Jos. A. Bank (NASDAQ:JOSB) is up close to 6% after reporting unbelievable sales numbers for July: same-store sales were up 16% and total sales were up 28%. July's performance has validated my positive view on the stock -- a view that is in contrast to that of the market.
When Yogi Berra said “In theory there is no difference between theory and practice. In practice there is,” he might well have been describing contrarian investing. In theory, it is easy to be able to think and act independently, but in practice it is a lonely and trying experience. Investing in Jos. A. Bank requires the investor to be contrarian. Wall Street hates the stock for sending the share price from the mid-40s in April 2006 to the mid-20s. The stock is trading at a pitiful 12 times forward earnings. The stock has been slaughtered as Wall Street did not care for the earnings miss in the first quarter coupled with higher inventories.
At this price, the market expects no growth from the company, but the market could not be more wrong. Here's why.
In December 2005, JOSB delivered 20% same-store sales. Management expected this trend to continue and built up a significant amount of fall inventory. However, the unexpectedly warm spring was not on the company’s side. The 20% same-store sales comps of December did not come through in the following months, and that disappointment, coupled with the warm spring, sent management on a discounting spree in the fall. Management has since admitted, with the benefit of hindsight, that it was too aggressive in discounting fall merchandise.
It is hard to tell what the next quarter will look like, but the future looks bright. In the first quarter, management made a mistake, but I believe that mistake will have little consequence in the long-term fundamental picture of JOSB.
Inventory is Not An Issue
Retailers live and die by their inventory. Too little inventory means the company doesn’t have enough goods to sell, too much means the company has to heavily discount merchandise in order to clear it. So here is the perceived bad news about JOSB. Its inventory days have almost doubled over the last six years from 173 to 334. This is twice the amount of its most comparable competitor, Men’s Warehouse (MW), whose inventory days have stayed in a stable range of 153-169 days over the same time frame. On the surface, inventory numbers look terrible.
Over the last six years since the new management team has taken the reins of Joseph A. Bank, it has intentionally increased inventories per store. This is not a cause for concern, as not all inventories are created equal. Inventory increases at a grocery retailer, like Kroger (KG), may lead to spoilage and thus lower profitability. Teen apparel retailers like American Eagle Outfitters (AEOS) and Abercrombie and Fitch (NYSE:ANF) need to have a fairly high inventory turnover, as teen preferences for the size and location of holes in their jeans could change with Britney Spears' new CD. However, when it comes to men’s apparel, men’s tastes shift at a glacial pace. Blue shirts and striped suits have been in fashion as long as...well, forever.
Instead of looking at JOSB's inventory as a risky, unstable asset that may have to be discounted by the retailer to clear the shelves (which is usually is the case for other retailers), one should look at it as an investment in long-term assets, not unlike an investment in store improvements. Though increasing inventory per store is counterintuitive for retailers that strive to achieve Wal-Mart (NYSE:WMT)-like inventory efficiency, JOSB customers come to the stores only once or twice a year. The company, knowing the customer won’t be back for a long time, wants to make sure he finds everything he desires in the right sizes. The inventory increase was mostly done in terms of size availability, not variety of styles. As customers find merchandise they like and sizes that fit, they buy more, which drives same-store sales and operating margins at the same time. Transcripts of the conference calls from 2004 show that management has been saying all along that raising inventory is a part of the company’s strategy.
This strategy has paid off handsomely. Earnings and sales have grown in double digits, margins have expanded due to increased same-store sales, and most importantly, returns on assets (despite a higher asset base due to increased inventories) have more than doubled. JOSB has beat Men’s Warehouse hands down on every one of these measures. Despite substantial increases of inventory per store, JOSB more than doubled its store base and achieved that mostly from its free cash flows.
What's more, JOSB is in the last inning of inventory increases. Although the inventory of new stores will still climb as they are brought to the company’s average level, management has indicated that they are happy with the inventory levels at the matured stores.
Pristine Balance Sheet
JOSB is allergic to interest-bearing debt as it was a byproduct of a leveraged buyout, though it does compare to most retailers' operating leases. The company has almost no interest-bearing debt and has an available credit line of $125 million that is used to finance seasonal capital needs.
Management has stated that they plan to bring the store count from 329 today to 500 in 2009, a goal that will be financed by internal free cash flows. But it has been mute about plans beyond that. The United States should be able to support more than 500 stores, which are only about 4,500 square feet each. There is also life beyond the United States, although it's riddled with unknowns.
This is probably the biggest risk facing the stock. An economic slowdown, deflation of the housing bubble and a weaker stock market are all risks that could create the headwinds for consumer spending and thus for the stock.
Though not immune to an economic slowdown, the majority of JOSB customers make over $100-125 thousand a year and are less sensitive to an economic slowdown. Business suit decisions could be postponed if one is not certain what the future holds, but clothes rip and coffee gets spilled. One way to gauge how the JOSB customers will behave during a recession is to look at their behavior in the last recession. Average same-store sales in 2002 were 6.6%, which isn't bad for any environment.
The Hidden Asset
Half of JOSB stores are less than three years old. It takes close to five years for a store to reach companywide average sales and operating margins of 23%. A store that is less than three years old has a profitability of 10% below company average. This makes sense, as a large portion of the costs of running a store (rent, salaries, utilities, etc.) are fixed. Either sales are at $0.9 million approximate average sales of a new store, or they are at $1.6 million approximate average sales of a relatively mature store. As new stores mature, sharply rising same-store sales arrive with much higher margins. Today, the company’s margins are depressed with half of its stores being relatively new, but as they mature, margins will rise and earnings and free cash flows should go through the roof.
I estimate the company’s net margins will rise by about 3-4% and the company will earn somewhere around $5 in 2009. Slapping on a 10 times P/E (no growth) multiple we get a $50 stock. There is plenty margin of safety in this stock.
By Vitaliy N. Katsenelson, Contributor
This article first appeared on Minyanville.
Vitaliy N. Katsenelson may hold positions in stocks mentioned in this article.