A: That’s a good question because it saves me the trouble of doing the next edition of the book. (laughter) The book is wrong on the Kelly formula. The Kelly formula’s correct, but you could only apply it if you’re doing a large number of repeated bets. If you have, let’s say 52-48 percent odds on coin tosses, then making the bets according to the formula makes sense if you get to participate in 200 coin tosses.

If you get to participate in two coin tosses, it doesn’t make that much sense to use the formula. In Kelly terms, we were under betting the Kelly at ten percent of assets going to one bet. We are even further under betting the Kelly now at 2 or 5 percent. We’ve gone even further. That’s because the way the funds are set up is it’s not like coin tosses where I get to make 500 bets. I only get to make a dozen or two-dozen bets over some period of time.

This year, we only made two bets so far. The good news is I never really applied the Kelly formula because I was applying the ten percent of assets even before I heard the Kelly formula. Then when I heard about the Kelly formula and I applied the ten percent asset test, all it ratified was that I was under betting the Kelly, which is fine.

We never went to the point of going to the full extent of the Kelly which would mean like 90 percent of your portfolio goes into a single bet. Or 95 percent goes into a single bet. That wouldn’t make sense. First of all, the good news is we can set the record straight that the Kelly formula doesn’t apply to a low number of stock picks. Even if the odds are heavily for you. The second is that return of capital is more important than return on capital.

Most of my investors here first care about return of capital, then they care about return on capital. I have always had a deep concern to make sure that we return the capital and then we make money on it. We saw large drawdowns, and the negative of the drawdowns is people redeemed at the point when the drawdowns took place. This means that there’s never a chance I have to ever get them back. They left when the funds were down. When I’m running temporary capital, like I am currently, large drawdowns are negative.

I may not care about volatility but the reality of having temporary capital is the volatility matters. What I was looking for is to temper the volatility. To not so much make it like an annuity or clipping coupons but I wanted to make sure that our likelihood of having large draw downs is reduced. I don’t think we’ve given up on one thing which is to make money for the investors. But what we want to do is we want to make money by being prudent. I don’t want to make irrational bets. I don’t want to make high-risk bets to get high returns.


There you have it. After having beaten the market handsomely from 2000-2007, market underperformance and drawdowns caused him to retreat from his prior strategy. Rather than own, say, 7-10 names, he now owned closer to 20-25. And that was a major change in my opinion.

Mr. Buffett talks about making sure bets with large portions of available capital, whereas here Mr. Pabrai was taking a step back from that and diversifying further, to appease his investors with temporary capital. This is a very real threat to one’s business model if not handled properly.

I didn’t write this piece to pick on Mr. Pabrai – just read the title. He now has the majority of his capital in just 5 names. This excites me. It means one of a few things:

  • He is back to his old self (my hypothesis)
  • He has fixed relations with his investors, who no longer will be impacted by volatility and will allow Mr. Pabrai to do his work in peace
  • He is still diversified heavily but the majority of assets are in overseas companies that do not require disclosure (unlikely given the disclosure dollar amounts, the 13-F has the majority of his assets)

For those of you too lazy or incompetent to find the names (kidding), here they are in order of size:

  • FCAU: 42%
  • GM-B warrants: 20%
  • ZINC: 16%
  • PKX: 10%
  • GOOG: 8%

I haven’t studied half of these but I do plan on it. Google was a no-brainer a few years ago but I’m not sure where it stands now in terms of valuation.

Happy hunting, and celebrate! One of our best has returned.

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Back from the Dead

I won’t go into it, but my health has been very poor. And although I haven’t posted much work to the Internet over the past few years, it doesn’t mean I haven’t been busy. So, rather than start a new blog, I’m coming back to my old one. I like how it’s set up, and with time, I think I can turn it into something worth checking out.

My Current Holdings

My current holdings can be seen on this site, unfortunately however the site is down. It will be back soon, and has much of the research I worked on in 2012 and 2013. Everything I’ve done then is not able to become public: I signed an NDA for much of my publishable research.

A short summary of my holdings is as follows:

  • SolarCity (SCTY): 53%
  • Tesla Motors (TSLA): 29%
  • Micron (MU): 8%
  • Chicago Bridge and Iron (CBI): 5%
  • National Oilwell Varco (NOV): 4%
  • Berkshire Hathaway (BRK): 2%

You can expect at least one post about each investment, save for Berkshire, which hopefully explains itself. You might be scratching your head as to why I have such a large holding in a company no investing professionals seems to own – SolarCity. I have a lot of research to share on them, so hang tight.

