Bet Against The Shorts, Buy Buckle

Sep. 2.12 | About: The Buckle, (BKE)

In an industry plagued with aggressive promotional wars, price-sensitive consumers, and until recently, soaring material costs, Buckle (NYSE:BKE) stands alone as a rose amidst weeds. When I'm on the hunt for a new portfolio addition, I love finding a company with great financials that also makes a product I use in my everyday life, and therefore understand from a consumer's perspective. Yes, I happen to be a big fan of Peter Lynch as well. I don't know how fashion-conscious Mr. Lynch was, but if he happened to suddenly wake up one morning in a 21 year old's body, but armed with all of his investment experience, the first thing he'd do would probably be to buy shares in Buckle.

In the original draft of this article, I devoted the next few paragraphs to discussing Buckle's amazing fundamentals, but in the end, I decided to toss it all out. Let's face it: followers of Buckle's story have heard it all before. There are a ton of articles out there delivering the lowdown on Buckle's fantastic numbers, the ticker pops up on almost every value-oriented stock screen you can run, and it's even a Greenblatt Magic Formula pick. For those who haven't been following the stock, this chart from Buckle's own investor relations page can tell the story much more concisely than I can.

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Rising revenue? Check. Rising earnings? Check. Debt-free balance sheet? Check. Low P/E for the stock? At less than 14, check that, too. Everything looks great, right? However, further research into the company will almost immediately uncover an enormous red flag: out of 27 million shares in the float, over 9 million have been sold short. Rather than rehashing what's been said before, this article will instead focus on what people aren't talking about: why such a seemingly superstar stock is so heavily shorted, and whether or not the shorts are right.

Short sellers are often referred to as the smartest guys in the room, and for good reason: short selling is an extremely risky investment technique where you're going to get burned if your thesis is anything less than dead on. Warren Buffett doesn't do it. I don't do it. When you bet against the guys who do do it, it's usually wise to triple-check your own investment thesis to make sure you didn't overlook anything.

I actually found Buckle more than a year ago, and had multiple opportunities to invest when it was trading at lower prices than today, but I held off on pulling the trigger because I didn't understand why it was so heavily shorted. Benjamin Graham has always advocated that investors can only succeed by ignoring the opinions of the crowd, and for the most part I agree with him. However, I've found that it's usually useful to at least know what the crowd is thinking and why they think it.

Chess players understand that as a player, you're in trouble if your opponent makes a move and you don't understand why they made it. It's one thing to disagree with the short seller's analysis and bet against him. It's another to not even comprehend it. For almost a year, I could not understand why so many market players were betting against Buckle, because as far as I could tell, there were many things right about the company, and nothing majorly wrong. More research didn't help - there were many bullish articles on the company, even here on Seeking Alpha, but not a single one offered a hypothesis on the reason behind the stock's huge short interest.

Why do I own the stock now? Because I finally get why short sellers are lined up to take it down, and I believe that they're wrong. The shorts betting against Buckle are either the major investment banks or their clients, who are receiving research reports like this one and this one. Those are just blurbs (only paying clients have access to the full reports), but they share one phrase in common: "peak margins." The chart above shows that Buckle does indeed enjoy fat margins, but what it doesn't show is how its margins absolutely crush those of its closest competitors.

Right now, the teen apparel retail industry is dominated by three major players: Aeropostale (NYSE:ARO), American Eagle Outfitters (NYSE:AEO), and Abercrombie & Fitch (NYSE:ANF). The three As have trailing fiscal year post-tax profit margins of 3.0%, 4.8%, and 3.1%, respectively. By contrast, Buckle pulls net profit margins north of 14%. Clearly one of these is not like the others. Driving Buckle's margins are a strong brand name and fashionable merchandise that consumers are willing to pay up for, which is one of the things that drew me to the company in the first place. However, this is also the main reason why short sellers are so bearish on the stock. They believe that Buckle's margins have nowhere to go but down, and that the company's earnings and stock price will be dragged down with it.

Let's discuss margins for a second. Jeremy Grantham refers to profit margins as "the most mean-reverting series in finance," and he's right. There are usually two reasons why abnormally high margins almost always get brought back down to Earth. The first is when an entire industry is operating at the peak of its business cycle, and the economy undergoes its inevitable contraction. This was the case for the entire apparel retail sector before the financial crisis hit, when the economy was in a boom and every company was pulling in double digit profit margins and returns on equity north of 30%.

