Express: Great Company But Wait For A Pullback

| About: Express, Inc. (EXPR)
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Express (NYSE:EXPR) is a specialty retailer of apparel and accessories primarily in the US and focused on 20 to 30 year olds. The company operates about 620 retail locations and a handful of franchisee locations in the Middle East as well as its e-commerce site. Since late last year the stock has more than doubled from $10 to trade near its 52 week highs today at $22.50. The strength has come on the back of earnings beats and commensurate analyst EPS raises that have propelled the stock to current levels. With the stock closing in on its all-time highs at $26 the question for investors is whether or not the rally still has legs. I intend to argue here that while EXPR is a great retail story its growth has largely been priced in and that there are better places for your money at present.

In order to determine what EXPR is worth I feel it is instructive to understand what analysts believe will happen. To do this, I'll use a DCF type model that you can read about here in greater detail. The model requires six inputs that it uses to compute a fair value. My inputs and sources are as follows: 1) reported earnings, 2) earnings estimates and 3) current book value all from Yahoo! Finance, 4) perpetual growth rate of 3%, 5) dividend rate assumed to be zero and finally 6) discount rate of 10%, all of which are my estimations.

 

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

             

Reported earnings per share

$1.60

 

$1.59

$1.79

$2.05

$2.35

$2.69

x(1+Forecasted earnings growth)

 

-0.50%

12.60%

14.50%

14.50%

14.50%

14.50%

=Forecasted earnings per share

 

$1.59

$1.79

$2.05

$2.35

$2.69

$3.08

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$4.79

$6.38

$8.17

$10.23

$12.58

$15.27

Earnings per share

 

$1.59

$1.79

$2.05

$2.35

$2.69

$3.08

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at end of year

$4.79

$6.38

$8.17

$10.23

$12.58

$15.27

$18.35

               

Abnormal earnings

             

Equity book value at begin of year

 

$4.79

$6.38

$8.17

$10.23

$12.58

$15.27

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

 

$0.48

$0.64

$0.82

$1.02

$1.26

$1.53

               

Forecasted EPS

 

$1.59

$1.79

$2.05

$2.35

$2.69

$3.08

-Normal earnings

 

$0.48

$0.64

$0.82

$1.02

$1.26

$1.53

=Abnormal earnings

 

$1.11

$1.15

$1.24

$1.33

$1.43

$1.55

               

Valuation

             

Future abnormal earnings

 

$1.11

$1.15

$1.24

$1.33

$1.43

$1.55

x discount factor(0.1)

 

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

 

$1.01

$0.95

$0.93

$0.91

$0.89

$0.88

               

Abnormal earnings in year +6

           

$1.55

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$22.20

               

Estimated share price

             

Sum of discounted AE over horizon

 

$4.69

         

+PV of terminal year AE

 

$12.53

         

=PV of all AE

 

$17.22

         

+Current equity book value

 

$4.79

         

=Estimated current share price

 

$22.01

         

As you can see, my model suggests that EXPR is fairly valued at $22 or within 2% of where shares trade as of this writing. Thus, I believe the potential upside for investors is limited barring some kind of upside surprises from EXPR. However, notice that analysts are expecting nearly 15% earnings growth for the next five years in order to justify a $22 price tag. While I'll admit this is possible, I'd also suggest that maybe the risk to this estimate is to the downside given that 15% earnings growth is difficult to achieve over the long term for any company but in particular one that is mature like EXPR.

So why do I believe this? It is a confluence of factors that may seem immaterial separately but when aggregated I believe they provide significant headwinds for further growth. First, EXPR caters to a relatively narrow demographic. Now, this isn't as large of a problem for Express as it is for other retailers such as PacSun (NASDAQ:PSUN) or Tilly's (NYSE:TLYS) that offer what I consider to be "fad" clothing but limiting your customer base to one segment of the young adult population can have its implications. While I believe the company does a good job serving this demographic the fact is that Express customers tend to outgrow the styles the company offers before they reach their peak earning power with commensurate disposable income.

Along the same lines is the price point of Express. While the clothes and accessories offered are sophisticated and stylish a $70 dress shirt or $50 tie are probably out of a lot of 25 year olds budgets. Granted Express doesn't need that many customers from its available base but it is limiting itself to relatively higher income 20-somethings by selling higher end merchandise. The quality appears to be there for Express commensurate with the higher price point but it still eliminates many potential customers because they are unwilling or unable to pay for the quality.

Next, one simple fact of any clothing retailer is that there is a lot of competition. This is very true in EXPR's case as well as we can see from this slide pulled from a very recent investor presentation.

