The Short Case On Jo-Ann Stores

Jan.29.07 | About: Jo-Ann Stores, (JAS)

Jo-Ann Stores, Inc. (NYSE:JAS) is a leading retailer of fabrics and crafts. The Company was founded under the name Cleveland Fabric Shop in 1943 by the Reich and Rohrbach families who had escaped Nazi Germany during World War II. The store name was changed to Jo-Ann Fabrics and became a public company in 1969 under the name, Fabri-Centers of America [FCA] before changing its corporate name to Jo-Ann Stores, Inc. in 1998.

JAS operates 814 stores, which include 641 traditional stores averaging 14,800 square feet and 173 superstores at sizes ranging from 35,000-45,000 feet. Traditional stores average 14,650 square feet, are generally located in strip malls, and produce about 55% of sales from fabrics and 45% from crafts. Superstores average 45,000 square feet and are more heavily skewed toward crafts with approximately 55% of sales from crafts and 45% from fabrics. Overall, traditional stores and superstores accounted for 59% and 41% of 2005 sales, respectively, although superstores have begun to account for a larger portion of 2006 sales (47%) as a result of the Company’s strategy to focus on the superstore format. Since 2005 the Company has focused on opening superstores that are 35,000 square feet or 22% smaller than older superstores.

Chart I: Sales By Product Category ($MM)
sales by product category

Table I: Category Description
Categories

The arts and crafts industry is worth $31 billion (Craft & Hobby Association 2005 estimate) and has a growth rate of approximately 3-4% per year. Considering the industry grew 11.3% in 2001, it is generally considered recession resistant as consumers may sometimes substitute arts and crafts for less expensive forms of entertainment during economic downturns. The arts and crafts industry is subject to various fads and is currently coming off a recent boom in yarn and scrapbooking, which drove industry sales from 2003-2005. Since that period, the industry has faced considerable challenges as no new trends have emerged to replace the drop off in sales. Chart II presents the sales of the industry’s largest participants: JAS, Hancock Fabrics (HKF), A.C. Moore Arts & Crafts (NASDAQ:ACMR), Michaels Stores (NASDAQ:MIK), and Hobby Lobby. The percentages represent their respective market share amongst the peer group based on revenues.

Chart II: Sales of Leading Arts and Crafts Retailers ($ Billions) 2005

Retails sales

Investment Rationale

For the few years prior to 2005, JAS stock had generally been range bound between $25 and $30 per share. In 2005, the Company’s share price dropped about 50%, reflecting major operational and industry issues. Same store sales were negative while gross profit and operating margins had fallen sharply with JAS posting an operating loss of $23.0 million. Since the stock’s drop to a low of approximately $11 per share at the start of 2006, JAS shares have rallied over 130% based on the expectation that activist investors and new management will be able to return the Company to profitability.

In July 2006, JAS hired Darrell Webb as Chairman, President, and CEO to take over for Alan Rosskamm who stepped down in February 2006. While Rosskamm was a direct relative to the founding families, Mr. Webb brings significant “big box” experience having spent his career at The Kroger Company (NYSE:KR) and most recently as president of its Fred Meyer division. Under Mr. Webb’s direction, JAS has completed its Repair Plan, which was drafted in 2006 prior to his arrival to address the operational issues facing the Company including tepid sales, inventory control, and marketing. Table II lays out the main initiatives of the Repair Plan.

Table II: Repair Plans Initiatives
Repair plans

Pros to Short

Valuation

JAS currently appears overvalued given that the stock is reflecting a successful turnaround despite little tangible evidence indicating that a turnaround is imminent. Current valuation metrics are presented in Table III:

Table III: Valuation Multiples (1/19/07)

Valuation multiples

Earnings have yet to materialize and EBITDA is currently depressed, resulting in the higher EV/EBITDA multiple which is typical of many turnarounds. Over time one could expect that JAS will “grow into” a normal historical EV/EBITDA multiple of 5.0x-6.0x EBITDA once its EBITDA returns to normal operating levels. The key multiple to consider is EV/Revenue, which at 0.42x reflects a “healthy” JAS based on historical multiples. Table IV presents historical valuation multiples for JAS, illustrating that the Company’s historical value tends to be around 0.42x EV/Revenue, 5.0x EV/EBITDA, 13.0x EPS, and 1.5x P/BV.

Table IV: JAS Historical Valuation Multiples

JAS Historical Valuation Multiples

Based on EV/Revenues and P/BV, JAS stock has completely recovered. To further illustrate that the Company’s current EV/Revenue multiple fully values a “normal” JAS, consider that JAS sales have generally been in the $1.8-$1.9 billion range over the past few years and during strong operating periods have produced net income margins of approximately 2.5% (see Table V). Applying this to $1.9 billion in sales for 2006 (above consensus estimates) results in net income of $47.5 million which translates into EPS of approximately $2.00, which would value JAS at about 12.5x EPS, very close to the Company’s historical P/E valuation range.

