I had been bearish Aeropostale (NYSE:ARO), the eponymous teen retailer, for the better part of this year, published a piece on it back in July - and then watched over the past 6 months or so as the stock bounced around in a $3-4 range even as financial performance deteriorated. In a sense, I am not entirely shocked by the stock's immolation yesterday (-25% to $2.45); on the other hand, the most-recently reported 3Q was poor, to be sure, but not really meaningfully different to the 2Q report (although the tone on the conference call was considerably more downbeat). Rather, it appears that the market - after a period of leeway - has woken up to the fact that ARO's structural challenges really are pretty intractable and that EV/Sales is a meaningless metric to try to value the company. I won't rehash the whole thesis here (please read the original, as not much has really changed) nor will I look too much at the recently reported financials. I'll just touch on a few points of interest and outline why I think this value destruction train keeps chugging a long way further into the abyss.
1. Brand vision
One of the main reasons I was originally so excited by the ARO short case was that I was never really convinced they had a strong vision for their own brand - it was never clear to me (nor, I believe, the consumer) what 'Aeropostale' meant. Frankly, I believe ARO's golden years were built on basically providing a cut-price Abercrombie-esque alternative, when basics/core/logo was fashionable and before kids stopped going to the mall. Take away mall traffic, add fast fashion and drop American Eagle (NYSE:AEO), Abercrombie (NYSE:ANF) et al's price points, and this brand vacuum has been mercilessly exposed.
This point was made abundantly clear on the most recent conference call, with the CEO delivering an extended, meandering monologue, which seemed pretty confused to me (my emphasis):
If I've learned anything over the course of the last 45-years in retailing, it is that change is inevitable and at many times desirable. I've also learned that the history of retailing is one indelibly linked to patterns of overreaction. While uniquely successful, the Aéropostale we knew between 2002 and 2010 had to change with the times....In no way do I think that we should be the fashion following logo-driven brand that characterized us for many years, not for a second. I do believe, however, that in our zeal to be thought of as being current, we've been overly influenced by the lure of fast fashion. Aéropostale's profitability is billed on a recipe calling for varying amounts of predictability and spontaneity. We sell real clothes to real teenagers....I still believe that while they strive for individuality in many ways, at 14 to 17 years old, they still want to be accepted by their friends and peers and that there is still a uniform that they wear that makes them cool....I think that our mandate is to be that store that best juggles this dichotomy. In the past, we always described our assortment as a blend of core, fashion and veneer, a term we coined to describe rich fashion bought in very limited quantities. Regrettably, the term core has developed an extremely negative connotation...When we talk about merchandize described as fashion or veneer, I think that we have become over assorted. We need to choose what we want to stand for, believe in it, make sure all works together and buy it in a manner that enable us to stay in stock in it the time it is intended to be on our floor...
Apologies for the lengthy quote, but it is important to understand how convoluted this message sounds. 'Varying levels of spontaneity and predictability'; 'our mandate is to be that store that best juggles this dichotomy'; 'we need to choose what we want to stand for, believe in it' - these do not sound like the tenets of a focused, well-conceived brand identity; rather, it sounds scarily as if the captain of the ship is lost at sea. Putting aside the horrid financials, it is the lack of brand vision at the company that is most worrying.
2. Capex intensity
This is a fairly simple point, but dovetails with the notion that ARO is stuck in a vicious cycle of under-investment, declining traffic, and lower brand awareness. Due to the inordinate cash burn at the company, ARO's capex has fallen from $84mm in FY13, to $23mm in FY14E, and was guided to just $16mm in FY15E - a puny ~0.9% of sales (and well below depreciation this fiscal year of ~$52mm). While clearly, with net store adds profoundly negative, we should not expect massive new capex, nevertheless, other teen retail chains also in store-rationalization mode (Abercrombie, American Eagle, Express) exhibit much higher capex intensity - suggesting maintenance capex to refurbish stores and maintain consumer interest (by appearing fresh, changing the store look and feel, etc) simply cannot be funded. I have included a couple of fast-fashion names in high-growth mode as well for comparison (by the way, Uniqlo capex intensity looks a bit low too at the margin):
(source: my estimates for FY15E)
While massively cutting capex is understandable given ARO's gargantuan cash drain, it is merely a short-term stopgap to a long-term issue and will only further serve to weaken the brand appeal as ARO stores (the ones that stay open, at least) fall further and further behind the competition.
3. More store closures = more short-term pain for (questionable?) long-term gain
ARO made some interesting announcements on their conference call regarding their future store plans. I had previously argued that ARO was perhaps 300-400 stores overbuilt given its sales profile and likely prospects; as such, the announced 125 store closure of the PS from Aeropostale stores was not enough. Management confirmed as much on the call (again, my emphasis):
With respect to our real estate portfolio, we've made significant progress with our real estate consultants and we expect to close approximately 75 Aéropostale stores in the fourth quarter, bringing our total 2014 Aéropostale U.S. and Canada closures to approximately 120 stores, which is well ahead of our guidance of 40 to 50 closures this year.