What To Expect Going Forward

You are probably surprised to see this showing up in your email notifications since you haven’t heard from me in about 3 years. What you can expect is a far more sophisticated approach to research, valuation, inquiry, and stream of consciousness from me as my health continues to rebound.

As with before, let’s keep this a fun experiment and please reach out! I enjoy discussing a wide array of topics.


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Farewell- It’s Been Fun

That’s my attempt at waving goodbye in a picture, take it or leave it I guess haha. Figured my readers may be interested in what I look like, although I’d hope it doesn’t matter for what I’m writing or how you interpret it.

My roommate’s father recommended to me, at the beginning of this past school year, to start an investment blog because it would help me meet people. I almost didn’t take his advice, but I’m glad I did. Writing in a public forum and getting feedback on my ideas has been invaluable.

It’s been an interesting journey the past 9 months or so. About 5 of you reached out and we’ve shared research notes, becoming friends, or at least colleagues/acquaintances. And, I’m glad to write, we are still collaborating today; this was the greatest thing I’ve gotten from the blog.

About 20 of you kept me on my toes at one point or another for my analysis; for this I’m grateful, it helps point out flaws in my thinking (nobody is perfect, I’m definitely still learning).

And with that, I guess it’s goodbye….

Just kidding! I’m launching a new site with a friend I met at IU, one of the most talented people I’ve met at the school, and we’re collaborating on a small LLC together in which we pooled our capital. I provide the in-depth research and valuation; he keeps very aware of emerging trends in the market and has been a trader for the past few years. He knows the options, futures, and international markets, as well as the dynamics behind some of these transactions (how they’re filled, shorting, option pricing). So, with every position we take (almost all of which is long-term stock holdings), we both consider it with different backgrounds and attempt to take advantage of option pricing when the situation warrants it.

The new website is: (Schneck-Thomas Report)

My first post is on Reading International, a cinema operator mixed with a real estate developer. I will warn you, it’s quite long, even for me. You can see my post here:

Thank you for all your support, criticism, curiosity, humor, hard work, and above all, for reading my work. It’s been awesome and I plan on continuing it. I’ll leave this blog up for my past posts and to reference from time to time, but I don’t think I have a reason to post on here again- everything new will go on theSTreport.

Being a businessman, I figured you’d like this as well- a small part of the decision to start a new site was the ad revenue. Not to mention owning my own domain name; it appears much more serious/professional for your own website as an investor just getting started (or so I hope).

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Noble Corp: Still Misunderstood & Worth a Serious Look

“I don’t know that you’re ever going to find a CEO who believes his valuation is correct.” ~David Williams

Noble Corporation held an analyst day Wednesday in Singapore and put up their presentation on their website. It’s about 3 hours, so while I’d recommend you listen to it, I think you should pull up a comfortable chair.

Above was David Williams’ quote after being asked a question on where he thinks Noble should be valued. He had been commenting numerous times on the comparison between Noble’s valuation and Ensco’s, and an analyst finally asked about it. It’s clear he still believes Noble deserves a higher valuation from today’s prices… In any event, Ensco has much more visibility in earning power the next year or two because less of their business was affected by the Gulf of Mexico and their rigs didn’t have any downtime, whereas Noble lost 30% of their business during the moratorium. I believe that’s why Einhorn favored them following the Macondo spill (his fund’s biggest position for awhile) and why he wasn’t as big a fan of Noble, even though the companies are very comparable long-term and Noble has been much cheaper all the way since the BP spill. If you compare fleets, they’re virtually identical (this assumes Ensco/Pride merger already took place and newbuilds as part of the current fleet).

Noble vs. Ensco:

  • 27 floaters vs. 27 floaters
  • 45 jackups vs. 49 jackups

While it is true that Noble’s fleet is slightly older, their floater fleet (which is more profitable than jackups) has better specs across the board. Noble’s management went into granular detail about the two fleets during the presentation & I think you should hear it for yourself on the earnings call.