Table V: JAS Historical Operating Data
JAS Historical Operating Data

Based on analysts’ expectations, JAS is trading at 83.3x 2007 EPS and 16.7x 2008 EPS. These appear to be fairly rich multiples on a forward basis considering that the Company has historically traded for closer to 13.0x EPS. While one can always question the accuracy of consensus estimates, even if JAS can return to EPS closer to the $2.00 range it generated in 2002 and 2004 by 2008, the multiple is still likely to be two years into the future and presents a simple bet on management’s ability to execute.

Operating and Execution Risk

While the Company’s valuation is healthy, there is not much evidence that suggests JAS is close to realizing a meaningful turnaround. JAS completed its Repair Plan which resulted in slightly improved inventory turnover, gross margin, and lower debt but overall the Company still has significant inventory on hand which will take time to rationalize and also shows no signs of improving top line growth. Management has been able to improve gross margins in a declining sales environment mainly by avoiding low margin products but the overall impact has not been as pronounced in operating income because JAS sales have not been high enough to leverage its SG&A. Further, cash flow was boosted through a one time sale-leaseback of an owned distribution center as opposed to any operational aspect.

For the most part, management has been able to address the low hanging fruit but the real challenge and main risk that does not seem to be priced into the stock is management’s ability to find the right product mix that will sell through at an acceptable rate and margin. Hardlines represent about 46% of JAS sales and are a big share of superstore revenue but performance across the majority of these products has been poor, with year to date same store sales of hardline and seasonal products at -8.5%. Softlines have declined 3.8% year to date on a same store sales basis. The poor performance has been an ongoing trend with few signs of any real progress in terms of strong product sales.

Another problem is that the Company continues to have weak performances from both existing and newly opened stores and is uncertain about how large its superstores need to be. About 70 of the oldest 45,000 square foot superstores are the Company’s best performers but the other 100 superstores, whether 45,000 or 35,000 square feet, have underperformed and management does not seem to really know why. In addition, management is now rolling out 25,000 square foot superstore formats demonstrating that there is still significant confusion in regards to what the appropriate square footage should be.

Aside from management’s uncertainty regarding ideal store size, the bigger problem could be the Company’s decision to focus more on superstores and less on its smaller, traditional stores. The issue with continuing with this superstore strategy is that the superstores do not perform as well as traditional stores. In the third quarter, superstores recorded a same store sales gain of -7.7% while traditional stores registered a same store sales gain of -3.5%. While same store sales are not the most important metric for older and mature retail businesses, JAS still must find a way to generate some positive same store sales growth considering the greater overhead with its larger store format. In contrast, competitors such as ACMR, HKF, and MIK focus on smaller formats with square footage generally in the 14,000-25,000 square foot range.

Chart II presents a map from the Company’s website which illustrates store locations. The Company’s massive geographic footprint could be an advantage during prosperous times but the fixed costs they present during slow periods represent a significant competitive disadvantage due to their larger square footage formats, which require strong sales to drive operating leverage. JAS revealed during its third quarter conference call that certain competitors have opted to hold back from developing new sites due to weakness in the industry. JAS is only planning to open 6 new stores in 2007 but given industry trends, its current store base could still represent a significant hurdle in terms of reaching profitability.

Chart II: JAS Store Locations
JAS Store Locations

The best strategy for JAS may be to drastically reduce its store count and go back to the traditional store format with under 15,000 square feet per store. With over 800 sites that are producing anemic results, JAS should target just the higher quality/higher sales regions and scale back in regions where stores are located within close proximity to one another, particularly in the northeast where competitor ACMR, which leads the industry in sales per store and sales per square footage, has a strong presence. Doing this would reduce sales but would likely have a tremendous improvement on margins. The problem is the Company has invested a lot of time and money into the current strategy and scaling back its store count would result in significant costs as most stores are in 5-20 year leases. As a result, JAS will likely continue on with the superstore strategy until it becomes apparent that the strategy is facing far too many obstacles.

Distant Number Two Market Position

There are certain industries in which there’s room for just one top tier player. While there will always be arguments that a number two or three player deserves to be valued closer to the leader based on relative valuation multiples, this rarely happens in practice. The interior home furnishings industry is an example that may have some parallels to the arts and crafts retail industry.

Bed Bath and Beyond (NASDAQ:BBBY) has always been the clear leader in the home furnishings industry which has resulted in a valuation premium relative to competitors ranging from Linens N’ Things (Private:LIN), which was taken private, Pier One (NYSE:PIR), and Bombay Company (BBA). Whether it was issues related to merchandising, presentation, marketing, logistics, site selection, store format, etc, BBBY has had a history of trumping these competitors in nearly every facet of operations which has resulted in its premium relative valuation.

The same can be said for Michael’s Stores (MIK), which was taken private in the late summer of 2006 by Bain Capital and the Blackstone Group. Like JAS, MIK has over 800 stores but the average square footage is 18,500. While its sales per store and sales per square foot lag ACMR, MIK’s profitability and consistent same store sales growth are above competitors ACMR, JAS, and HKF. Reasons for this could be site selection, product mix, logistics, etc. but the main point is MIK’s consistent above-peer performance is what has warranted above-peer valuation multiples.

