There's few things in the market more interesting - and more divisive - than retail turnarounds. Bulls see a turnaround as a way to provide hope for what are often large paper losses; bears see turnaround hopes as an opportunity for higher entry points for a short sale. Each quarter sees trailing results and forward guidance analyzed closely - and often is accompanied by violent trading results.
Teen retailer Aeropostale (ARO) is, right now, one of the potential turnaround stories. And of late, its stock has certainly shown many turnaround characteristics. It has moved violently around quarterly earnings - up 23% on a Q4 pre-announcement, then down 17% when those results were reported, due to weaker-than-expected Q1 guidance. Bulls argue that the issues are priced in by a long, nearly 90% decline; that the Aeropostale brand still has value and relevance; and that a new (old) CEO, strategy changes, and a footprint rationalization can return the company to profitability (the classic turnaround phrase, of course). Bears see the cash burn of the last two years continuing - if not accelerating - and ending, most likely, in bankruptcy and shareholders being wiped out.
The problem for bulls in this case is that what Aeropostale is attempting is not a simple turnaround - where a company can simply fix execution issues and get back on the right track. Rather, Aeropostale must transform its business model in the midst of sea changes in its niche. Meanwhile, a financial situation that is far more precarious than it seems means Aeropostale has a lot less time than many realize. The combined impact of both issues brings Aeropostale's long-term viability into serious doubt, while a recent rise in the share price gives an attractive entry point for a short sale.
How Much Time Does ARO Have?
Turnarounds are sort of the mirror image of growth stocks (which, of course, often become turnarounds years later). In both cases, the argument is whether past results truly do portend future performance.
So the argument about how long Aeropostale has to turn around its business naturally depends on one's inclination toward the business and its 2015 (and 2016) performance. But at first look, ARO seems pretty solid from a liquidity standpoint. As of January 31, the company had cash of $152 million and borrowing availability of $117 million on a revolving line of credit, for total liquidity of $269 million. Meanwhile, ARO has burned $94 million at the operating level the last two years total (including negative $55.7 million in operating cash flow in fiscal 2014 - ARO fiscal years end in January of the following year.)
With capital expenditures guided to just $16 million in fiscal 2015, even a repeat of 2014's abysmal performance would burn roughly $70 million in 2015 (-$55 million in OCF + -$16 million in CapEx). But if you look at analyst estimates for 2015, which exclude non-cash charges, net income improvement is projected, and the consensus average is for an $89 million net loss (or $1.12 per share, down from $1.42 per share in 2014). D&A appears to be ~$40 million for the year (based on Q1 guidance for $10 million) and stock-based compensation would be ~$12 million, based on the Q4 run rate, though that figure could drop substantially in 2015 in line with ARO shares. All told, consensus expectations would seem to put estimated operating cash burn at $38 million, net of working capital adjustments. Add in the $16 million guided for CapEx and free cash flow looks set to be about negative $54 million. That's hardly impressive, but at that rate ARO's current liquidity would last it some 5 years.
But that $54 million figure likely understates ARO's 2015 burn rate. Aeropostale has at least $11 million of current lease exit obligations (see page 66 of the most recent 10-K). That moves cash burn to $65 million. It also doesn't account for any additional closing costs that may come up should Aeropostale decide to close more stores - that figure appears to have been about $21 million in 2014 (10-K p. 59), and could be in the $5 million range in 2015.
All told, it's quite likely that Aeropostale's 2015 cash burn rate will hold around $70 million - or even increase, should the impact of stock-based compensation decline, working capital turn against the company (after a $28 million benefit last year) or the company underperform. It's also worth noting that ARO's first quarter guidance was for a net loss of $0.53-$0.61 per share - actually worse than 2014's Q1 adjusted net loss of $0.52 per share. The company - and analysts, apparently - is guiding for improvement in the second half, and Aeropostale will need it to narrow net loss year-over-year. If it doesn't, cash burn could climb closer to the $90 million level this year.
But, still, Aeropostale has $269 million in liquidity, so it can handle a $90 or even $100 million burn in 2015 without sending equity holders fleeing for the exits. Right?
