Thursday, December 9, 2010

Same Store Sales Irrelevant For Aeropostale

Same-store sales data can be a useful indicator of the health of a retailer. But its importance should not be magnified such that it is the defining factor for all retailers in the determination of their attractiveness as investments. For example, we've discussed how the same-store sales metric for retailer GameStop is virtually useless in assessing the profitability of the business. Last week, shares of Aeropostale (ARO) fell 15% after it was reported that November same-store sales were down 1% from a year ago. But the same-store sales number fails to capture the health of this business, and its value as an investment.

The first problem with monthly same-store sales data is that they cannot be extrapolated endlessly into the future, but they often are. Huge overreactions in stock prices result from relatively minor variations in sales, apparently on the assumption that the positive or negative news will continue forever. But there tends to be a lot of mean reversion in industries where competitors can copy the latest fashion trends. As such, poor sales numbers force managements to catch up to the competition in the areas in which it is weak, while strong sales numbers draw copycats. Aeropostale will actually experience both sides of that paradigm, as their menswear was up strongly, but their women's apparel was weak.

The second problem with same-store sales data is that they do not capture profitability whatsoever. But to the shareholder, that's what ultimately counts. A company can have massive inventory-moving sales that drive up traffic and generate higher top-line numbers, but if those sales don't occur at a profit, there is no benefit to the higher sales. In Aeropostale's case, it generated $58 million of profit in the latest quarter (that resulted in a 15% drop in its stock price). On shareholder equity of less than $500 million, this represents a return on equity of almost 12% for the quarter. Only about half of all public companies will manage to generate that kind of return over the entire year.

Finally, same-store sales also do not capture a company's ability to grow. By focusing only on existing stores, investors are ignoring potentially profitable growth from new stores. For Aeropostale, the strong returns on equity suggest the company has a winning business model. As such, the business model should be applied to new locations. If these new stores are as successful as the existing stores, shareholders will see profit growth without requiring much equity (in the form of retained earnings) to finance this growth.

Value investors, however, don't like to pay for growth, as it is far from assured. But at Aeropostale's current price, they don't have to. The company trades at a P/E of about 8, based on its current market cap (excluding its net cash balance) and its last four quarters of earnings. This is despite the fact that the company's ROE last year was over 50%!

In many ways, an investment in Aeropostale is similar to an investment in Kirkland's, which was an investment idea discussed a couple of weeks ago. While they are in different segments (apparel versus home decor), they are both retailers operating in very competitive areas that have found a way to generate strong returns. Despite this, they trade at single-digit multiples despite strong cash positions and decent growth potential.

One difference between these two retailers, however, is Aeropostale's willingness to return cash to shareholders. Over the last four years, the number of shares outstanding for Aeropostale has decreased from around 120 million to 90 million, despite strong profit growth for the company overall. (It can both grow quickly and yet still buy back a ton of shares because of its strong returns on equity.). On the last conference call, the CEO reiterated that whatever the company does not need for capital expenditures (planned at $70 million next year, which is probably pretty close to depreciation expenses, despite the fact that the plan is to open 50 new stores) is returned to shareholders. Furthermore, buybacks are concentrated in the last half of the year, which is now. At the current P/E, that could be very beneficial to shareholders.

Of course, no investment is without some risk. Fickle teenagers can change preferences quickly when it comes to their fashion choices. Aeropostale has to constantly ensure that its products and marketing are meeting the requirements of its target customers, or it will see inventory writedowns and reduced margins during some periods as it hastily tries to catch up to the competition. Over the last several years, however, it is clear that Aeropostale has been able to do this, as operating margin levels have been consistently above 10%.

On that note, however, there have been some recent management changes which may call into question the company's ability to continue this streak. The company's CEO left in February, and was replaced by two co-CEO's. Last week, one of the co-CEO's (who had previously been head of merchandising) has now left as well. As such, it is possible that the know-how behind this company's returns is no longer present. But at the current price, shareholders aren't asked to pay very much to find out.

Disclosure: Author has a long position in shares of ARO

13 comments:

Anonymous said...

I am wondering, when you say: half of all public companies have an roe of 12% or better, where did you find this information? Is it from a screener? I always wondered what that would be, and where one could find it. Is this for US companies? I wonder what tangible return on equity would be. I am guessing that it would be higher.

I also wonder what the average annualized 10 year sales/share and EPS would be for US companies and for all publicly traded companies in the world.

I tried being able to see this from the FT.com's screener, but I am not sure if I can find this info from the FT.

Thanks for the great article!

Hugh

Anonymous said...

hi,

been wondering-do you capitalize leasess for your calc of ROE? beside -i think the main reason the stock's down so much is the fact that the market beleive's it is reaching saturation in the states and that their buisness model will not succeed abroad like ANF.
also, ARO has been showing peak margins for the last quarters that most beleive will be unsustainable long-term.

love to hear your thoughts on that one

John P said...

Saj, this analysis, like others, is very interesting and illuminating.

The real question I have for you is: How do you find these gems? Do you pick industries and just start digging through the financials of every company in the industry? Do you use screeners to look for various metrics (ROIC, Price/Cashflow, P/E, ROE, etc)?

I would love to see a really detailed blog post on how you find ideas.

tscott said...

Good comment John P, i run ncav and net net screens all the time and don't come across the same stocks.

Saj Karsan said...

Hi Hugh,

It was a very rough estimate based on the universe of stocks in the Google Finance screener. Of the 3300 or so stocks, only 1300 or so show an ROE above 12% when you screen only for that metric.

Thanks John P,

I get that question a lot, so okay, I will take your advice and do a post on it soon.

Paul said...

Saj,

If you are following our advice, I'd suggest you open up your own fund and let us invest. Just sayin' ;)

Anonymous said...

ARO is trading at a little less than 5 times equity, in my book nothing can justify such a price.

Saj Karsan said...

Hi Anon, Leases are not equity so they should not be part of ROE. However, I would include them in calculations of ROIC. Margins are higher than normal right now, but even if they come down to their average, the company is still very profitable.

Hi Paul, I wish I could! But regulations pretty much make that impossible at this point.

Anonymous said...

Hi Saj,

Isn't the ROE metric here sort of artificially inflated because of the company's large amount of buybacks over the last few years?

Not saying its a bad thing for the company to buy back shares, but how do you look at it as a new investor? The return the company is generating isn't 50% given the price you pay to enter the company.

Thanks for your insight.

Saj Karsan said...

Hi Anon,

As a new investor, what's important to look at is the earnings yield (reciprocal of the P/E), because to your point, that's what you're getting as a new investor. However, you still get to earn the company's ROE on its new investments (whatever it re-invests from its earnings), presuming it can get the same return as it always has (unlikely at 50%, but still possible at attractive rates)

Anonymous said...

Given the latest earnings of ARO the stock is getting crushed. Same store sales down heavily 7% this time. Profits have dropped. This company is going to collapse is what Wall Street is saying.

Given your long position, and the latest drop in price, do you as a manager double down by buying more of what you must now think is reallllly cheap or do you cut your losses?

Saj Karsan said...

Hi Anon,

Without giving away portfolio activity, definitely more likely to buy more than cut losses

another value investor said...

Saj,

Looks like David Einhorn agrees with you. I couldn't resist to buy in today. Look forward to an update on this idea after Q2 results are released. :)

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