Aeropostale (NYSE:ARO) is primarily a mall-based teen clothing retailer. Motiwala Capital has owned shares of Aeropostale in our managed accounts since early 2011. Our original thesis (Part 1 and Part 2) was that Aeropostale is an extremely well run and very profitable retailer. Aeropostale had reported several years of profitable growth, produced solid free cash flow, had a debt free balance sheet and bought back shares regularly. ARO had much higher sales per sq feet than competition, lowest cost structure in the industry. ARO had come out of the recession really well compared to direct competitors American Eagle (NYSE:AEO) and Abercrombie (NYSE:ANF).
Here are summary financial statistics from 2001 - 2009
At the original purchase, ARO was trading at a 10% FCF yield. Concerns at the time of purchase were peak margins, cotton prices spiking in 2011/2012 that would hurt margins, increased competition from AEO and ANF and other mall-based retailers.
All the risks came true and ARO business suffered dramatically . Same-store sales [SSS] have been down for almost two years. The Co-CEO Mindy Meads left the company. Gross margins took a big hit. Profitability came down. Cash flow is down. The stock suffered in late 2011 before rebounding in early 2012 on a "lower-guidance-and-beat" approach by management. Q2-Q4 2012 were just horrible and the stock is back in the gutter. Management recently guided for a loss in Q1 2013. Business has not gotten better. Management does not seem to know the business well. There is an inventory over hang. So, then investors must wonder why we continue to hold this company?
Here are some of the reasons:
1) Free cash flow: I estimate that ARO produced about $85 million in free cash flow in 2012 (cash flow statement was not released in Q4 results press release) despite the weakness in the business. In FY2011, ARO produced about $56 million in free cash flow (cash from operations - capital expenses). This is down from $280 million in FY 2009 and $163 million in FY 2010.
2) Balance sheet: ARO has about $230 million in cash (and no debt) on the balance sheet. That is ~21% of the market cap. We always like debt-free balance sheets.
3) Valuation: At today's prices ~$14 and 78 million shares outstanding, the market cap is about $1,100 million. Ex of cash, the enterprise value is $870 million.
With FCF of $85-$90 million, the valuation is 10% FCF yield. This would be a good entry point if we were looking to initiate a position in most businesses.
On a EV to Sales basis, ARO trades at 0.35x. AEO is at 1x and ANF at 0.7x. HOTT is being acquired at 0.7x.
4) Acquisition Potential / Private market value: Recently, mall retailer Hot Topic received a Private Equity bid for ~$600 million or EV of $530 million. The valuation multiples were: 2.5% FCF yield, 37x P/E, 12x Cash flow, ~8x EBITDA.
If we apply a 6% FCF yield on ARO, we arrive at ~$19. We are not assuming any improvement in FCF in this case. That is a 35% upside from the recent price of $14.
5) Recovery/turnaround potential: If business were to stabilize and margins can mean revert to somewhere close to the mid point between what they are now and what the peak was, there is tremendous upside. None of this potential seems to be priced in at current levels.
6) Management change Catalyst: Often times in retail, when a misfiring management is changed, the stock can take off.
So, even though the business has not been doing well and management seems to be bungling, we continue to hold ARO for the reasons above. At the current valuation (10% FCF yield) with that balance sheet, it does not make sense to sell ARO.
Additional disclosure: Accounts managed by Motiwala Capital have a long position in ARO