BONTON - Slashing prices on the stock
Much has been written about Bon-Ton's (NASDAQ:BONT) current turnaround, so we will skip the company description and jump right into our thesis of why we think the recent run-up in BONT makes it an extremely attractive short candidate
1. Short-term outlook at the cost of long-term recovery
Retailers in a downturn typically rationalize store counts in order to generate profitability and FCF in order to survive. However, these increased margins aren't free and come at the cost of declining growth. This is the position that BONT is currently in, but for some reason, the market has rallied incredibly aggressively around the stock. Many believe that the "turnaround" is on track, but we have seen the same story unfold poorly for other retailers this year. Ruby Tuesday (NYSE:RT) and Abercrombie and Fitch (NYSE:ANF) both looked like huge FCF generating companies that were turning the corner earlier this year. These companies were closing down the worst performing stores, driving up comp sales and margins. However, three to six months later, their stock prices retreated back to pre-turnaround levels. While gross margins may look better, comp and absolute sales continue to decline, and operating leverage decreases as a result of reduced scale. The short-term gains end up as unsustainable and actually hurt long-term growth.
We believe the same is happening with BONT. Underperforming stores are closing which expands margins and makes profitability look achievable. The company has also been increasing capex spend to boost stores while generating lower cash flow from operations over the last few years. While the initial numbers may look promising due to industry tailwinds, the company is still growing smaller and smaller each day. Furthermore, BONT cannot continue to close stores in perpetuity, so the hope of profitability continues to dwindle.
Even with minimal cash flow, we've seen debt tick up over the last few years, nearing $1 billion this quarter. With interest coverage at less than 1, we think there is high likelihood that BONT will continue to issue incremental debt. The 5x debt to EBITDA will continue to grow and become more troublesome.
2. Zero downside protection
We find it valuable to consider a safety net during turnaround situations, especially one as troubled as BONT. Normally, we do this by determining asset value in order to gauge what our downside scenario is in a liquidation-type event. However, BONT has nothing of real value. The company trades at a negative tangible book value with over 100 million of intangibles on the balance sheet. The inventory is overstated as well, with the recent focus towards clearance and promotions to improve bottom line.
How about real estate value? The upside is that a company could pursue sale-leasebacks to provide temporary liquidity to stay afloat. If a company has long-lasting land/buildings that are worth substantially more than their book value, selling these assets could unlock additional value. However, we see the opposite with BONT. The company owns 30 out of their 272 stores, but based off their last store transaction in 2012, we see that the company sold stores at a loss. The selling has stopped in 2013, probably due to the lack of a market for the lower-income and less desirable locations. While we can't extrapolate if these units were idiosyncratic anomalies or if they represent the entire population from a unit economics perspective, it does support skepticism that BONT can generate additional cash flow if needed.
To sum it up, BONT has both real estate and inventory worth less than what is on the balance sheet and increasing debt, which will continue to be a burden even with constant refinancing.
3. Weak competitive positioning that is more sensitive to external shocks
As we've seen from the last quarter, BONT benefited from ~10% cheaper gas prices, colder weather, and below normal rain, especially in the Northeast. However, even with these tailwinds, BONT still posted negative comps. We believe that BONT is especially sensitive to these factors due to their target customer - one that is lower income and incredibly price sensitive. Any change in these tailwinds (gas prices recently moved to their highest levels in two months in the Northeast) may cause an impactful shift in BONT's performance.
We've also seen BONT shift towards a clearance mentality to capture these price-sensitive customers, opening up new discount-only centers to clear inventory and drive margins. While we see this as the possible long-term strategy for the company, we remain confused every time management mentions adding higher end brands such as Ralph Lauren, Michael Kors, or Coach. Is management trying to reposition the brand to a higher price point or are they more focused on discounting to stay afloat? How will this new positioning gel with lower-income locations with the respective unit economics? We've seen this pattern before in JC Penney (NYSE:JCP), in which management shifts the brand and alienates their price-sensitive (and inherently less loyal) customer base.
4. Difficult Q4 quarter and comp sales will result in a guidance miss
The Street is modeling negative 2.7% comp sales for Q4, in line with management's guidance. However, we believe that this number is very optimistic and unachievable. The company was coming off an easy Q3 12 comp, but only able to achieve negative 2.8% comp sales. While there are uncertainties with these tailwinds in Q4, we do know some additional headwinds that will occur. Q4 12 is a very tough comp (the best in four years) and more importantly, retail is expected to have a very competitive winter. All retailers are becoming more aggressive with discounts due to the one less week of shopping in between Thanksgiving and Christmas, and the Black Friday weekend looks to be even more intense as retailers move up opening times (BONT, along with about half of the mall retailers, is opening on the back end of the day). Furthermore, management's assumptions are unreasonable regarding competition with other mall retailers. With less and less traffic funneling to malls, similar operators such as JCP and BONT cannot coexist successfully. Contrary to management's belief, a recovery in JCP is detrimental to BONT. Management doesn't understand this, and believes that additional JC Penney traffic will net positive for BONT.
Lastly, we have a few other issues to consider. The consumer confidence index dipped to a 7-month low in November (released today) and the large storm currently headed east is expected to cause huge impacts in the beginning of the shopping season.
5. Artificial run-up due to shorts covering
As of the last update (end of Oct), BONT had approximately 35% of shares shorted. We believe that this caused a massive short squeeze over the last two weeks. As the dust settles, we believe that the short market will realize the huge overvaluation that BONT is currently at and be more willing to get back in.
We do not think there is much upside remaining in BONT. Management's comps sales guidance is relatively narrow (compared to EPS), which mitigates our biggest risk that growth will turn positive. Instead of being priced as a zero, the company is now expected to turnaround, which inflates sell-side expectations as well.
There isn't much visibility on current short interest, but if a substantial amount exists (over 20%), we could see shorts getting squeezed further. However, given the 60% run-up in the last few weeks, it's more reasonable to assume short interest to be substantially smaller. Other impacts to the stock price are earnings calls by other mall retailers. BONT typically announces last, so earnings from Macy's (NYSE:M), Dillard's (NYSE:DDS), Kohl's (NYSE:KSS), and JCP are all leading indicators.
So why didn't we issue a short notice a week ago and what's the catalyst now? Besides the overvaluation, we finally saw the sell-side capitulate and change their outlook. Credit Suisse upgraded BONT to Neutral and changed their price target to $15, and Telsey changed their target price to $16. Their 12-month targets were suddenly reached in 3 days. Even with the higher sell-side at an average of $15.50, the stock has already exceeded this and is trading north of $17! While we are not technical investors, we've seen multiple times in the past year where the stock outruns fundamentals, only to crash by 30-40% quickly after.
It's hard to only use EV/EBITDA as a multiple, because one turn down in the multiple cuts over half the stock price due to the huge sensitivity with the amount of debt. However, from a quick glance, we see that BONT trades at 7x EV/EBITDA, which is at a PREMIUM to comps such as M, DDS, and KSS. Adjusting this down to the industry 6x changes the valuation to $8/share. From a P/E perspective, we think that BONT should trade at 10x P/E on the high end, which is a discount to the industry. That price results in $14/share. Taking a blended amount (both EBITDA and earnings), we calculate an average stock price of $11/share, or a 35% discount from today's price of $17.10.