Readers of my other articles on retail names like Elizabeth Arden or Vera Bradley will know that in searching for profits in the space, I much prefer to jump on existing trends and ride them (up or down), rather than trying to pick the 'next big thing' in fashion. Aeropostale (NYSE:ARO), the New York-based teen retailer, makes an interesting case study in this regard. As the teen retail market has been upended by the entrance of 'fast fashion' powerhouses like H&M, Zara, Uniqlo and Forever 21, ARO stock crumbled from $15 a share to current levels around $3.2 - all just in the last year! But while some may argue risk/reward now favors a long position, as I will discuss below, I still view ARO as an excellent short, given the intractable structural issues faced by the company.
What went wrong - the quick summary
The advent of fast fashion and its impact on teen retailers like Abercrombie (NYSE:ANF), American Eagle (NYSE:AEO), ARO, as well as other specialty retailers like Express (NYSE:EXPR) and Bebe (NASDAQ:BEBE), is relatively well known, so I won't rehash too much recent history. To summarize briefly: fast fashion players utilize superior factory-to-floor operations management to update their store offerings almost as fast as new styles get designed (say, once every 2-3 weeks), in contrast to 'traditional' retailers who follow seasonal release patterns (once a quarter). The changing consumption habits amongst teens and young adults - more variety, more online purchasing, fewer mall visits - also hastened fast fashion's success, as invariably the older retailers (teen retail in particular) already possessed large in-mall store footprints and (generally speaking) were slower to pursue ecommerce aggressively, unlike the newer, more nimble fast fashion names.
While all the non-fast fashion players have suffered in recent years, ARO has fared particularly poorly, for a couple of reasons:
- ineffective brand positioning/low brand value: even when ARO competed just against Abercrombie and American Eagle, they competed mostly on price, providing an 'Abercrombie-esque' look at a fraction of the price (management would never admit to this, but just look at peak gross margins to tell the true story: ARO's peaked at 38% in 2009, while ANF's were 64% in 2009). So when ANF cut prices to compete with the fast fashion entrants, ARO was forced to a) cut prices more aggressively to maintain share; or b) lose more traffic to perceived higher-quality brands that had become available at similar pricepoints. They did a bit of both...resulting in both cratering margins and lower top-line sales (see below)
- poor management of large existing store footprint: despite the fact that the secular challenges in the space have been well known for at least two years, management was net adding new stores in North America as recently as last fall; only in the last 1-2 quarters has ARO begun the painful work of store closures, and even then moved very slowly. Primarily all store locations are in traffic-starved North American mall locations
- almost negligible ecommerce presence: ARO acquired the ecommerce retailer GoJane.com in late 2012 but has chronically underinvested in their online platform; in the most recent fiscal year, ecommerce constituted just 10% of total sales and in the most recent quarter, online sales were -18% YoY
(source: company filings)
Of course, these three factors interplay: the brand competed on price alone, so it had to keep cutting prices even as competitors did too, in a self-defeating race to the bottom; while less desirable merchandise could not generate much online traffic. Recent quarters have been a recurring mess of declining double-digit comps, impairment charges, belated store closures, and cash burn. The below chart demonstrates how complete the collapse has been. In two fiscal years Adjusted EBITDA margin has fallen from ~19% to -3%; while last year the company burnt $122mm of cash:
(source: company filings)
So, What Happens Now?
With the stock having fallen to $3.2 - implying a market cap of just $251mm - many argue that all the bad news is in the stock. However, I believe there's plenty more downside ahead, even from here. Let me explain why.
1) Store closures: the reverse of a virtuous sales cycle
Let's think about successful retail stories for a moment. When you have a retail chain that is both growing its footprint (building new stores) as well as growing same store sales (SSS), you have something of a 'virtuous cycle' as you get the dual effect from increasing comps as well as a growing base of stores to multiply that comp growth: during this period you see earnings grow rapidly due to supercharged top-line expansion, and often margin expansion (operating leverage from SSS growth) - think of Chipotle (NYSE:CMG), Michael Kors (NYSE:KORS) in recent years, or even ARO in an earlier incarnation (2007-2009). In fact, if SSS growth slows or stops, but the store footprint is still small, it is not necessarily the end of the growth story (though often it is the end of margin expansion). In the restaurant industry, you often see lower, or even near-flat, SSS comps, but still decent top line and EPS growth from new openings alone as the store buildout continues (Panera (NASDAQ:PNRA) is one example that comes to mind, at least until recently).