The second reason margins revert pertains to individual companies that come up with an innovative new product. The product is a hit, and the company is the sole beneficiary of the enormous consumer demand for it, until new players enter the space and competition puts the squeeze on its margins. It's anticipation of this second phenomenon that's plaguing stocks like Green Mountain Coffee Roasters (NASDAQ:GMCR). In Green Mountain's case, this is a legitimate concern, because it's about to go head to head against Starbucks (NASDAQ:SBUX), a competitor with much larger resources and a much more recognized brand.

Neither case applies to Buckle. Buckle investors don't have to worry about an industry-wide margin drop, because the apparel industry as a whole is operating at trough-level margins right now. So what about competition clamping down on its margins? Unlike Green Mountain, Buckle has been operating and succeeding for years in an industry filled with much larger competitors. It doesn't owe its margins to first mover status. On the contrary, Buckle manages to pull such high margins because it's the best mover.

Some believe that the company will be in trouble when competing department stores like Macy's (NYSE:M) begin to stock similar merchandise, but it's not that easy to steal Buckle's ideas. For one, a third of its merchandise is private label. In addition, according to the company's 10-K, it negotiates contracts with many top brands like Buffalo Jeans and Hurley to provide certain designs exclusively to the company. Buckle's other competitive advantages, like its great customer service, experienced management team, and attractive store design aren't easily duplicated either. The stock's high short interest isn't a recent development. Shorts have been betting against Buckle for years, and every year they've had to pay the stock's massive dividends out of their own pockets.

So if we don't have any reason to believe that the company's margins will go down, does that mean that they'll go up? I don't necessarily think so, but they don't need to. While Buckle's profit margins are indeed far above the industry average, its revenue per square foot, at $460, isn't. Increasing margins is only one way to drive up profits. The other is to increase sales. Setting aside anomalies like Lululemon Athletica's (NASDAQ:LULU) $2,000 sales per square foot, companies in the sector usually manage to pull around $600 per foot in good times, which means each individual Buckle store can still make more money by increasing sales output alone. Furthermore, even if the short sellers turn out to be correct and the company's margins contract, lower prices may lead to higher revenue per square foot, which would mitigate the effect on the bottom line.

Let's not forget that Buckle only owns 431 stores across the United States. Aeropostale, Eagle, and Abercrombie have roughly 1,000 domestic stores per saturated concept, and they're launching new concepts on top of their core as well as expanding internationally, so clearly Buckle still has a lot of room to grow. Even if its income per store remains the same, its annual profits will still increase simply by virtue of new store openings. Most of its current stores are concentrated in the Midwest and the South - it hasn't even penetrated large metropolitan areas like New York City yet. Unlike many of its competitors, Buckle doesn't try to spread like a virus, choosing only to plant down roots in locations where success is almost guaranteed, but considering how many stores and concepts its rivals have closed down in recent years, shareholders should be relieved that their capital is not being squandered by reckless expansion.

When I first began investigating the apparel industry last year, my pick at the time was American Eagle, which was trading at $12 versus $40 for Buckle. Today, Eagle has risen more than 80% to $22 per share, while Buckle is still in the low $40s. I've since liquidated my entire position in Eagle, taken my profits off the table, and redeployed the capital into Buckle, which I now believe to represent a superior investment opportunity. The only company in the sector to execute on the same level as the team at Buckle is Lululemon (which, perhaps not coincidentally, also has very high short interest). There are a lot of similarities between the two companies, from a loyal customer base to stylish clothes to well-designed stores. Of course, lululemon is trading at a much higher valuation, with investors buying each dollar of earnings at almost four times what they can buy Buckle for.

Make no mistake: an investment in Buckle is a bet against some of the smartest guys on Wall Street, who are so firm in their belief that this stock will collapse that they're willing to put their own money on the line. I'm firm enough in my belief that they're wrong that I tossed down my chips on the table to go head to head against them. Only time will reveal the winner of this face-off. Of course, not everyone on the Street hates Buckle (Royce holds it in significant quantities in five of their funds), but those that do exist as a large enough population to represent a significant risk factor that must be taken into consideration. For my part, I'm thankful for the short sellers, whose efforts are allowing me to purchase a great company on the cheap, an investment that I expect will pay many dividends, both literally and figuratively, for years to come.

Disclosure: I am long BKE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.