Aeropostale's (NYSE:ARO) fourth-quarter earnings report on Thursday afternoon really couldn't have been any worse. Recent optimism - shares actually doubled in the three weeks leading into the report - was wiped out by the results (notably another steep comp decline), and a dispute with a sourcing partner (an affiliate of ARO's lender) might accelerate already-serious liquidity concerns.
Truthfully, there's an argument that ARO's decline on Friday should have been steeper: shares, after all, trade in line with February levels while the news, and the cash balance, are substantially worse. A sale makes little sense at this point, with bankruptcy looming if the company continues on its current path, and its assets thus likely to be available at a cheaper price (and its leases broken) in the not-too-distant future. And though CEO Julian Geiger again spoke optimistically on the Q4 conference call, investors have heard that before, and the reversal required is so dramatic - and needs to be so fast - that chances of success seem slim, indeed. Overall, from an equity standpoint, there simply doesn't appear a viable path to any return.
Option #1: Aeropostale turns profitable before its cash runs out
Aeropostale closed Q4 with $65 million in cash and no borrowings on its credit facility, which seems to imply Aeropostale has a reasonable amount of liquidity left. But as I've argued for nearly a year now, the situation is more dire than it appears at first glance.
Most notably, the term loan agreement with Sycamore has a minimum liquidity covenant of $70 million, and the current dispute with Sycamore (as well as the departure of two Sycamore executives from Aeropostale's board) likely means a breach will be considered non-negotiable and put Aeropostale at Sycamore's mercy.
In addition, the availability under the credit facility is primarily based on inventory, and that presents two problems. First, it negates the short-term benefit of store closures; what inventory is converted into cash doesn't help overall availability. The same goes for any positive news relative to ARO's inventory management - which Geiger highlighted on the Q4 call. Secondly, it only strengths Sycamore's position in the sourcing debate; Aeropostale guided for potentially $5-$8 million in incremental operating losses if the dispute isn't resolved, and for inventory to be down as much as 10% by quarter's end, or about $12 million. The combination implies as much as a $20 million reduction in total availability relative to the current $196 million (including $130 million in revolver availability and exclusive of the $70 million liquidity covenant).
To be fair, this is a bit of a temporary issue, and as inventory is rebuilt ahead of Q4 FY16 (ending January 2017), availability will rise toward (although likely not to) the $215 million limit. But it shows the power that Sycamore has over Aeropostale, and it puts Sycamore in a position, should ARO near the liquidity covenant, to push the company over the edge, declare default, and take possession as the sole secured creditor.
Meanwhile, Aeropostale's cash burn remains high. The year-end figure of $65 million is over $85 million lower than the figure at the end of FY14. The midpoint of Q1 guidance implies an operating loss of $26.5 million; capex is guided at $14 million for the year, and D&A at $8 million for the quarter. With $1.4 million in income tax expense, and likely $2.5 million in cash interest expense, normalized cash burn should be about $26 million in Q1 (the gap between capex and D&A mostly offset by tax and interest). And Q2, seasonally, shouldn't be much better. That could leave Aeropostale with as little as a $75 million cushion heading into Q3, even assuming it hits guidance. From there, it doesn't take much of a stumble before Aeropostale nears that $70 million covenant, which almost certainly would wipe out the equity.
Improvement is needed almost immediately, but it hasn't come yet. Geiger had cited 2015's back-to-school season as the time when new strategies would be judged; back-to-back disappointments in Q3 and Q4 don't reflect much in the way of success. -6.7% comps in Q4 after a 10% decline in Q3 are troubling on their own, and particularly so given how weak the longer-term stack has been:ARO Q3/Q4 Comps, FY10-FY15
|Fiscal Year||Q3 Comp||Q4 Comp|
Geiger offered an optimistic take on Q1, guiding for flat to positive comps, and said that "the initial reaction to T's, polos, shorts, and short-sleeve knits during the last month has been excellent... We believe that this initial reaction could be an important sign that we are succeeding in regaining customers we lost in the past."
But we've been here before: Aeropostale badly missed comp guidance in Q3 and Q4, with Geiger optimistic on back to school only to see a deceleration later in the quarter. On the Q4 call, Geiger said a move toward rebranding certain stores as "Factory Stores" and focusing on lower-priced, more basic merchandise had driven double-digit comps since the rollout at the end of February.