However, when a brand with a very large existing footprint goes into rapid decline and the company begins to close stores, you get the reverse effect: a negative cycle on the way down, as lower comps and a decreasing footprint drives top line rapidly lower and aggressive margin deleverage.
With this in mind, let's refocus on ARO. The most interesting aspect of the collapse in business in the last two years has been the fact that store count was still increasing up until the most recent two quarters - that is, the collapse in performance was due almost entirely to declining comps. In fact, total store count - 1081 currently - remains not far removed from all time peak count (1124) and at similar levels to end fiscal 2012 (1084 stores) - despite the massive pressures suffered by the business. See below chart:
(source: company filings)
This means that as management - belatedly - begins to shutter stores, the top line will come under additional pressure from the smaller retail footprint, in addition to the existing negative SSS trends. And gross margins are unlikely to improve much, at least in the medium term as a) the breaking of leases incurs significant one-time, cash penalties that the company has to bear; b) store closures often see the liquidation of remaining inventories at highly discounted rates; and c) store closures in prominent mall locations do NOT drive pricing power and/or positive brand equity.
2) ARO's restructuring plan: why it won't work
This brings us to ARO's restructuring plan. At the end of April, ARO announced a broad-based restructuring plan consisting of the following objectives:
- shutting 125 (of 150 total) 'PS from Aeropostale' (the kids sub brand) stores by fiscal year end;
- streamlining of SG&A cost structure (to cost $40-65mm in 2014 fiscal, of which $20-45mm would be cash)
Together, ARO hopes to achieve $30-35mm in 'cost savings' (I assume these will come via lower SG&A expense) in fiscal 2015, with some small contribution this year. They also closed a punitive $150mm 'last in, first out' secured financing with Sycamore, to provide additional liquidity (more on that later).
Firstly though - in the face of the rapidly declining top line, will these cost savings really move the needle? It's important to note at this juncture that ARO has only closed 1 store so far (as of end of 1Q, 2014). From the 1Q 10-Q (my italics):
Based on changing consumer patterns, we plan to close approximately 125 mall-based P.S. from Aéropostale stores by the end of fiscal 2014...By taking these steps, we expect to eliminate pre-tax losses of approximately $15.0 million that were generated in the mall-based business in fiscal 2013, excluding any impairment charges. We anticipate that substantially all of the planned store closures will be completed by the end of fiscal 2014. As of May 3, 2014, one store had been closed...
While the company has taken substantial impairments the last two quarters, the efffect of store deleverage on the top line has hardly been felt.
Putting it all together then: ARO ended 1Q with 1081 total stores, 1005 comparable stores (a comparable store is one open at least 14 months) and is guiding to closing at least 124 PS stores in the next three quarters. Let's say net store closures for the fiscal amounts to 117 (to account for some new outlet + other store openings); that these closures occur at a measured pace over the next three quarters; and that of these closures, only 50 come from the comparable store count. This is a very conservative assumption - it's most likely all of the stores being closed are older, underperforming stores - but even this conservative assumption will demonstrate how powerful the negative leverage on top line can be. In addition, let's assume SSS trends moderate further from 1Q numbers (-13% YoY) and post declines of 'only' -10%, -9%, and -8% for 2Q, 3Q, and 4Q respectively. Here is the formula putting it all together:
Current Period Sales = (Prior Period Sales) x (Current Period Comp Store Count/Prior Period Comp Store Count)x(1+Same Store Sales Growth Rate)
So, for ARO's case, you get a table looking like this:
(source: company filings, my estimates)
The key takeaway: even if we assume SSS trends improve a bit, store deleverage suggests ARO will forego an additional ~$60mm in sales through store closures in 2Q-4Q (while incurring substantial lease break charges, discounting inventory associated with the closing stores, etc). It kind of puts the $30-35mm 'savings' touted by management into perspective...
3) Store closures part 2: how many more stores need to be closed?
