Investors who utilize stock screens to search for hidden gems are no doubt well acquainted with teen apparel retailer Aeropostale (ARO). A few months ago, this stock showed up on one of my own screens, and it certainly looked like an interesting opportunity. The numbers looked picture perfect: great earnings growth, solid balance sheet, extremely generous valuation. After further research, I decided that competitor American Eagle Outfitters (AEO) was the better play in the sector, but I still expressed bullish sentiment on Aeropostale in the comments section of one of my articles. Even though I didn't lay down any money on it, I still thought it was a bargain compared to industry peers like Abercrombie & Fitch (ANF) or lululemon athletica (LULU).
After further review of the company, I take it back. All of it. Investors looking for a bargain would be better served turning their attention elsewhere. Sorry guys, but it's time to 'fess up: I was dead wrong on this call. Granted, I never invested in the company and never wrote an official pitch for it, but we have to own up to what we say, even the offhand comments. I never should've given Aeropostale a thumbs up before investing an adequate amount of time into researching the company, not even in casual discourse.
To explain why I've done such a sudden about face on the company, we have to first talk about the relationship between owners and managers in a publicly traded corporation like Aeropostale. When I refer to management, I'm including (and in the case of this article, emphasizing) the board of directors. The typical shareholder is usually far removed from the day-to-day operations of his company. Instead, he hands stewardship of his capital over to his managers, who he entrusts to invest this capital into the business and generate profitable returns over time.
Ideally, management's interests should be aligned with the owner's, and indeed, many managers in Corporate America are committed to the job they were hired for. Uncle Ben told Spiderman that with great power comes great responsibility, and the majority of managers take their responsibility to shareholders seriously. However, some self-serving managers recognize that with great responsibility also comes great opportunity to dip into the cookie jar and siphon off the wealth of shareholders to line their own pockets. Short of outright fraud, this is the worst thing managers can do to betray the trust owners have bestowed upon them. On these charges, the management at Aeropostale is guilty on all counts.
Aeropostale's managers are not incompetent. On the contrary, every action they have taken has been expertly calculated to advance their own interests at the expense of company owners. Cash rich retailers make attractive buyout targets for private equity firms in today's economic environment. Back in December of last year, Aeropostale was approached with one or more such takeover offers. Rather than presenting the proposal to shareholders, management decided to save its own skin by hiring Barclays Capital for "strategic advice" on how to neutralize a takeover. It's not hard to see why management would be opposed to an acquisition: the board of directors raked in over $150,000 a head in fees last year for a job that basically amounts to attending four meetings every year. The chairman cleaned out almost $2 million. If the company was acquired, this very lucrative income stream would vanish instantly.
Well paid directors naturally encounter a conflict of interest when a takeover offer gets placed on the table, but loyal directors who have the best interests of their shareholders in mind would not let this deter them from making the right decision. Aeropostale's board members have shown themselves to be anything but shareholder-oriented. Private equity firms usually offer owners a substantial premium over the market value of their stock in order to secure an acquisition, but scuttling a takeover attempt is the right move if owners believe that their company can appreciate in value beyond the offering price within a reasonable time frame.
In December 2010, Aeropostale was trading at $25/share. Half a year later, the stock has dropped to $12. Aeropostale refused to comment on the takeover bids, but the rumor mills report that the number bootstrap buyers were putting on the table was $40 a share. Clearly owners would've been better served selling to private equity, but in this case, management didn't even give them the option to vote on it. If there's a more egregious case of management abuse out there, I have not seen it.
Unfortunately, the transgressions don't stop there. Due to the recession, apparel retailers are finding precious few opportunities in which to profitably deploy their earnings. After all, there's no point in opening new stores when your current stores are barely breaking even. As such, many of these companies have opted to return a large part of their cash flow to shareholders in the form of a special dividend. For example, American Eagle paid out a special dividend last year which, when combined with its normal dividend, returned to shareholders a yield of more than 7%. The Buckle's (BKE) special dividend brought its trailing yield up to almost 8%. Not only has Aeropostale failed to pay a single dime in special dividends, it doesn't even offer a traditional dividend. True, as a low priced retailer, Aeropostale has fared better than its cyclical competitors during the downturn, but it spent less than half of its operating cash flow on capital expenditures last year. Rather than returning the unused profits back to company's owners, management has been furiously burning up the money by buying back shares.
Here, I have to give full credit to the evil genius behind Aeropostale's management team. The company's head honchos understand that value returned to owners in the form of dividends is not reflected in the stock price or the financial statements. Clemens Scholl wrote an excellent article illustrating how a company with an unimpressive chart may have actually returned vast profits back to owners over the years through dividend distributions. On the other hand, capital appreciation generated by a share buyback program is instantly baked into the stock price and provides an immediate boost to earnings per share. Buybacks are the beer goggles that make a poor showing look less dismal, and a good showing even more impressive.
For managers who want to sustain the illusion of exaggerated performance, it is clear that buybacks are the superior option to dividends. In order to pull off this magic trick, Aeropostale's managers have been withholding earnings from owners and eagerly spending it to buy back stock in order to prop up the share price. They haven't been very successful - in the past year, diluted share count has been reduced by more than 10%, but that didn't stop the price per share from getting cut in half. This result is regrettable, but Aeropostale's top brass had no other choice...had they not performed the buybacks, the shares would be trading at an even lower price today, and they would look the worse for it.
Aeropostale's managers remain unconcerned because the plight of the shareholder is not their own. Owners have traditionally compensated managers with options and restricted stock in hopes of aligning their interests with shareholders. This is a good idea in theory. After all, managers who are also large stakeholders should remain invested in the company on which their fortunes ride.
However, there is one very obvious loophole in this theory: managers can simply cash out their stock as soon as they receive it. At Aeropostale, management has been milking this escape card for all it's worth. Despite generous stock awards, insider ownership accounts for a mere 1% of the float, compared to 8% for American Eagle, 22% for Urban Outfitters (URBN) and a whopping 35% for Gap Inc (GPS). It is foolhardy to hope for more commitment from Aeropostale's managers, because they've clearly demonstrated that they view the company not as a nest egg to be nurtured, but as a cash cow that they fully intend to milk dry.
Long term stakeholders in Aeropostale should think hard about whether or not they want to stay invested in a company managed by those whose agenda is not to help them grow their capital, but to profit from it themselves. The most effective course of action for owners is to perform an immediate purging of the ranks in order to replace the current management team with one that is committed to the interests of the company's shareholders. The company's financials remain sound, its weak link is its self-serving leadership.
However, for most investors who do not hold a controlling stake in the company, this is not an option, so my advice to them is this: Formulate an exit strategy, and when the opportune time arrives, sell your holdings and walk away. Your management has failed you. There are better companies out there, with better managers who are worthy to be the custodians of your capital.
Post-scriptum: This article was written two weeks ago, but publication was delayed in order to give Aeropostale's management the chance to respond to these allegations. I have still not yet received a reply.
Post-post-scriptum: Readers should know that famed hedge fund manager David Einhorn has recently opened a new position in Aeropostale, so clearly he disagrees with me. Then again, maybe not - Einhorn is well known for his willingness to invest in companies with solid financials, but weak management, such as Microsoft (MSFT). As always, it's important to remember that for every buyer in the market, there's a seller, and vice versa, so do your own due diligence.
Disclosure: I am long AEO.