Relative to my feelings about Gordmans Stores (NASDAQ:GMAN) nine months ago, a lot of my biggest worries have materialized and come home to roost, burying the stock under a mound of guano. Sluggish traffic is an issue across the retail space (amply demonstrated by many mall-based teen retailers), but Gordmans seems to have particular issues with its merchandising and it is taking a toll on same-store sales. What's more, I really disagree with the company's decision to pay out a sizable debt-funded special dividend earlier this year.
I feel as though I am in an uncertain and uncomfortable place with Gordmans now. I believe management is moving aggressively to deal with its merchandising issues, and I do take encouragement from the apparent willingness of developers to continue extending financing to the company. I also continue to believe that Gordmans has a differentiated discount retail model that can support a much bigger store footprint. The setbacks in same-store sales and a balance sheet-induced change to my discount rate lead me to meaningfully lower my estimated fair value here, but it still looks as though Gordmans is undervalued relative to what I see as its long-term prospects.
Fiscal Q3 Brings More Of The Same (And That's Not Good)
Gordmans had a weak fiscal third quarter, and the Street did not spare the shares, taking them down about 10% from the prior day's close and nearly 20% from their close on the Friday after Thanksgiving.
The company's reported revenue wasn't terrible, with sales up 6%, but comps were weak again - down about 6% as reported (against a negative 1.4% comp in the prior year) and down 4.5% on a comparable calendar basis. That was about 200 basis points worse than expected, as accessories were particularly weak (down by the high single digits).
With ticket up a bit, traffic was even weaker than expected. Results don't look any better looking at the peer group. Kohl's (NYSE:KSS) disappointed the Street with its fiscal third quarter, but same-store sales were just barely negative (down 0.1%). Basket-case Sears Holdings (NASDAQ:SHLD) saw sales drop about 4%, with Kmart (the more relevant Gordmans comp, in my opinion) down about 2%. TJX (NYSE:TJX) did even better, as overall same-store sales rose 5% with Marshalls and T.J. Maxx comps up 4%.
All of that is disappointing enough, and somewhat mitigated by an improving comp trend that saw the month of October and November comping more evenly with the year-ago levels. What really hurt was the margin performance. Due in large part to higher markdowns needed to move merchandise, gross margin declined 60 basis points. That lead to a nearly two-thirds decline in operating income and a sizable per-share miss.
Merchandising Needs To Get Right … And Right Away
Merchandising is really the name of the game for any retailer. Maybe a handful of retailers enjoy such strong cache and brand image that they can foist whatever they want on their shoppers and they'll buy it, but that's definitely not how discount retail works. Companies like Kohl's, not to mention Target (NYSE:TGT) and Wal-Mart (NYSE:WMT), have been trying to invest in their assortments and improve their merchandising and there is a limited amount of shopping dollars to go around.
Gordmans saw overall inventory rise 14% from the prior year, those the average per-store increase was more modest at 1.6%. It's also true that in-store inventory levels aren't so bad, but the fact remains that inventory is outpacing sales and that's a bad situation.
Management is not pretending that merchandising isn't a problem, and they highlighted four significant efforts underway, including more diversity in the assortments, improving supply chain execution to remove bottlenecks, refocusing around identifiable national brands, and encouraging closer cooperation between merchandising operations and store managers. Even so, management guided to ongoing markdown-related margin pressure in the next fiscal quarter.
Gordmans management also talked of a "challenging" Black Friday for the company. It didn't sound as though sales were bad per se, but it certainly appears that more aggressive Thanksgiving store hours at retailers like Kmart, Kohl's, and Wal-Mart made a difference. For all of the bellyaching about stores opening on Thanksgiving, it doesn't look as though companies who held back have been rewarded for doing so, and that adds a little extra unneeded sales pressure to this story.
Capital Management Now Concerns Me
Gordmans made the decision back in August to pay a sizable special dividend of $3.60 per share in September. Special dividends are all well and good when a company is flush with cash, but Gordmans funded more than half of that payout with new debt.
Management mentioned on the call that developers are still providing 95% of the capital for new store construction and that they are still getting at-market or below-market rents, as the company is a desirable tenant and has long-standing relationships with developers. Even so, the company has not earned positive free cash flow since 2010 and won't be doing so this fiscal year either. I get that Gordmans doesn't need a lot of capital to grow the business and should generate free cash flow again relatively soon, but I still do not like seeing a small company borrowing money for a luxury like a special dividend - particularly when there are significant operating issues (merchandising and same-store sales) that need to be fixed.
The Bottom Line
I still like the basic model here, including the specialty store feel, the significant discounting (as much as 60% relative to specialty and department stores), and visible "theirs versus ours" in-store price marketing. I also still believe there is a sizable potential store footprint out there and that sales can grow at a rate of 7% or more for the long term.
I don't like the near-term merchandising problems, though, nor the impact it is having on margins. I still believe that Gordmans will ultimately produce free cash flow margins on par with other discount retailers (in the mid-single digit range), but the numbers are shifting out a bit. I'm also not happy with management's capital management and the modest discount rate "bonus" I once gave them for a clean balance sheet has to go away now.
The net impact of all of this is to reduce my fair value to about $12 a share. That's a steep drop, and I could be too hasty/severe in adjusting the discount rate. Either way, though, I still believe this is a meaningfully undervalued discount retailer with a basically attractive model and good growth prospects. Buying today takes guts, but a lot of the undervaluation will be gone by the time its obvious that merchandising and store traffic have improved.
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.