Note - due to the difficulty of posting extremely long posts (which this is) and excel tables on seeking alpha, I will be breaking this post up into three parts and release them over the next few days. To view the post in its entirety and see the excel tables, please visit my blog.
I became attracted to the retail sector through two things - the spate of acquisitions by private equity we’ve seen recently, including JCG a few weeks ago and JAS in the past day or two (private equity tends to be longer term, value oriented buyers, and their valuations reflect a nice view of what a knowledgeable financial buyer will pay for businesses) and the appearance of several retailers on magic formula like screens.
My interest drew me particularly to three companies - the teen retailers Aeropostale (NYSE:ARO), Abercrombie & Fitch (NYSE:ANF), and American Eagle (NYSE:AEO). Using the acquisition of J. Crew as a guide, I looked at these three companies to try to determine what they are ultimately worth.
First, some background on the retail sector. Retailing is marked by intense competition, but at the same time successful retailers can generate tremendous returns on capital. Teen retailing takes this one step further, as hitting or missing on this year's fashion can drive tremendous same store sales (SSS) and profit growth or a steep drop off in profits and share price. The great recession has obviously been devastating for these companies, as it has caused massive price mark downs and cut into SSS drastically for everyone but ARO (ARO is a more value oriented retailer and thrived during the downturn). However, the companies also cut back on new store openings and closed their unprofitable second brands, and as a result, we saw some of the teen retailers generate tremendous cash flow. Interestingly, unlike almost every other sector, we never really saw a significant teen retailer go under. What this means for the future is open to interpretation, but I thought I’d point it out.
That said, let’s look at the JCG acquisition (note: all numbers following come from either their from SC 13E3 filed on 12/6/10, or their PREM14A filed 12/3/10). According to their proxy statement following the acquisition announcement by TPG, the company was first approached about being taken out by TPG in the beginning of September at a price of $41 per share. After some negotiations, the parties settled on a price of $45.5 per share in the beginning of November. However, JCG’s management then dropped a bomb: that sales had deteriorated materially since negotiations had begun, third quarter results would surely disappoint the market, and that fourth quarter results would be well behind current guidance. This would eventually cause TPG to withdraw their offer to purchase the company, and, on November 18, a special committee of JCG’s board began to discuss ways to mitigate the pressure sure to come on the share price after earnings were announced November 23, including a large share buyback or instating a quarterly dividend. However, on November 22, the day before JCG was going to come out with quarterly results, TPG came back to the table and agreed to acquire the company for $43.5 per share. JCG quickly accepted the offer. Note that TPG also agreed to an unusually long go shop period, running through January 15.
Let’s look at the offer from JCG’s point of view. Their stock price would have been crushed the next day, so they were certainly motivated sellers. However, they also note that, by agreeing to the deal with a longer go shop period, they shifted all of the risk of the Christmas season to TPG. In the event of a weak Christmas season, they get acquired at the current price. However, if results are stronger than expected, they can shop for a buyer willing to pay a higher premium.
Now let’s look at it from TPG’s point of view. Why would they agree to this deal? Why not come back to the table the day after quarterly results are announced and the stock’s been crushed, or at least demand a bigger discount from the original price in light of deteriorating results? I can only think of two reasons - 1) they see a lot of long term value in the property, and 2) part of their business model is doing friendly acquisitions, and it could hurt their reputation and ongoing relationship with management (who is one of the best in the business, and will continue running the company post transaction) if they tried anything funny.
What about valuation? According to the SC 13E3, the transaction valued the company at 8.6x trailing EV / EBITDA. It valued them at 8.9 times consensus 2010 EV / EBITDA and 8.5 times consensus 2011 EV / EBITDA. According to mgmt’s new projections, it values them at 9.6x 2010 EV / EBITDA and 8.3x 2011 EV / EBITDA estimates. Note how far below projections that meant FY 2010 was going to fall. It means EBITDA would be almost 10% short of current analyst projections and management guidance, with all of that shortfall coming in the third and fourth quarter.
Let’s now move on to my three retailers, ARO, AEO, and ANF. Per Bloomberg, ARO is trading a 4.15 trailing EV / EBITDA and 4.35 forward EV / EBITDA, AEO trades at 5.2x trailing and 4.26 x forward, and ANF trades at 10.89 trailing and 7.01 times forward. Given JCG’s takeout multiple, this suggests significant upside for both AEO and ARO and that ANF is fair to slightly undervalued. If I use 8.5 times forward EV / EBITDA (again, from Bloomberg), I come to a target of $45 for ARO, $25.7 for AEO, and $68.3 for ANF.
However, it’s important to note a couple of things. First, in general, JCG stores sell higher value clothing than AEO and ARO and are much more comparable to ANF stores. JCG had about 321 stores open. ANF has 346 Abercrombie and Fitch stores open and 525 Hollister stores open (ANF mgmt has placed the potential store count for Hollister at somewhere around 550), so JCG probably has room to grow their store base by 100 to 150 stores, or about 50%. A+F has pretty much reached saturation with it’s A+F and Hollister stores, and future growth will likely need to come from its Abercrombie kids or Gilly stores. Aeropostale, with just over 900 domestic stores, is also nearing saturation (around 1000 to 1100 stores, their stores are less expensive than ANF and thus can go to B level malls that ANF can’t/won’t), and future growth will need to come from the P.S. from Aeropostale brand or intl. growth. American Eagle has around 950 domestic stores (potential for 1000, much like ARO) and 137 aerie stores, so again, future growth will come from the aerie brand, the just beginning 77kids brand, or intl. growth.
While JCG has the crew cuts and madewell brands, these were so small and fledgling that it’s safe to say they were assigned no value in the purchase. While retail has an extremely spotty history of opening successful new brands (see AEO’s M+O brand, or ARO’s JimmyZ brand), the fact that these companies have second concepts that are on the verge of breaking even and reaching critical mass that they can use to grow has some value. M+O lost about $40mm per year before AEO finally shut it down, so these new brand strategies are both A) expensive to pursue and B) very risky. Having a new brand near breakeven speaks volumes to the fact that it could be a successful growth option, and should have some value as a pure call option. Also, just the fact that they are a drag on current results implies that the main business is even more profitable than the EBITDA numbers are leading us to believe.
While EV / EBITDA relative valuations are nice, they are extremely limited. In the next post, we will take a look at some of the operating metrics of the businesses to see if there is any value in these companies.
Disclosure: I am long ARO. I also may consider a long in AEO at any time.