Age is a serious issue for customers, along with specifications, when it comes to these offshore drilling rigs. Ensco flaunts a graph of avg. fleet age in their latest investor presentation, but they don’t adjust it to be an earnings-weighted average fleet age. As a result, it shows Ensco being 7 years old on average, while Noble shows up at 19 years. However, Noble relies much less upon their older rigs for earning power. Their incoming globetrotters, bully’s, and HHI rigs will constitute a large chunk of earning power, as well as the Jim Day and some of their newer semi-subs and high-spec jackups. The old jackups are what skews the average fleet age, and despite this, many more will get tenders the next few months, according to Noble’s management Wednesday. In any event, it’s best to visualize the 4 classes of jackups that Roger Hunt separated out below. It speaks to the disparity between older & newer jackups and the demand for both today:

As you can see, utilization and dayrates are significantly affected by when a rig was built. The newer ones are getting poached first off the market and then it trickles down- this speaks largely to those drillers aggressively investing in their futures, not only at the jackup but also the floater level. It’s why Ensco & Noble are my two favorites for the industry. I just think they should be valued about the same, perhaps giving Noble a small premium once their earning power is more clear in a 2013 (when many of their newbuild rigs will be delivered). Today, Ensco/Pride trades at $15.5 B, whereas Noble’s at $10.7 B. This 50% disparity is completely unreasonable, but then again, that’s what happens I guess when a situation is difficult to analyze.

So, I want to go back through some of the numbers so you can assess it for yourself. Here are the figures of importance (click for larger picture):

Some things to note are that the op. cash flows are adjusted for working capital changes, maintenance capex is a combination of “other capital expenditures” and “major maintenance capital expenditures”, the operating margins don’t include depreciation/amortization or other non-cash charges, ROA/ROE is based on returns of my definition of “owner earnings” (my op. cash flows less my maintenance capex), and the working capital subtracts out cash.

As you can see, the fleet size hasn’t changed materially over the last decade. What has changed is the profitability per rig, and that has a lot to do with disposing of non-core rigs and building newer high-spec rigs. Return on equity & return on assets are very high, especially for the industry, and a lot of that has to do with the rig selection they’ve made the past five years. 2010 was substantially lower due to the moratorium in the GOM, and this is not going to continue as a good number of permits have been issued already. If you focus on my definition of owner earnings, you’ll see they peaked in 2009 at $1.45 B. Since then, there was the Frontier acquisition and a number of newbuilds being announced as well. Below I’ve listed Noble’s presentation on their floater fleet expansion through 2014:

As I noted before, deepwater floater rigs are much more profitable than their jackup counterparts, and this expansion from 12/13 rigs up to 27 show Noble’s significant growth through the past 2 years. At $1.4 B in 2009 and having 13 floater rigs, having 26 floaters in 2013 will end up much higher, at least approaching $2 B in annual owner earnings in 2013. I realize I don’t have the figures for floater vs. jackup profitability and it’s difficult to assess just how much earning power has been added through the Frontier acquisition, as well as through their newbuild program, but I believe the business will be in very solid shape moving forward with these high-spec rigs.

Moving on, it’s hard for me to quantify all the industry knowledge I’ve obtained the past year from reading so much, but I do know that demand for offshore rigs is as strong as ever and is picking up in various parts of the world. Noble has always stuck to not building any new rigs “on speculation”, meaning they need a firm contract in place before ordering one of these $500+ MM rigs because Noble is the most conservative in the industry. To see them order a few extremely high-spec, expensive rigs on speculation shows me that they have confidence in future demand for offshore drilling.

For example, Noble has a near-exclusive relationship with Shell as their main offshore provider (80+% of drilling), and Shell is filing for permits now to drill 10+ wells off Alaska’s shores. This is a huge development that looks likely to be approved and Noble’s Discoverer will be the first one up there, along with Shell’s Kulluk rig that Noble will operate for them. Shell has already invested over $3.5 B up there in various projects to allow them to drill in Alaska. Another example was Noble’s management discussing strong demand in the North Sea for the latest high-spec jackups, the JU3000N’s, which the customers are now getting up to speed on their new capabilities.

I believe Noble has the best rig selection team in the world as well. David Williams has given numerous examples through the last 2 years of their team going around the world to look at every secondhand rig, each shipyard to work with them on specifications & price, and looking at their existing fleet for possible refurbishments. He said at the presentation Wednesday that the refurbishment & purchasing secondhand rigs has run its course, and that customers are now looking for newer, high-spec rigs for much of their drilling needs. This speaks very well to those companies in this industry with newer rigs being built or currently in place (Noble, Ensco/Pride, Seadrill), and not so well to those who don’t replenish their existing fleets (Diamond especially). I showed the jackup table that Noble provided earlier; it’s another indication that newer fleets will win in the long-run for this industry.