Not exactly. In the most recent 10-K, Aeropostale added a note about its $150 million financing deal with Sycamore Partners that did not appear in its previous 10-K (released soon after that agreement was finalized). The term loans from Sycamore have a $70 million minimum liquidity covenant, the breach of which "could result in default..." Combined, the bank-led credit facility and Sycamore's term are both secured by "substantially all" of Aeropostale's assets.
It's far from certain that should Aeropostale's liquidity drop below $70 million that Sycamore would simply declare default and take ownership of the company. (Aeropostale's revolver could also go into default if the Sycamore covenant was breached, though per the agreement the revolver default would be postponed if Sycamore released ARO from the $70 million covenant.) But what is certain is that the market will see that $70 million level at a point where ARO - and its shareholders - are essentially subject to the whims of Sycamore and other creditors, and where ARO equity could be wiped out by a declared default.
Of course, Aeropostale has nearly $200 million clearance over that $70 million availability covenant, so it doesn't necessarily seem a near-term problem. But the company could see pressure there far faster than investors might realize. ARO management refers to its credit facility as a "$230 million" revolver. Yet as of year's end, per the 10-K, borrowing availability was just $117 million. The availability is based on inventory and receivables (the borrowing base consists of 90% of appraised inventory and 90% of credit card receivables - see p.6 here) and has declined sharply in conjunction with declines in those assets: from $173.6 million at November 1 (page 16) to $116.8 million at January 31. (Inventory declined $80 million over the same period, as a Q3 buildup was sold in Q4.)
This creates a bit of a problem for ARO: one way to boost liquidity going forward is to gain cash from inventory declines from store closures and better merchandise management. But gaining that cash also appears to lower its credit facility availability, and to offset much of the breathing room gained relative to the $70 million minimum covenant.
That leaves Aeropostale dependent on controlling unadjusted cash burn to keep from breaching its liquidity covenant. Should ARO post negative free cash flow of $70 million this year, a breach could loom as soon as mid-2017. Should ARO stumble this year - or face higher-than-expected lease termination costs, try to build inventory year-over-year, and/or see the stock-based portion of compensation decline - Aeropostale's cushion relative to its loan covenants could drop close to or even below $100 million by year's end.
Even assuming cash burn comes in at $60-$70 million for 2015, there's a big concern for equity holders. The bank-led credit facility comes due in the fall of 2016, per the Q4 conference call. With cash at the end of fiscal 2015 likely to be below $100 million (from a current $154 million), that credit facility will likely be required to prevent Aeropostale from a 2016 default on the Sycamore term loans. What leverage will Aeropostale have in negotiating those deals? Who will lend to the company, knowing its shrinking asset base has another claim? How will suppliers (other than Sycamore, who has a sourcing agreement with ARO as well) respond to a company facing a potential default? At that point, full control will be with Aeropostale's lenders and suppliers - and that is a dangerous point for a company, and its shareholders, to reach.
Bulls will likely respond that this is a bit of an overwrought scenario; Aeropostale can manage its cash burn, work with its lenders, and extend its liquidity. That may be true - and is probably even the more likely scenario. But there is a rather reasonable possibility of a significant liquidity crunch at Aeropostale as soon as early 2016, should its lenders and its suppliers see the $70 million covenant in sight. More importantly, there's a stronger possibility that the equity markets will start focusing on liquidity no later than Q3 (when two quarters' of burn and inventory stocking ahead of the key holiday quarter will have depleted Aeropostale's cash balance). Any discussion of liquidity, or the addition of a 'going concern' disclosure in an SEC filing could lead the market to panic and drive ARO shares down.
Even if Aeropostale can refinance its revolver, and manage cash burn this year, the larger point is that its liquidity - and its time for a turnaround - is not as long as it might seem at first glance. The $200 million cushion can disappear quickly, as cash is burned and revolver availability diminishes. Barring a dramatic near-term reversal, Aeropostale at current burn rates has 2-3 years - at most - to effect its turnaround. That might sound like a long time - but the market is a forward-looking mechanism and won't wait until liquidity concerns are imminent to punish the stock. And given the magnitude of Aeropostale's task, a couple of years may not be long enough.
Is It Really Even A Turnaround?