Clearly the immediate future looks bleak for ARO, but if we could convince ourselves that SSS comps will stabilize and store closures will slow, you could maybe make a case for the equity. Unfortunately, despite the planned 125 store closures this year, I still think this is just the beginning of the store closure pain, for a few reasons:
- the footprint is still far too large: even after these store closures, by my estimate at fiscal year end ARO will still have 964 stores for a business doing ~$1.6bn in in-store sales (excluding ~$200mm in ecommerce sales), or roughly $1.65mm sales per store). Compare this to ANF or AEO (see below). ARO would need to cut an additional ~450 stores - whilst maintaining the same total sales - to achieve similar store efficiency just to American Eagle (which is not doing all that well). Put another way: sales would have to organically grow to $2.7bn per year - an increase of ~70% - to achieve similar sales efficiency per store as AEO, if no further stores are shut. Whilst this analysis simplifies a little - we should really look at total gross square footage, rather than store count, as store sizes can vary - given the massive disparity between ARO and its competitors (who are also still suffering), it's quite clear ARO remains wickedly overbuilt for its sales profile.
(source: company filings, my estimates)
- there are plenty more 'impaired' stores left to close: looking at all the asset impairments over the past 4-5 years, we can tally how many stores have been impaired since the business started going south. Working from two assumptions - namely, that stores only get impaired once; and that once impaired, it becomes a more likely candidate for closure - we can see that the population of poorly-performing stores is pretty large. ARO has impaired a total of 483 stores since 2009, leaving an additional 358 store population of potential closures, even after the 125 slated for closure this year. Even if only 150-200 of this population is really considered for closure, that is still a very large part of the footprint to remove.
(source: company filings)
- only 'PS from Aeropostale' closing so far: the announced large store closure of 125 stores this year is exclusively the 'PS from Aeropostale' (kids) brand; this leaves management the 'core' Aeropostale branded stores, which have largely been untouched, for aggressive pruning in future years.
Putting it all together: what does the business look like in 2015?
For a base case 2015 forecast, I made the following assumptions:
- SSS growth (yes, growth!) of 7% for the year (some rebound after two awful years)
- additional 150 stores closed (again, much lower than they realistically should close)
- gross margin improvement of 6ppts YoY (to 25%, FY 2012 levels, from 18.9% estimated this year, due to improved sourcing costs from the Sycamore partnership)
- SG&A 27% of sales (implied ~$110mm lower YoY, far in excess of management guidance)
- tax rates of 15% (still loss making at operating level so tax treatment is a bit of a wildcard)
- no additional asset impairments/goodwill costs/cash out restructuring charges (pretty optimistic)
Here is how my model comes out (showing historical years, as well as how I think 2014 ends as well, for comparison) with the above assumptions:
(source: company filings, my estimates)
Let me be clear: I feel these are somewhat aggressive assumptions given the state of the business and I expect fiscal 2015 to look materially worse. Nevertheless, even in this scenario, ARO would still see revenues fall a further 10% (to ~$1.62bn), remain loss-making at the operating and net levels (~-$0.41 per share), while eking out a tiny profit at the EBITDA level. And the company would still burn ~$30-35mm cash during the year, even if capex remains at criminally low levels.
Hence, even in this bullish scenario, the current stock price implies a 2015 EV/EBITDA of ~22x, with negative net income and negative FCF. Still very expensive in my book when ANF, AEO trade at 5-6x, generate net profits and positive FCF, have better brands and no liquidity issues...
So, how should we value ARO?
This highlights the main problem with ARO right now: how do you value the company? It has negative earnings and EBITDA, and will continue to do so for the forseeable future - so throw out P/E or EV/EBITDA, and with it any 'easy' comps to profitable peers in the same sector. It also has negative free cash flow, so FCF metrics get tossed out too. Bulls argue that price/sales, or EV/sales, makes it look incredibly cheap - but that method discounts the prodigious rate at which ARO has been burning through book equity and cash, and has been proven wrong by the market. Personally, I think given the level of distress in the business - even though liquidity should not be too much of an issue for another year - we should value the stock on a multiple of book value, and think about what recovery would look like in a liquidation scenario.
At $3.2, ARO currently trades at 1.2x last reported shareholder's equity ($250mm market cap on $208mm book equity). In the scenario I mentioned above - some moderation in SSS declines over the next three quarters, plus net 117 stores closed this year - I see the company burning through another ~$108mm in shareholder's equity (ie, net losses) over the next three quarters (after losing ~$77mm in 1Q): this is a full 43% of ARO's current market value. That suggests book equity will be around $100mm at fiscal year end (excluding FX, other accounting adjustments to equity, as well as potential equity raises which are a long shot at this stage). This suggests that if the book multiple stays the same - 1.2x - the stock price should naturally devolve to a much lower level, along with the decreasing net asset value: that is, to 1.2x of 2014 end proforma net assets, or $1.5 per share. Even if we assume the book multiple expands - due to a lower base, and perhaps if the business shows some stabilization - even at say 1.8x book, that implies $2.3 a share - still 30% below the current price; and again, it is most likely that the company will continue to burn net assets and cash next year as well.