I count no less than thirteen competitors on this slide and while not all of them serve exactly the same customer base they are all pretty close. And to be fair, this doesn't even include mass market retailers like Target (NYSE:TGT) or Kohl's (NYSE:KSS) that also cater to 20-30 year olds. The point is that EXPR has to do a tremendous amount of work to even get on the minds of potential customers before it can even begin to think about converting them to purchasers.

These factors and others have conspired to drive down productivity and profitability for EXPR in recent past. The biggest problem for EXPR has been margins. The chart below shows EXPR's GM% for the past six fiscal years.

As you can see, EXPR's gross margins were below 26% in 2007 but subsequently rose all the way to 36%+ in 2011. While this is great, the problem is that the growth appears to be over and GM% has stabilized at around 34% to 35%. With falling gross margins last year and no catalysts for increasing them according to management commentary, I'm forced to assume that the days of 36%+ gross margins are gone and that we may in fact see lower GM% before it goes higher again. Only management knows this for sure but I don't like the very clear top I see in this chart.

Next, the company's store count is already quite high at 600+ stores and in fact, the store count is only marginally higher than it was in 2010. Thus, I have to believe that the company is near its saturation point in terms of the North American retail footprint or it would be opening more stores than it is. The company is remodeling some of its existing stores in order to provide a better customer experience but any growth achieved from that will likely be incremental. The days of big revenue growth are gone at EXPR barring high single digit comps. As management has guided for low to mid-single digit comps I'd say that is a bit far-fetched.

Coupled with that is the company's international expansion strategy that I consider to be so immaterial it's almost not worth mentioning. However, the company does offer shipping from its website to 60 countries so there is potential for some revenue growth there in the future but again, this piece of the business is so tiny it will likely never have a material effect on the company's financials. Apart from that, the company is operating internationally with franchise partners that buy their merchandise directly from Express. There are only a handful of stores operating this way at present and the revenue is nearly non-existent. This too will be immaterial until there are hundreds of franchise locations and that is likely a decade or more away.

One final reason I believe EXPR's growth is at best priced in and at worst implausible is the company's lack of a growth strategy. The investor presentation linked above touts the company's "four growth pillars." Those would be international expansion, existing stores, new stores and e-commerce. I've commented on all of these already so I won't rehash the same argument but the prospects for all of these aren't exactly dim but they're not bright either. I think EXPR is a pretty mature retailer and mature retailers don't grow earnings at 15%+ per year. Plus I don't consider those four things to be growth pillars; I consider them to be operating a business. This leads me to believe Express doesn't have any better ideas.

I don't want to give the idea that I am completely negative on EXPR because I'm not; the company is well run and profitable but it is simply too expensive at $22 for my tastes. One thing I'm particularly fond of is EXPR's "go to market" strategy. Basically, the company test markets roughly 75% of the products it sells in select stores before shipping them out nationwide. This has a couple of positive effects. The biggest one in my view is lower inventory risk. Instead of purchasing, let's say, 5,000 units of a particular shirt to roll out to its stores the company can buy a few hundred and put them in select stores to see how they sell. If they sell well the order can be completed. If not, the order is cancelled. This results in significantly reduced inventory risk on those items that are test marketed before being rolled out. It also allows the company to have its purchasing dollars available for only the best selling items. This is an important advantage of this program and should not be overlooked. Many retailers must spend their money before they know what will work but EXPR is largely isolated from this problem.

Finally, the company's e-commerce platform is a positive in that it allows the company to reach customers in markets that don't have an Express store. Not only does this mean the company can sell internationally but it also means that markets, like the one where I live, that don't have an Express store can still have access to its merchandise. The e-commerce platform has grown to over 10% of net sales in recent years so it is working; I'm just weary of the growth of this platform continuing. Even if the company can produce huge comps for the website it is only a fraction of total sales so the impact is likely going to be limited.

Given all of these factors the bottom line with Express in my view is that at $22, close to the best case scenario is already priced in. I've laid out several reasons why I think 15% earnings growth over the medium term is likely unrealistic and as such, I think a lower price is necessary before taking a long position. In fact, given my views, I think 9% earnings growth is more likely and if I replace the analysts' earnings growth rate with mine in the model it produces a fair value of $17.68. That is a long way down from here so if you must get long please wait until the stock drops below $19. Express is a great company but it is far too mature to grow earnings at 15% per year over the medium term. I'm certainly not advocating a short position and I would even recommend getting long if the price was right. But until such time, I'll be staying away.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.