Added to the 48 Aéropostale store closures completed in 2013, we will have completed the vast majority of our estimated 175 store closure program by year-end. In 2015, we are considering potentially closing approximately 50 to 75 additional doors which would bring our total closures to a range of approximately 220 to 240 Aéropostale stores. In addition, as we discussed previously, we will also close approximately 126 predominantly mall-based P.S. from Aéropostale stores by the end of January 2015 including approximately 116 stores in Q4 as we restructure that business.
So, ARO will close another 75 Aero stores in 4Q, as well as the previously announced - and largely provisioned for - 116 PS from Aero stores. Then, next year, another 50-75 stores will be closed.
While this is potentially money-saving in a year's time or so, here's the catch: the company spent ~$55mm (including ~$30mm cash) in restructuring/severance/impairments/lease break charges to close just the PS from Aero stores this fiscal year; now we need to budget for another 75 stores this 4Q as well as up to 75 more next 4Q. Even if these stores have already been largely written down - and therefore cheaper to write off now - I can't imagine this will cost less than another ~$30-40mm minimum cumulatively. It could easily cost more than the $55mm spent to close the PS stores. And even if just half of the lower figure is cash cost, that is significant for the company...
While I don't model the impact of restructuring costs in 4Q and FY15 (to keep it cleaner), it is worth keeping this in mind as an added negative weighing on book value and especially cash balances and provides a further complication to ARO's liquidity position.
4. Book value destruction + equity valuation
One thing that originally attracted me to the short case in ARO was that the pace of book equity destruction was so massive relative to the overall size of the enterprise (clearly, restructuring charges as discussed above played a large role in this). In FY13, ARO destroyed $130mm of book equity (on a starting-year book value of $410mm), or 32%. This year (incorporating my 4Q estimates), the company should burn ~$212mm in book (vs. $281mm starting book equity), or an astounding 75% shareholder value destruction in one fiscal year. The fact that almost zero of this was intangible writeoffs and was therefore mostly either cash out the door or fixed asset impairment was, to me, profoundly disturbing. With the stock still trading at a large premium to a book value that was in precipitous freefall, it seemed highly likely that the stock would follow book value lower (clearly there are other factors at work, but when shareholder equity is -50-75% in a year, stocks don't tend to go up).
(source: company filings, my estimates)
Looking at the most recent quarter, ARO lost ~$52mm (including 'one-timers'), and book value therefore shrank almost inline from $153mm to $104mm. Going forward, I estimate ARO will lose ~$1.09/share, or ~$86mm (ex adjustments - model discussed later), and will therefore go negative book equity (likely sometime in 1Q-2Q15). While I realize book value is something of an accounting artifact and we should really focus on cash + available liquidity, thankfully, ARO has burned and will continue to burn tons of cash too ($122mm in FY13, ~$96mm in FY14E, ~$72mm in FY15E).
Thanks to Sycamore's $150mm debt financing and a large (but likely to shrink) untapped revolver, liquidity will likely not be an issue for at least the next 3-4 quarters. However, I continue to believe book value is the right metric to value ARO because:
- post-tax earnings as well as adjusted EBITDA will remain profoundly negative for the foreseeable future
- operating earnings will also remain negative for the foreseeable future
- ARO has shown no ability to recover gross margins (even on an adjusted basis), making EV/Sales metrics irrelevant
- other structurally impaired, cash+book equity burning companies (some in retail, such as hhgregg (NYSE:HGG)), trade at a discount to book
In my previous article, I thought year-end book value would be ~$100mm and a 1.2x multiple would be appropriate, or even generous. Clearly, book value will end the year closer to ~$70mm, which - with the stock at $2.45 - implies current year-end proforma price/book of 2.8x - the highest price/book since 1Q-2Q13 (when the stock was in the $10-12 range). Frankly, I still feel 1x book value would be generous given the pace of asset destruction, but even 1.5x pro-forma book suggests a $1.3 price target (47% downside from here).
I have updated my model to include the latest results and recast my assumptions as follows:
- 115 comp stores shut in 4Q, and 50 comp store closures in FY15; comp sales only -6% in 4Q (vs. -11% in 3Q) and +7% in FY15
- gross margins improve ~350bps (from adjusted levels) in FY15, to 23% (store closures should help eventually)
- SG&A savings of ~$50mm YoY (higher than ~$35mm management estimate)
- $12mm interest in FY15 (increase in leverage), some tax benefit from negative operating earnings
- no adjustment for restructuring costs (i.e., just looking at operating business)
(source: company filings, my estimates)
Even with these relatively generous assumptions (especially on the comp sales recovery and margin improvements), ARO still loses $86mm (and burns ~$71mm cash), and ends the year negative shareholders' equity (pre any further restructuring charges).
Hence, with no end in sight to the bleeding, the brand message just as confused, the structural headwinds as strong as ever and, in fact, any kind of recovery appearing less and less visible, I am just as confident in my ARO short now as I was six months ago, and am maintaining my position despite the fall we saw yesterday. SHORT ARO.
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.