In my previous two posts, I’ve looked at the teen retailers on an EV / EBITDA basis and looked at them based on historic earnings. In this post, we will look at the company’s margins and a few other important metrics to see where the companies are headed. You can find all of the numbers and metrics I refer to here.
Looking at the numbers, we can see Abercrombie & Fitch (NYSE:ANF) has by far the highest gross margins, around 65%. American Eagle Outfitters (NYSE:AEO) and J. Crew Group (JCG) trail with around 45% margins. Aeropostale (NYSE:ARO) has the lowest with around 35%. This speaks to their strategies. ANF and JCG sell the highest quality goods, followed by AEO focused on the middle value and then ARO, focused on pure value. I’m actually a little surprised by JCG’s margins, considering a higher percentage of its business is made by direct sales (online/catalog, which carry higher margins) and its focus on quality.
Let’s breakdown the numbers a little further.
AEO: You can see operating margins were absolutely crushed during the recession, dropping from 20% to under 8%. This could represent a significant opportunity though. If you believe the economy will eventually improve and we will come out of this discount-or-die retail environment, a return to even 15% margins would represent a pop to today’s stock price, even keeping the multiple of earnings steady. Also notice AEO's sales per square foot: They are way behind both JCG and ARO, but a little ahead of ANF. I think this speaks to AEO's strategy of trying to emulate the large “club” feel of ANF to some extent. Still, an improvement in this number would create some significant operating leverage towards getting the operating margins up.
ANF: The company's sales per square feet are by far the worst of the group. However, this speaks to ANF's strategy of creating large, insider club type atmospheres within its stores. Once again, operating margins and sales per sqf were crushed during the great recession. However, notice gross margins barely budged. This speaks volumes to the company refusing to cut price to maintain brand integrity. As the economy recovers, ANF should enjoy huge operational leverage as, with 65% GM and most other costs fixed, increased sales will flow almost directly through to the bottom line.
ARO: Clearly the great beneficiary of the great recession. Operating metrics are at an all time high. The bear case on this stock hinges on it getting crushed as the economy recovers. However, even if operating margins return to 12% (where they were before the recession), you are still looking at a company trading for around 8 times operating earnings and even better on a cash flow basis.
So where does this leave us? ANF and AEO both clearly have tons of upside if they can return their business to pre-recession operating levels. AEO’s stock, especially, still has very little in the way of recovery baked into it. ARO’s stock is trading at levels that suggest it has no profitable growth prospects, and margins will drop to a level lower than they were before the recession happened.
With tremendous balance sheets and attractive ROIC, I think all three stocks should do well for long term investors. However, I think ARO and AEO are really attractively priced:
For AEO, you get a business with great valuations and significant operating leverage as the economy improves, plus a tremendous brand name.
For ARO, you get a business that has already completely discounted margins below where it was before the recession. The company is buying back stock hand over fist, the company is still performing tremendously well, and it is trading at a great valuation despite tremendous ROIC and ROE numbers.
With the recent purchase of Jo-Ann Stores (NYSE:JAS) and JCG, I wouldn’t be surprised to see both ARO and AEO put into play sometime in the next year. We saw some evidence of this in the past week, as ARO hired an advisor to help with takeover defenses. This shows people have approached them about a buyout, and management likely wants a higher valuation before they will consider it.
However, even if they aren’t taken out, an investor at today’s prices should still do well as the retail environment gets less promotional and the stocks are given more reasonable valuation levels. There is also the call option on the two from any improvement in their new brands. Both have brands that are currently losing money but approaching breakeven. If the brands begin to be profitable, even applying the same multiple to the stocks could cause a huge increase in the stock prices.
Disclosure: I am long ARO.
Additional disclosure: I may also go long AEO at any time.