Closing remarks:

I feel I got a very solid picture of today’s situation in offshore drilling after this long presentation. Management views these tough times as a trough in the drilling cycle and the industry is investing in the next generation high-spec rigs (except for Diamond, who plans on dying slowly by not building any new rigs). Also, finally emerging from this Gulf of Mexico mess will contribute significant industry tailwinds. In addition, management reiterated the $70/barrel that allows offshore drilling to be profitable, and they saw 2010 as a very rough year for them, with much optimism for the next few years.

Overall, Noble has some uncertainty as to 2013/2014 earning power moving forward, but it’s easy to see today’s situation as being significantly misunderstood. With a fleet with better specs than Ensco/Pride’s and being almost identical in terms of size, a 50% discount to Encso/Pride’s valuation is unreasonable and, at the very least, gives today’s investor a significant margin of safety for the future. With a belief in at least $2 B owner earnings in 2013, shareholders can pick it up at a 19% yield to long-term earning power. I continue to believe in this company and it remains as one of my largest holdings, as well as my favorite moving forward.

Also, did I mention? T. Boone Pickens now has Noble as his largest position for his BP fund this latest quarter (more than doubling his position from last quarter from $11 MM to $30 MM)… in my mind this is no coincidence. He sees what I’m seeing and believes in Noble’s current valuation. I think this is the best purchase at today’s prices, except maybe Aeropostale, and shareholders should be very excited for the next 3+ years.

If I were an analyst working for a bank, my recommendation would be “Strongest Buy Possible”. Take a close look into the industry, I think you’ll do well at today’s prices in Noble.

Posted in Noble Corp, Stock Updates | Tagged , | 3 Comments

Aeropostale: I spoke too soon.

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).

Posted in Aeropostale, Stock Updates | 3 Comments

Buckle vs. Aeropostale: A Comparison


I had planned on posting this a few days ago, but don’t think that the drop in Buckle’s stock affected this decision- if anything, I wish it was posted beforehand because it makes me look like I’m validating my research by Buckle’s 12% drop today.

For those few of you who follow my blog, you’ll know I previously wrote an article about Buckle in August talking about the company. The business is solid, it was undervalued, and I liked what I was seeing. Since, it has run up 75% or so. This is not a bragging moment- I sold out before it ended up above $40 and think it’s somewhat crazy how high the stock has gone in such a short time. It was frustrating for me because my sale was pretty close to when they announced a special dividend & it shot up 30% or so in about a month. I had predicted a special dividend in September, as they had done the previous two years, but they waited a little longer this year. It was their main way of returning excess cash to shareholders and I figured it was coming again in the same month… maybe they were on vacation, who knows…

Compare that now to Aeropostale. I found a similar valuation with them in October when I wrote an article discussing my decision to invest. In a subsequent 7-month time frame, the stock has come down about 15% and I’m scratching my head. So here I’m thinking: am I wrong, or is everyone else just crazy? That’s what I’m here to analyze.

Buckle hasn’t opened any new stores since my article, and has actually closed three. Apparently my original vision of 800-1200 stores may not have been accurate (currently 420), but then again, they do expect 12 new stores in 2011. This is far lower than their avg. growth of 20 stores/year, but I’m not too worried for them. They have one of the best store location selections of any retailer and you can read about it in their ann’l report, or just visit a nearby mall & see what I’m talking about. With 43.5% director ownership, you know every action they make is still in the best interest of the shareholder. So, my views of the business have changed little since the original article. Adjusted for working capital changes, their earning power was:

  • 2010: $180 MM
  • 2009: $157 MM
  • 2008: $133 MM

This growth trend will continue, although stated previously, perhaps at a slightly lower rate. So, in buying Buckle today, what are you getting?

  • 420 stores
  • $100 MM reserve cash
  • $180 MM earning power growing at perhaps 3-6% per year (if store growth continues at current pace)

At a current valuation of $2 B, you’re effectively getting a 9% owner earning’s yield with some growth in front of you. Not bad, but also not near a price I’d be interested. My original purchase was much closer to $1.1 B and that was a much better time to invest.

Now, let’s compare that to Aeropostale. Unlike Buckle, who returns excess cash in the form of dividends, Aeropostale buys back as much stock as possible. Here are the latest figures for shares outstanding:

  • 80,723,152- May 2011 Proxy
  • 81,776,929- March 2011 10-k
  • 87,968,635- December 2010 10-q
  • 92,445,136- September 2010 10-q
  • 93,523,697- June 2010 10-q
  • 94,207,445- March 2010 10-q

I think I’ve made my point. You’ll notice between December & March, Aeropostale bought back 7% of shares outstanding. This was done without additional cash on the balance sheet & all from operating earnings- what other companies do you know that do this without explicitly stating an aggressive repurchase program or borrowing money to recap? I’d like to hear about them if you can find one.