Table VI: Competitor Operating Metrics
Competitor Operating Metrics

While JAS may have the highest gross margins amongst its peers, these margins are not comparable because, as indicated in the Company’s filings, parts of JAS SG&A expenses include items that competitors would categorize under gross margin. Aside from operating metrics, JAS has been underperforming in respects to same store sales performance which could indicate the Company’s product mix is not appropriate relative to what consumers want. Analysts had expected JAS to post a same store sales loss of 4% for December but even the holiday season couldn’t improve the Company’s same store sales trend which came in worse than analysts expected.

Table VII: Historical Same Store Sales
historical same store sales

Unlikely Buyout Expectations

Some investors may be viewing JAS as a potential buyout candidate. Given the current state of capital markets, anything is possible but the reality is JAS must significantly improve its cash flow before any sponsor will consider buying the Company. With its cash flow significantly depressed, a high share price, and no real estate to support a potential buy and break up/sell strategy, no financial sponsor will purchase the Company, especially given many other attractive buyout candidates that require far less operational risk.

Secular Industry Decline

JAS management has given few details in suggesting how the Company can revive sales and has instead cited the basic secular trend of an aging U.S. population that will eventually bolster the industry. While this may occur, it may also be likely that aging boomers take up other hobbies beyond the arts and crafts industry. Many baby boomers are computer savvy and a lot of aspects of scrapbooking and paper crafts have migrated to computers which offer portability, storage, and creative aspects that could match if not exceed the “real” scrapbooking and paper craft experience. Further, while baby boomers will have free time, this generation appears to have a preference for more active pursuits suggesting that a host of other activities will offer strong competition relative to sewing and other fabric crafts. At best, the aging population phenomenon will help JAS in terms of sales, but it would also help a variety of other industries as well, leaving JAS unchanged on a relative valuation basis.


Cons to Short

Activist Investors

JAS attracted interest from value investor, Robert Olstein, in mid 2005 and his fund, Olstein & Associates, L.P. [OA], now holds about 8% of the Company’s outstanding shares. In addition to OA, Tennenbaum Capital Partners [TCP] has amassed an 11.6% stake over the course of 2006. These two firms have been pushing for strategic changes and have largely been successful in their requests. OA pushed then CEO, President, and Chairman Alan Rosskamm to step down as CEO and President while TCP was successful in lobbying the firm to have the removal of its poison pill provision up for voting at the next shareholder meeting. While it may appear that JAS is fully, if not overvalued, the presence of two firms like OA and TCP with their significant risk capital at stake could serve as a positive signal for passive investors that there may be more upside to JAS, thus driving up the share price regardless of fair value.

Nonetheless, OA has made mistakes in retail turnarounds, notably investing in PIR when no turnaround was achieved. TCP is a more versatile fund and can be both a buyer of equity or lender of debt. This fund was recently featured in an article discussing a “loan to own” result with Radnor and it may be possible that TCP pursues other alternatives with regards to JAS to generate the returns it is seeking. Based on TCP’s current push to remove corporate takeover defense measures, it appears that TCP believes JAS could be a potential sale candidate.

New Management Team

Mr. Webb has significant experience in “big box” retail having spent his career at KR. His background should help JAS in improving its logistics and streamlining operations to the point that if sales do eventually improve, it could be possible that profit margins surpass historical trends. However, a key distinction is that the current CEO’s background was in groceries, where sales are not driven by changes in trends and tastes. Further, as Warren Buffet has stated (paraphrased), when a great manager works in a poor industry, it’s usually the industry that leaves with its reputation intact.

Wal-Mart Leaving Fabric Industry: Wal-Mart’s (NYSE:WMT) will be eliminating its fabric department in 2007 which has upset some residents in communities that depended on WMT for their fabric purchases. This could be beneficial to JAS and other competitors such as HKF but keep in mind that WMT will still offer other arts and crafts supplies. JAS and HKF may be able to capture additional customers and sell more items beyond just the fabric purchases but if WMT can significantly compete against these two in terms of price and quality, then consumers may just opt for fabric purchases at JAS and HKF and buy arts and crafts supplies at other stores such as MIK or WMT.

The market opportunity from WMT leaving the fabric market could be a total of $540 million according to Laura Richardson, an analyst at BB&T. Since the industry is fragmented, Richardson expects JAS and HKF to capture just $69 million and $56 million of those sales, respectively. Richardson indicates that there are 2,165 WMT stores within 30 miles of JAS stores and 1,815 WNT stores within 30 miles of HKF stores.

The fabric business which JAS and HKF are tied to is a dying industry and does not offer high levels of profitability. Other businesses included Target, Kmart, and J.C. Penney have all bowed out of the fabric business, suggesting there may be little opportunity in this market. JAS stores offer the potential for significant operating leverage but it’s difficult to believe that an additional $69 to even $100 million in sales could generate the EPS results necessary for further stock appreciation, especially when considering that the stock is priced as though EPS was already $2.00.

Disclosure: Author manages a hedge fund that is short JAS.