Ascena Retail: Investment Thesis Intact Despite Recent Sell-Off

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About: Ascena Retail Group, Inc. (ASNA)
by: Faizan Muhammad
Summary

Interest payments not anywhere near being a burden given the company's real economic earnings. Investors aren't focusing on cash flows.

Non-cash charges have been the main drag on GAAP profitability, not just cash expenses. These non-cash charges are decreasing each year, pointing towards profitability over the next couple of years.

Positive FCF along with a $600m credit revolver gives the company a long runway to complete its turnaround.

The company's adaptation to the omnichannel model is a very good sign. Omnichannel has been successful for specialty retailers.

Currently trading at around 1 times my projected 2022 earnings, I still believe there's huge upside in ASNA.

As a value investor, apart from looking at relatively undervalued high-quality companies, I also tend to look for opportunities in the most hated sectors in the market. Unlike cigar-butt opportunities, I look for an important difference of opinion with what the market is thinking so that I have an edge on investors on the other side of the trade. As much as I believe in cheap stocks outperforming exuberant ones in the long run, I still firmly believe that trying to have an edge on the counterparty by using the mere fact that a stock is cheap is foolish. Sometimes stocks are cheap for the right reasons. But more often, negativity is magnified once a stock hits 52-week lows, leading to huge valuation disconnects for the wrong reasons.

Ascena Retail Group (NASDAQ:ASNA) has been one of those companies where I've had a highly contrarian view over the past year. I was lucky enough to present my stock pitch on Ascena at the Young Investors Society's Global Stock Pitch Competition in May 2018. The main thesis was that investors had magnified the negatives and discounted them unfairly into the stock price as I referred to events such as the 2017 write-offs that cut the stock in half in one day. A swift path to profitability and huge earnings potential on more than $6.5bln in annual revenues relative to its $300m market cap enticed me to pitch a buy recommendation on the company. Since then, the stock has been nothing short of a roller-coaster ride, rallying more than 150% to $5/share before crashing back to around $2/share on Wednesday.

ASNA stock

Source: Bloomberg Terminal

These huge price swings come amid fairly positive developments in the business such as two consecutive quarters of GAAP profitability along with positive year-over-year comparable sales. Here's an excerpt from the company presentation for Q1 FY 2019:

Source: Company Presentation

While the Value Fashion and Plus Fashion brands continue to struggle growing revenues, the remarkable growth in Kids Fashion and Premium Fashion segments more than make up for the laggards, helping the company attain low- to mid-single-digit year-over-year growth. The robust growth at Kids Fashion comes from the huge success of the Justice brands. I expect Justice to continue with the wonderful growth, as it continues its journey on becoming a household brand name for Kids Fashion.

However, when I'm paying 4% of sales for the whole company on the stock market, I don't have to care at all about revenue growth. The crux of the thesis here is profitability. Ever since Ascena bought Ann Inc. in a debt-fueled overpriced deal, the company has been struggling with GAAP profitability. Write-offs, depreciation, amortization and restructuring expenses along with high interest payments contribute to this phenomenon. It's important to note here that most of the expenses that have been a drag on Ascena's profits are non-cash. A peek into the cash flow statements shows that the company still generates cash from its operations and is positive free cash flow.

The main bear thesis on Ascena recently has been focused on the mountain of debt and interest payments. According to recent articles, the company doesn't have earnings to support these interest payments, which could lead to a situation where the company has to use its credit revolver to pay interest on its debt - raising money from one group of investors to pay off the income requirements of others. This argument is not accurate at all, as when adjusted for non-cash expenses like depreciation and amortization, it can be clearly seen that the interest payments are a small portion of the expenses, and the company has more than enough cash to continue paying these interest payments.

Also, as the CFO puts it in an analyst call, trailing twelve-month EBITDA is around 4.5 times the interest obligation. Given all the non-cash expenses in EBITDA other than interest, there is lots of flexibility in paying off debt. The company is nowhere near insolvency. The excerpt below from Q2 FY 2019 presentation and the CFO's comments in Q1 FY 2019 earnings call both show that debt coverage isn't an issue. Another thing to note in this excerpt is that the company ended the latest quarter with $215 million in cash. With a market capitalization of about $270 million, Ascena is trading at its cash value. Most companies that trade at cash value are on the edge of bankruptcy. This shows how the market has been magnifying the negatives.

Source: Company Presentation Q2 2019

Regarding our capital structure, net debt is 2.7 times trailing 12-month EBITDA; and trailing 12-month EBITDA is 4.5 times our annual interest obligation. From a capital allocation perspective, we continue to believe debt reduction is the best path to generate shareholder value at this time and expect fiscal 2019 free cash flow of $200 million to $240 million. - Robb Giammatteo, CFO, Q1 FY 2019 Earnings Call

Another consensus among Ascena bears is that the company is closing stores, which is a bad sign. There's a groupthink among people that closing stores is always going to be bad for a retail company. This is not true. The fact that Ascena is closing stores is a positive sign as it's a step towards shifting to an omnichannel business model. Having one great store at a great location is better than having lots of average stores in average locations in a specific area. I believe that shifting towards omnichannel is the key to success for specialty retailers in the future. While it's true that revenues are almost certainly going to take a hit with this strategy (and they have been), the revenue decline rate hasn't been anywhere near alarming rates, and this is an important step to profitability. The company has accelerated store closures with 110 store locations closed in Q2 2019. This is an important step to transforming into an omnichannel model and becoming profitable. While this may hurt sales slightly, it's going to help a lot with profitability, as lower occupancy/rent costs and other store operating costs are cut down.

Source: Company Presentation Q2 2019

One extremely shortsighted argument against ASNA is that it trades at more than 30 times 2019 earnings which makes it very expensive relative to other retail companies. This is an uninformed statement, as it doesn't look into the future earnings potential of the company and tries to distort numbers like P/E ratios in the middle of a turnaround to justify not being long. Using the fact that the company is going to be trading at more than 30 times earnings next year to justify overvaluation is the silliest measure of valuation for a company like Ascena. This analogy stems from a clear misunderstanding of the bull and ignores the huge earnings potential. The company is trading at less than 2 times 2015 peak earnings today with revenues down only a few percentage points since the peak. The problem here has been profitability. The fact that Ascena is inching towards profitability each year and given the huge spread between peak earnings and today's earnings, this P/E number is set to shrink.

Mr. Market seems to be extremely depressed on ASNA as the market tries to use every piece of information as a negative for the company. Recent bear arguments on SA show that even though it's been three years since the ANN acquisition, people still like to use the bad acquisition as a reason to why the stock is not worth buying today. I totally agree that the ANN acquisition wasn't a good decision by Ascena's management, but after looking at management's comments on analyst calls, I know that it isn't rewinding the tape to dwell on bad past decisions, but is focused on making the right decisions in the future to stabilize the business by reducing debt and returning to profitability.

Valuation

As non-cash expenses like depreciation and amortization continue to decline each year and the company's cost savings program goes through, I expect Ascena to inch towards GAAP profitability over the next couple of years, eventually hitting earnings that at today's market cap would price the stock at a little over 1 times earnings. Give it a modest P/E ratio of 10, and there's some very good upside.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ASNA over 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.