Aeropostale Inc: Is it really that bad? ($ARO)

Annus horribilis? Aeropostale, Inc (NYSE: ARO) didn't need a full year, May 2011 was bad enough. Over just twenty-one trading days, the company managed to shed 28.2% of its market cap (though, this undervalued company managed to lose almost this much in a single day).

What happened?

The terrors started early. On May 4th, the company lowered its 1Q 2011 guidance,

The market responded swiftly, knocking shares from $25.49 to $21.29. where they hovered for the next two weeks, until, on May 19th, the company issued its actual results:

First Quarter Performance

Diluted net earnings per share for the first quarter of fiscal 2011 decreased 58% to $0.20 per share, compared to $0.48 per share in the same period last year.  Net income for the first quarter decreased 64% to $16.4 million, compared to net income of $45.4 million last year.

For the first quarter of fiscal 2011 net sales increased 1% to $469.2 million, from $463.6 million in the year ago period. Same store sales for the first quarter decreased 7%, compared to a same store sales increase of 8% last year.

Though these results were exactly what the company announced on May 4th, Mr. Market dealt another blow, sending shares down a further $3.04. The added insult was likely due to the fact that the company failed to reiterate or update its previous guidance. Thus, the market was left to reach its own conclusions and as they say “idle analysts are the devil's playground.”

Ok, maybe I am the only one to say that.

So let's look at what happened here and whether the company should be trading for so little. First, we'll start with the company's revenue and margins:

Aeropostale Margins, 2002 - 1Q 2011

Though the company's long-term revenue growth has been strong, the following graph shows that this has been achieved by both increasing the number of stores, and increasing the average revenue per store (and sales per square foot):

Aeropostale Store Data, 2002 - 1Q 2011

For Average Revenue per Store, I used the company's total revenue divided by the average number of stores in the period, rather than the company's provided same store sales data. Readers of Financial Shenanigans will note that this metric is more difficult to manipulate and provides a clue as to whether newly opened stores are underperforming (this does not appear to be the case) (Read my in-depth review of Financial Shenanigans here).

I like the company has been doing well on all of these metrics, but before we get too far, let's turn back to the first graph and take note of the problem that spooked the market in May. As you can see, the company's Gross Margin fell quite significantly (from 35.5% in Q4 to 29.1% in Q1). From the company's 10-Q:

Gross profit, as a percentage of net sales, decreased by 10.3 percentage points for the first quarter of 2011 compared to the same period last year.  The decrease was due to lower merchandise margin of 7.4 percentage points, primarily due to significantly increased promotional activity during the quarter as well as higher product costs.  The decrease in gross profit was also due to higher occupancy costs of 1.8 percentage points, which included rent for our New York City stores, higher depreciation costs of 0.5 percentage points and higher distribution and transportation costs of 0.5 percentage points.

I am not sure anyone is surprised that, with the household clothing budget contracting during the recession, businesses in this industry are competing more heavily for their share of that budget. But only the most bearish of observers would suggest that this will be on permanent factor. The economy moves in cycles, and this recovery has been rockier than normal. For these reasons I am less worried about the discounting. The bigger concern might be the higher product costs. What might these be? From the same 10-Q (emphasis added):

Global inflationary economic conditions, as well as increases in our product costs, such as raw materials, labor and fuel, will reduce our overall profitability. Specifically, increases in the price of cotton, that is used in the manufacture of merchandise we purchase from our suppliers, negatively impacts our cost of goods. In addition, any reduction in merchandise available to us or any significant increase in the costs to produce that merchandise would have a material adverse effect on our results of operations.  We have strategies in place to mitigate the rising cost of raw materials and our overall profitability depends on the success of those strategies. Additionally, increases in other costs, including labor and energy, could adversely impact our results of operations as well.

The company singles out cotton as a key input, with labour and energy close behind. Let's look at the price of Cotton over the last five years:

Cotton, 2006 - 2011

As you can see, the price of cotton peaked in March and then fell swiftly after that but still remains far above historical prices. Though the company says it has strategies in place to mitigate the rising cost of raw materials, its 10-K and 10-Q do not mention any form of derivative hedging, so we are left to assume these strategies relate to some sort of moving average pricing with its vendors. I looked at the last six analyst conference calls, and all discussion about what these strategies might be relate to the company's long-standing relationship with a relatively concentrated group of vendors, and that these vendors have been very good at shifting production to lower cost areas to help reduce product costs.

If you look at the 30 year chart here you will see that the recent run-up is unprecedented, so it is no wonder the company doesn't hedge the price of cotton. Luckily, the volatility of cotton has impacted ARO's competitors as well, and we can expect that if this is a secular trend, industry participants will raise prices rather than allow their margins to erode. Thus, I expect that cotton will either move more in line with historical levels (see the 30 year chart here) or competitors will respond by passing on these costs to consumers. Either way, it would seem irrational to ignore the company's long-term margins and mindlessly project future gross margins to be forever compressed as the most recent quarter.

The company's SG&A expense for the quarter was flat as a percent of revenues compared to 1Q 2010 and 1Q 2009, so this quarter's poor performance is limited strictly to the competitive discounting and increasing product costs, which are industry-wide issues, rather than company specific.

In valuing ARO, I created scenarios that vary based on their assumptions about the gross margin, and revenue per store. Since the company is at a  historical peak sales per square foot and revenue per store (note, they accomplished growth in these metrics during a recession), I started with a longer-term average for this figure and then used the most recent square footage figures. Then I looked at different possibilities for the gross margin. The company doesn't break out what portion of the recent margin contraction is due to discounting versus what portion is due to product costs, so I tried a variety of possibilities.

My results suggest that the current price is justified only in the situation that the recent margin contraction is permanent. If you agree with me that margins will revert toward (not necessarily achieving) a long-term mean, then the company appears to be significantly undervalued.

Keep in mind the following things:

1. The company has been taking advantage of its depressed share price by buying back shares. Over the last eight quarters, the company has repurchased $531.8M worth of shares. They still have authorization to repurchase another $145M, which would represent 10% of the company at its current share price.

2. The company has approximately 10% of its current market cap in cash (enough to finish off the rest of its repurchase program without generating any new cash), and no debt. Its cash hoard has come down quite a bit in the last two quarters as the company repurchased $251M in shares. Historically, the company has eschewed debt and maintained a very conservative balance sheet.

3. Management seems highly capable. As shown in this post, management has consistently earned high returns on equity (even adjusted for operating leases). Returns on Capital Employed and Returns on Invested Capital are likewise exceptional. When compared to other retailers, ARO is among the very best operators. Also keep in mind my emphasized note above, about the company attaining peak operating metrics during the recession; these guys are no slouches!

From my perspective, Mr. Market seems to overreacting to recent margin compression and ignoring the fact that this is a very strong operator in an industry that is near a cyclical low. While no one can be certain of the future, I like the current odds. At these prices, Aeropostale may just make this annus mirabilis after all.

Author Disclosure: Long ARO

Talk to Frank about Aeropostale

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3. Financial Shenanigans – Chapter 1: As Bad As It Gets