Of course, that's a three-week period or so, and truthfully the logic here seems somewhat questionable. Geiger said the move would "return to our roots," adding that the assortment in the ~60% of revamped stores would have a higher share of basic and logo merchandise. But Aeropostale doesn't seem to need to return to its roots; its legacy business model doesn't work anymore. Logo merchandise is near dead; both American Eagle Outfitters (NYSE:AEO) and Abercrombie & Fitch (NYSE:ANF) are phasing out those products, and I'm skeptical that demand by Aeropostale customers somehow is immune to that trend. The fear surrounding Geiger's return was that he would see the company and the market as it was in the 2000s (during his first stint as CEO), a very different time in the teen and mall retailing spaces; this move seems to validate those concerns somewhat.
It may be that the move is the right one, but at the same time, the EPS guidance given with those comps shows just how far Aeropostale has to go. This isn't a situation where stabilization of the business is enough; the company needs a dramatic reversal in a difficult space, where even a leader like AEO is seeing flattish comps on a multi-year basis. If comps go up a couple hundred basis points, it potentially gives Aeropostale a bit more time. But in that scenario, the liquidity crisis simply gets pushed out a couple of quarters - it doesn't get solved.
Option #2: Aeropostale is sold
Aeropostale said in its Q4 release that it had retained Stifel, and other firms, to consider "strategic and financial alternatives," including a possible sale of the company. Such a sale appears highly unlikely. There seems little logic in buying the company now, which requires paying Sycamore its owed $143 million in full. A sale at $0.50 per share would imply about $40 million for the equity and the assumption of ~$100 million in net debt (by the time the deal closed), for a total cost of $140 million. Tilly's (NYSE:TLYS), another teen retailer that is profitable (though its earnings are declining), has an enterprise value of about $110 million. Should a private equity firm want to enter the space, paying a 30% premium for TLYS at a net cost of ~$170 million seems far preferable to paying $140 million-plus for Aeropostale only to fund losses for the foreseeable future.
The argument might be that Aeropostale offers more upside: ARO, after all, had a multi-billion dollar market cap just three years ago. But the other issue is operating leases. Aeropostale itself is accelerating its store closures, but that would be far easier in a bankruptcy situation, where leases could be broken. Per the Q3 10-Q (the 10-K hasn't been filed), Aeropostale still has over $600 million in operating lease commitments, which limits portfolio flexibility and adds significant risk to even a minimal price for the equity. Sycamore itself - long considered a likely buyer in the event Aeropostale's turnaround stumbled - doesn't seem interested at this point and given those leases is hugely incentivized to take possession in a restructuring.
After all, the bull case for ARO largely rests on high-margin international licensing revenue and a smaller footprint; a restructuring makes that case much more viable, with sharply lower lease termination costs and a larger share of revenue coming from the profitable international business. The problem with using that bull case to support the equity is that the existence of the equity gets in the way of that very same bull case.
Option #3: Aeropostale goes through a restructuring
Any restructuring obviously would lead to the equity being wiped out, with the possible exception of a debt-for-equity swap. But that swap, even if it boosted Aeropostale's near-term survival, doesn't seem particularly attractive even at Friday's close of $0.26. A current market cap of about $21 million against $143 million in debt implies substantial dilution; Sycamore's negotiating position likely means it would ask for a substantial majority of the company in such a deal. Is an effective price of $1.50 or $2 per share at the current share count really attractive for an unprofitable company that likely will exhaust its $65 million cash balance no later than Q2 FY17? The revolver expires in CY2019, so liquidity questions still wouldn't be resolved solely by the equity issuance.
And, of course, Sycamore's recent actions seem to imply that it's not interested in making a deal. The firm appears to be either backing away from Aeropostale or pushing it in the direction of bankruptcy, at which point Sycamore can simply take ownership, thanks to the secured term loans. Such a swap seems doubtful to occur - and even if it did, Sycamore's current negotiating position implies a punitive outcome for any equity holders.
How This Ends
I still believe the most likely outcome for Aeropostale is bankruptcy; but that, in and of itself, doesn't necessarily imply the stock currently should trade at zero. Even a 10% chance of survival and an assumed $3 or $4 per share price in that outcome justify the current price.
Truthfully, I'm not sure ARO's chances are that good - nor, necessarily, that the best-case scenario implies that type of price appreciation. A $4 stock price implies a $320 million market cap in a space where TLYS has an enterprise value of barely $100 million and multiple retailers have single-digit handles and sub-$300 million valuations.
Beyond theoretical valuation, there's the very practical problem of Sycamore and its power over the company at the moment. If Sycamore decides to play 'hardball' - as appears to be the case - Aeropostale doesn't really have any tools with which to respond. It simply doesn't have the resources to handle a protracted standoff, which Sycamore knows well and which will inform negotiating positions on both sides. Aeropostale's only chance is a reversal in the core business - and one of the most dramatic reversals in recent history at that. It doesn't seem a wise bet to take at almost any price.
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