Liquidation scenario: ARO recovery for stockholders is zero
As mentioned previously, ARO signed a $150mm senior secured facility with Sycamore partners on fairly onerous terms to ensure additional liquidity to fund working capital heading into the holiday season. It is not entirely clear why ARO signed this punitive deal with Sycamore - paying 10% on the first $100mm, along with giving Sycamore first call on all their non bank-pledged assets, therefore significantly subordinating common shareholders - when they claim to have $174mm in available liquidity on their bank credit lines (which should be enough liquidity for their needs, despite their distress, even during the capital intensive 2Q-3Q period). My sense is the banks pushed them to raise additional capital as they may look to rein in their commitment lines if the business doesn't stabilize this fiscal year.
In any case, while ARO most likely still has enough cash for the next 4-6 quarters, given the amount of distress in the business, I don't think it's amiss to look at what recovery could look like if banks and/or Sycamore give up on the company after a few more tough quarters. And unfortunately for common shareholders, it does not look pretty:
(source: company filings, my estimates)
After adjusting the 1Q balance sheet to account for 3 more quarters of burn, and even applying fairly generous recovery assumptions (namely, assuming 70% recovery on inventories for a busted retailer is very high), ARO would likely be left with ~$350mm of recoverable assets against ~$115mm of trade claims (payables), ~$62mm of super senior debt (Sycamore debt), and over $200mm in other claims senior to stockholders (lease liabilities, accrued expenses, etc). And the longer ARO exists (while it is still burning cash and net assets), the more negative this hole becomes (the Sycamore debt burden will simply increase). Hence when/if ARO goes, recovery on the stock will be a goose egg. This analysis helps buttress the short case, with the stock trading at such a low dollar price.
Upside risks
There are really only a couple of risks to the bear case that jump out at me (other than a technical short squeeze, which could really plague any popular or 'consensus' short):
1) Takeover risk: given that Sycamore was likely the only logical acquirer, and since they clearly viewed a full takeover as risking too much capital (hence the more-favorably structured - for them - secured financing), I view takeout risk on a business in this kind of shape as extremely, extremely low.
2) Business rebound risk: clearly more likely is a slowing of negative comps and/or a recovery in the margin profile of the business (given rapid deterioration in recent years). Regarding this, the retail environment, particularly teen retail, remains extremely promotional and difficult, and it seems unlikely that ARO will be able to rebrand enough of their business to move the needle (despite some 'fast fashion' efforts of late). To this point: ARO has been effectively forced to cut core capex to the bone to conserve cash: capex fell from $84mm last fiscal to $23mm estimated this year. This makes it that much more difficult to rebrand/reinvest in the business to attract shoppers, exacerbating the problems with brand image and falling traffic.
And regarding the potential for stabilization of traffic and/or margin expansion: as discussed above, even in fairly optimistic scenarios regarding recovery, the stock is still priced somewhat aggressively. Having said that, there is a risk that if trends show signs of turning around you see a bit of a rally in the stock due to positioning. But given my strong view of the secular trend engulfing the company, clearly this is a risk I am willing to take.
Conclusion
Putting it all together, I can see no real reason why this stock should trade at much of a premium to forward book value; hence I fully expect the stock to trade down over the coming quarters in line with the destruction in book equity over 2Q-4Q, to around 1.2x fiscal year end book of ~$100mm - in other words, to $1.5 per share (45% downside versus current). While it is always difficult to determine if or when a company may disappear, I think there is a solid chance ARO doesn't survive the next 18-24 months. But even if it does, I envisage a scenario akin to American Apparel (APP): where the stock continues to drift lower and lower as - unable to combat the secular threats to its business - the company continues to burn book equity and cash, with senior secured debt effectively replacing equity in the capital structure, disenfranchising stockholders and leaving nothing left when the company ultimately shuts up shop.
Disclosure: The author is short ARO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