So, although the stock has fallen from $24/share to $21/share, a 12.5% drop, the market cap has fallen from $2.25 B down to $1.7 B, a 24.5% drop.

So, what has happened to the business to deserve such a valuation decline? Some good, some bad, but nothing close to what Wall Street seems to believe in terms of how bad things really are. Here are some goodies since my last article:

  • 15 new U.S. Aero stores (now up to 906)
  • 7 new Aero stores in Canada (now up to 59)
  • 8 new P.S. From Aeropostale stores (now up to 47)
  • 5 new license stores in the U.A.E.  (now up to 10)
  • New licensing agreement for 25 new licensee stores the next 5 years in Singapore, Malaysia, and Indonesia

I said there was some bad; the items above are the good stuff. Now, brace yourself, here comes the bad news:

  • Same store sales have declined last few quarters or stayed flat (figures below)
  • Margins are taking a hit from a highly promotional teen environment
  • Sales/square foot likely coming down this year (figures below)
  • Management hired Barclays to block a takeover offer

As you can see above, the last few quarters have hardly been something to get excited over. However, did anyone stop to check sales/square foot the past decade to see what happens if same store sales decline 7% for the year?

As you can see, during the recent recessionary period, Aeropostale added on a considerable amount of efficiency to their stores. The business has increased in productivity every year since 2003, the year of the IPO, and their sales/square foot are the highest in the industry. What I believe happened during the recession was Aeropostale added some customers that I would consider “non-core”, whose parents were struggling with tough times & went to the more discount stores to buy clothing for their children. Lately, these “non-core” customers have been defecting back to the stores they used to shop at, namely Abercrombie & Fitch, American Eagle, Buckle, etc… and as a result, Aero’s figures have come down. While I expect their sales/square foot to drop back to perhaps the $600 or as low as the $550 level in normal times, this is still above all their competitors and is hardly reason for concern. And yet, Wall Street has worried with recent news events from Aeropostale the business is dying or that they’re running into serious margin problems.

However, their margins peaked in fiscal 2010 at 17.2% operating and 10.3% net. Fiscal 2011 was a slight drop to 16.1% operating and 9.6% net. Even if they came down to the worst year in the last decade, at 13.1% operating and  7% net (which I view as highly unlikely), the business would still earn $325 MM operating and $175 MM net on sales of $2.5 B (a reasonable estimate).

The only really frustrating negative is management not accepting the previous takeover offer and hiring Barclays to advise them on how not to be bought out. I guess they want to receive more options on Aero’s stock and ride the gravy train… at less than 5% inside ownership, I feel as though a lawsuit should be filed. In any event, the business will eventually print enough money to overcome these frustrating management antics.

So, to summarize the bad, the margins aren’t a major issue because they’re pretty high and the store efficiency argument about declining same store sales doesn’t have any economic reality. They’re well-positioned with their business and I have little concerns about either. Oh, and did I mention? Throughout this entire period of declining same store sales, they’re still posting increased sales because of the additional stores that they’ve built. They’re outgrowing the declines in efficiency for now, and because I don’t expect them to continue declining indefinitely, I think the business is perfectly fine.

Here’s earning power adjusted for working capital changes the past 3 years (fiscal years):

  • 2011: $317 MM
  • 2010: $284 MM
  • 2009: $207 MM

Now, on to what you’re getting today at Aeropostale:

  • 965 Aeropostale stores (906 U.S., 59 Canada)
  • 47 P.S. From Aeropostale Stores
  • 10 current U.A.E. licensed stores
  • 25 future licensee stores in Singapore, Malaysia, and Indonesia
  • $265 MM cash balance
  • $300 MM conservative earning power
  • Growing perhaps 5-10% moving forward
  • Aggressive share repurchases (tax efficient)

So, at a valuation of $1.7 B, you’re getting an owner earning’s yield of 17.5%. If I were to be more aggressive on earning power, I could argue closer to perhaps $325 MM, giving us closer to a 19% yield. There’s also some flow-through from working capital changes for the next year or two to be expected that should increase that further up to 20% or so.

So, would you rather have 965 stores from Aeropostale at $1.7 B or 420 stores from Buckle at $2 B? For me, the answer is simple. I think Wall Street is wrong and I no longer own Buckle. Aeropostale is now my largest position.

Posted in Aeropostale, Buckle Inc., Stock Updates | Tagged , , , | 6 Comments