It is our belief that the stock of Aeropostale (ARO) is undervalued relative the earnings potential of the company. Notice the key word here is potential. ARO is simply not living up to its potential as a discount teen retailer, and we think the reason lies solely with the current management team.
As the great recession began in earnest in early 2008 the company was thriving. Sales were increasing, same store comparables were increasing and sales per square foot were the best in the industry. This momentum continued until the fiscal year 2011 when, by all measures, the company went into decline. Between 2010 and 2011 diluted earnings per share went from $2.49 to $0.85, total company sales went from $2,400.4 million to $2,342.3 million and sales per square foot went from $626 to $561. The most common excuse provided by management was to blame the difficult times on a highly promotional environment. It looks as though these tough times will continue as the company recently reported lackluster results during the most recent holiday season. It is yet to be seen if sales will outperform last year, but earnings certainly will not.
So why do we say this company has potential? There is a long list of reasons, and we will not get into the specifics but there are a couple of key points to make. For starters, they have a very efficient model. Their turnover in sales is one of the highest in the industry, their product is proprietary and more focused than competitors and they still have one of the highest sales per square foot in the industry. The capital used in the business is very low as most of it is reserved for inventory and fixtures which leaves plenty of cash for other purposes, such as buying back shares. The company has been aggressively pursuing this strategy and the shares outstanding have gone from roughly 112 million shares in 2008 to 78 million shares as of their most recent filing. As Charlie Munger has pointed out, pay special attention to companies that eat themselves.
Finally, they sell good product in a notoriously fickle age group. The brand is everywhere in the United States and increasingly abroad. They are actively pursuing licensing deals outside the country which should strengthen the appeal of the brand. Their product is durable, cheap and many would consider it fashionable. Their quality product at low prices is appealing to many, especially in this economic environment.
The company should, and has every ability to, earn upwards of $2.00 per share. Compare that to the current price of $13 will give you an earnings yield of 15%. Pretty strong in my book.
So why isn't the company earning $2.00 or more per share? We think the reason lies solely in the board and with management. For starters, the statistics of insider ownership is abysmal. Management and the board own very little stock and it is especially stark when compared to their income from the company. Also troubling is that the board elected to have co-CEOs after long term CEO Julian Geiger stepped down in 2009. In our eyes, this was a near fatal flaw, as the co-CEOs were dismantled almost a year later. This was the last year the company posted solid results. It is our estimation that during the power struggle the eye was taken off the ball, competitors gained ground and the company made major strategic missteps. They are paying for those mistakes now as their competitors have gained ground and the only way the Aeropostale believes it can compete is to sell their products at intense discounts. This has reduced all the metrics above and has wreaked havoc on gross margins.
We, as an investor in Aeropostale stock, felt so strongly about the inability of current management to right the ship that we sent them the following letter in November. We are still waiting for a response.
Dear Ladies and Gentleman:
I have been a shareholder of Aeropostale, Inc. since early 2010, and although I am a long term investor, I am becoming increasingly concerned with the companies near term performance.
I am highly confused on why the company is faltering in the first place. In the most recent quarterly press release, dated August 16th, Thomas P. Johnson, Chief Executive Officer, commented, "Our core basics business experienced significant pricing pressure due to the highly promotional and competitive retail landscape." From my calculation the U.S. has been going through very difficult economic times since 2008. How is it that after four years we are saying a promotional landscape is causing bad results? Isn't price discounts Aeropostale's competitive advantage against others in the marketplace? Reading the 1st quarter 2010 press release dated May 20th, 2010 you would get that impression. Co-Chief Executive Officers Mindy C. Meads and Thomas P. Johnson, said, "The consistency and strength of our results truly underscore the on-going momentum in our brand, the power of our promotional specialty store model and the tremendous talent across our entire organization." How is "promotional" able to describe a good quarter, but also a bad one? I think it would be wise to explain to your investor base in more detail of how "promotional" affects results, especially gross margins.
The gross margin also concerns me. More clarification is needed in quarterly reports on what specifically affects gross margin. I understand the disaster cotton prices had on margins during the late part of 2010 and the early part of 2011, but as prices have moderated this year, I don't see much improvement. Take the 2nd quarter for example. Cost of sales for the 2nd quarter 2012 were 74.7% of sales. During this quarter and the quarter before, the price of cotton were consistently below 100 cents/lb. Compare that with the 2nd quarter of 2011 margin of 75.6% in an environment of considerably higher cotton prices. With same store sales essentially flat and cotton prices dramatically lower, what is the cause for a non-improvement in the gross margin? Are your suppliers passing on their rising costs to the company? Is it because comparable units per transaction are increasing, but the comparable sales transaction change is decreasing? Does the non-core fashion cost more to produce and we should expect this kind of margin going forward? More explanation on this would greatly help.
Finally, I can't help but notice the timing of these troubles with the timing of executive leadership change. The previous CEO Julian Geiger stepped down at the end of 2009 and it didn't take much time, 2nd quarter 2010 to be exact, until the word "challenging" appeared in press releases. Prior to Mr. Geiger's stepping down, many of the companies press releases were peppered with the words "record breaking." Even more remarkably, this was through the difficult 2008 and 2009 economic time period. After Mr. Geiger stepped down, although never a good idea, the board chose to appoint Co-CEO's. It didn't take long before that was unraveled and Mr. Johnson was appointed sole CEO. How much of the year long power struggle led to the current predicament? Now earnings releases are mostly bad news and peppered with the words "highly promotional." Is Mr. Johnson the right person to lead our company?
A response to the above questions and more disclosure on a quarterly basis as mentioned in this letter would be greatly appreciated.
We believe Aeropostale is undervalued and should be thriving in this environment, but worry current management is squandering a solid brand. We ask our fellow shareholders for their thoughts on the current situation at Aeropostale.