When attempting a turnaround, company leaders will often use phrases like "return to our core competencies" or "we haven't performed the way we should." The nature of a turnaround usually implies that a) the company hasn't executed well in the past and b) better execution going forward can change results. Often, there are industry changes to manage as well (think Best Buy (BBY) and its attempt to manage competition from Amazon (AMZN) and other e-commerce vendors).
In Aeropostale's case, it clearly must adapt to sea changes in its niche. The rise of 'fast fashion' from H&M, Forever 21, and others has changed the competitive landscape. Teens aren't spending time at the mall the way they used to, and are spending more money on electronics than clothing. ARO's traditional competitors Abercrombie & Fitch (ANF) and American Eagle Outfitters (AEO) are facing struggles of their own, though not to the extent that Aeropostale has.
Industry conditions aside, there's one key problem for Aeropostale: the business model that drove it to a $3 billion market cap last decade is quite simply, no longer viable. In older filings, Aeropostale repeatedly cited two key components of its business plan: a "logo-driven design strategy" and its "promotional business model."
Both those paths to success are essentially dead. Abercrombie has already dropped logos from its clothes, and Aeropostale itself is de-emphasizing those products. CEO Julian Geiger, returning to the company after departing in 2010, said on the Q3 conference call - the first for which he had time to prepare - that "in no way do I think we should be the fashion-following logo-driven brand that characterized us for many years."
Aeropostale still does offer logo product (click here and scroll down, then scroll some more) but the decline in that business is a huge change. As recently as fiscal 2012, logo products were "a majority" of Aeropostale sales. Overcoming that decline is a difficult task; as I've noted before, logo apparel is (or was) one of the all-time great business models. Aeropostale (and its rivals) could charge high (and high-margin) prices to customers who were paying for the right to market Aeropostale's brand to even more potential customers. ARO itself wrote in its 2010 10-K that "(we) view the use of our logo on our merchandise as a means for expanding our brand awareness and visibility." Minimizing the logo business - which, again, accounted for over half of the company's product just two years ago - requires big changes in sourcing, design, marketing, and promotions. It is not a simple task, particularly amidst industry-wide turmoil.
Meanwhile, ARO's promotional strategy, once cited as a competitive advantage, has been co-opted by Abercrombie and AEO and perfected by H&M and other, more nimble competitors. What's left? In the most recent 10-K, Aeropostale lays out its new business strategy. It aims for "brand differentiation," with a goal "to gain market share by differentiating the Aeropostale brand through compelling product" and a "deliberate promotional pricing strategy." 'Deliberate' apparently means $6 T-shirts and massive discounting:
Source: Aeropostale home page, March 22
Source: Aeropostale home page, April 7
Aeropostale also cites as potential growth drivers "customer insight and engagement," (which includes focus groups), "store productivity" (sales per square foot have gone from $626 in 2011 to $403 in 2015), "real estate portfolio optimization" (though the company is so far only "considering" closing 50-75 stores, and may not have the cash to do so), and e-commerce (e-commerce sales are not broken out, and the business is completely managed by a subsidiary of eBay (EBAY)).
With all due respect to Aeropostale management, that's not a path to any sort of differentiation. All retailers look to amass "compelling" product, and engage their customers. E-commerce - particularly given the preference of modern teens - would seem to be a required focus of management, not something to be outsourced and treated as an afterthought to a declining bricks-and-mortar business.
And, indeed, this business model, with the benefit of logo sales gone, hasn't worked for the last year or so. Comps are collapsing, and a recent Piper Jaffray report on teen spending showed Aeropostale continuing to hold its number one down-trending brand in the space:
"brands that teen girls no longer wear;" source: Piper Jaffray via Business Insider
It's hard to see how Aeropostale can reverse that trend with what seems to be a vanilla model and drastically cut spending. (CapEx has gone from $84 million in 2013 to a guided $16 million next year.)
The larger point here is that Aeropostale can't go back to doing what it did best - that business model is gone. Aeropostale, right now, seems to be trying to pivot to doing what its competitors are doing - only with far less resources. That doesn't seem like a business plan in which investors should have confidence.
Risks To The Short Case
ARO's tangible book value is about $70 million; marking fixtures and equipment down by 50% and inventory by 10% wipes that equity out, making current liquidation value zero by any standard calculation. There is simply no value in ARO shares barring a return to positive cash flow.
International licensing revenue has been one bright spot for Aeropostale, growing from $7.2 million in 2012 to $34.7 million in 2014 at impressive margins: operating income was $31.2 million last year, a 90%+ operating margin.
However, it's hard to see how much more growth the company can wring out. The company announced the addition of Ireland to its international portfolio on the Q4 call, with "a pipeline of deals" in progress. But there are already 239 locations licensed worldwide - meaning each location brings in about $130,000 in income. Adjusted operating loss in 2014 (including the $31 million in licensing profit) was about $115 million - it's simply difficult for growth in the international business to make a substantive dent here.
A long-rumored buyout makes little sense at current levels. Aeropostale, by its own admission, needs to minimize its footprint; private equity would be better served putting the brand through bankruptcy rather than shelling out the millions needed to break unwanted leases. Indeed, Sycamore's covenant seems a way to get claim to distressed ARO assets before the company, like many bankrupt retailers before it, passes the point of no return in terms of restructuring.
ARO shares have no other path to price appreciation beyond a rebound in the domestic, owned business. With that business having little apparent competitive advantage, and facing a host of larger, faster-growing, more popular, and deep-pocketed rivals, the path ahead seems difficult indeed.
Looking at the financials, the current valuation would require the ~$150 million operating shortfall in the U.S. business to be erased. How that happens is not clear. SG&A cuts from lower stores aren't enough - as noted, Q1 looks set to show a larger loss year-over-year, and SG&A as a percentage of revenue is projected to increase. For all the hype about Q4's adjusted profit (of less than $1 million), comps were still down 9% in the quarter, and net sales down 11%. Even if the company could stabilize sales at 2014 levels, gross margin would need to expand at least 800 basis points to reach breakeven. That would be a level last seen in 2012 - when the logo business still mattered, when H&M wasn't expanding throughout the U.S., and when Aeropostale wasn't facing a wounded A&F that has decided to finally compete on price.
Meanwhile, ARO shares have rebounded after their steep drop following Q4 earnings, coming close to "filling the gap":
The rise appears only to offer a better entry point for a short. Shorting ARO ahead of Q1 earnings - to be released in mid-to-late May - does invite the risk of a short squeeze into or after earnings. But at least one analyst sees comps coming in below an already-weak consensus of 8.6%, and Q1 retail sales haven't been especially strong to begin with. With net loss - not including charges - guided to $40 million-plus, ARO could report cash 30% lower than at the end of Q4 (assuming a modest inventory build and/or lease termination costs), bringing liquidity issues into clearer focus. And with shares still up 60% from early December lows, downside pressure could come from profit-takers as well as short sellers. Both will be looking to sell if there isn't clarity from management on the way forward - surely something more than focus groups and "compelling" merchandise - and/or some sign that Aeropostale is moving back toward profitability.
One, or both, of those things may happen in Q1. And Aeropostale may post an above-expected 2015, minimize cash burn, and find a way to get the cash and/or credit needed to give it breathing space for its strategy pivot. But all that seems unlikely, to be blunt - and even if it works, it's not clear that shorts will take a beating, beyond occasional post-earnings short squeezes. Is the market, any time soon, really going to give Aeropostale a $500 million market cap (up 80%+ from current levels), or even a $400 million market cap (up ~50% from current levels) when it is hoping to 'only' burn $100 million over the next two years? Or when a single bad quarter can bring liquidity issues to the forefront of the conversation surrounding the stock?
The possibility of Aeropostale zooming past expectations this year seems slim. Far more likely seems the possibility that the market will see Q1 (or Q2) earnings and realize that Aeropostale's cash balance is precariously above the $70 million minimum covenant, leaving it dangerously reliant on Sycamore and its credit facility. That can provide a catalyst for even further, and significant, downside and lead to each quarter's results needing a higher and higher bar to satisfy the market. Looking to 2016-2017, there's simply not much reason to believe that Aeropostale can gain market share, increase sales, return to profitability, and satisfy lenders and suppliers while minimizing investment in its own business. ARO is the weakest company in a weak space; and when the market realizes that its liquidity is not what it appears at first glance, its share price seems likely to take a large hit. That could come as soon as early May, and seems likely to become more widely known no later than the back half of this year. And once the word "liquidity" begins to surround a stock, there's usually no going back.
