At Home Is Decimated, But Leaves An Opportunity

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About: At Home Group Inc. (HOME)
by: Josh Arnold
Summary

At Home reported Q1 earnings on Thursday and shares lost more than half of their value.

Gross margins are a concern but I think there is a good explanation for most of it.

And while comparable sales were weak, they were only slightly below zero.

The market has overreacted and I think it is a great opportunity.

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A 57% decline in one day

That. Was. Ugly. At Home Group (HOME) reported Q1 earnings on Thursday and the stock was absolutely obliterated, plunging more than 57% on the day and making a new all-time low in the process. I’ve been a big fan of At Home for the majority of the time it has been public as I like its differentiated concept, its margins, and its growth potential. I see a lot of value in the company as a mature entity – which it is far from being today – and after the woodshed beating it took after Q1 earnings, I have to think there is value to be had.

At Home was trading near strong support prior to the earnings report in the $17 area, where it bounced on two previous occasions recently. However, since the beginning of May, the stock has now fallen from near $25 to $7 as I write this, including a $10 decline in one day, wiping out more than half of the company’s market capitalization in a matter of hours.

Q1 earnings weren't pretty

So, what happened? The Q1 report isn’t great and to be fair, I certainly didn’t expect this sort of carnage. However, I also think that investors with a longer-term view than next week can benefit from the clear mispricing of the stock that has occurred as a result of this bear-market-in-a-day situation we find ourselves in.

Total revenue was up 19.6% in Q1, which counts as a strong result where I grew up. However, At Home missed the mark on comparable sales, seeing its first comparable sales decline in five years. The decline was just 80bps, but the fact that it was negative has clearly spooked investors. One of the things that attracted me to At Home originally was its (now deceased) streak of comparable sales increases, but as of Q1, that momentum appears to have ended abruptly.

Management blamed the weather, mostly, for the miss, which I tend to find as a bit of an excuse, rather than a reason. Indeed, I’ve lambasted management teams on this platform before for using the weather to explain away their own shortcomings, and I won’t attempt to defend At Home now. The first quarter comparable sales number was a miss, and that is all there is to it.

The company’s gross margins took an enormous hit in Q1 as well, which I’m far more concerned by than the streak of comparable sales gains ending. Gross margins fell 450bps in Q1 from 33.3% of revenue to 28.8%. This is a horrendous result, however, investors would do well to understand what drove the decrease, because I think this is where Mr. Market has messed up.

First, At Home, like any other retailer, is now subject to a new lease accounting standard – ASC 842 – that essentially increases the occupancy costs that At Home must report for the same exact real estate it used in prior years. This is not a change in the company’s business, but a bean-counting exercise that is performed in a different way than it used to. For what it is worth, At Home reckons ASC 842 would have been responsible for 90bps of gross margin deterioration last fiscal year, so we can assume the year-over-year impact for this year is around that value. In addition, At Home completed a sale-leaseback transaction that saw it offload five properties for $74.7 million, which it then leased for $5 million in annual rent. This caused further deterioration in margins from higher occupancy costs, adding to the ASC 842 pain.

Next, the company is building out its supply chain capabilities so that it can support its eventual goal of 600 stores, which is about three times higher than the current share count. That takes distribution centers and understanding the best ways to move product around to various stores, and At Home is taking a beating from this expansion in fiscal 2020. Indeed, the company’s new distribution center is guided for a further 90bps to 100bps deterioration in gross margin this year. Growing retailers eventually optimize their supply chains and boost margins in the process, and At Home is at the beginning stages of that transformation.

Third, At Home went highly promotional in Q1 to combat weak comparable sales. Management commented that the industry was very slow in Q1 so it follows that At Home may struggle with comparable sales. That is, of course, what happened, but the company’s reaction with heavy promotions may have proven a bit too hasty. Still, if we consider that roughly 1% of gross margin deterioration is likely from ASC 842 and another ~1% is from the distribution center build out, actual merchandise gross margin likely fell meaningfully less than 2% in Q1 when higher occupancy costs are factored in.

The point of all of this is to say that while At Home produced a horrendous gross margin number in Q1, much of it is explainable by non-operating or temporary factors. In addition, weak merchandise margins are apparently transitory as management said it will be working through its inventory in Q2 and Q3 for a fresh start in Q4. Yes, that implies weak gross margins in Q2/Q3, but it also means that there is light at the end of the proverbial tunnel, and that sunnier days are ahead. Indeed, I expect that next year’s gross margins will be more normalized, and operating margins will reflate commensurately. As bad as Q1 was from a margin perspective, management’s comments make me think the pain is temporary.

In addition, many of the products At Home imports are now subject to a 25% tariff the Trump Administration has levied on certain goods from China. Management stated that certain pricing increases were effective when tariffs were 10%, but that it cannot raise prices enough to maintain margins at 25% tariffs and retain market share. Obviously, this is very damaging to the company’s margins, but keep in mind that trade wars like the current one tend to resolve themselves eventually. How long that will take is anyone’s guess, but there is no reason to think it is permanent. A word from Washington could immediately improve At Home’s margins materially, while additional downside seems unlikely given the already-high level of tariffs.

The outlook is intact

At Home guided for 32 net new stores this year and $1.38 billion in total sales, representing high-teens increases on both metrics. Comparable sales are expected to be between -1% and +1%, so just about all of the company’s top line expansion will be from new stores.

Gross margins are forecast at ~29.3%, which would be a ~300bps decline from the recast fiscal 2019 number, including ASC 842 impacts. That means the weak merchandise margins, tariffs, occupancy, and distribution center costs still add up to 300bps or so in margin deterioration, but as I said, some or all of these headwinds should eventually resolve themselves in the coming quarters.

EPS is now guided to $0.67 to $0.74, which is a long way down from analyst consensus prior to the earnings report of about a dollar. Indeed, adjusted net income was about $77 million last year, and should be around $46 million this year.

The valuation is your friend

At 67 cents of EPS this year, the stock is trading for 11.2 times earnings, which is the lowest valuation it has traded for – by a wide margin – in its short life as a public company. That would come as no surprise to anyone that has a brief look at the share price chart, as the company’s value was more than halved in one day. However, I think the beating the stock has taken has opened the opportunity for investors to own a rapidly-growing retailer for peanuts.

At Home is still going to triple its store base to 600 stores in the coming years. At its current pace of store openings, that should only take a decade or so. In the shorter-term, we should continue to see high-teens or better sales growth, which management has reiterated for this fiscal year after Q1. That sort of sales growth is very difficult to come by in retail but At Home has a plan to make that happen, and it is working.

Margins are also taking every single hit one could possibly think of this year, which is artificially depressing the company’s profitability. I’m not sugar-coating a weak performance in Q1, but the reality is that lease accounting standards, tariffs, higher occupancy from sale-leasebacks, and heavy supply chain buildouts don’t happen every quarter. These things will moderate over time so even if At Home cannot figure out a way to fix its assortment – history would suggest it will find a fix – margins will reflate, likely into next fiscal year.

In other words, At Home’s ugly Q1 and even worse guidance justified a sizable selloff, but nowhere near half of the company’s value. Investors are bailing when things look the worst, but with some patience, I think there is tremendous upside from today’s price.

Sales will likely crest $1.6 billion next fiscal year and with an operating margin of just 8% - which is well below the recast value from last year of 9.5% - At Home would see $130 million in operating income. Removing $35 million for interest expense takes us to $95 million pre-tax. Applying a 23% tax rate leaves about $73 million in net income. With the share count around 66 million today, it doesn’t seem like much of a stretch to expect $1.10 in EPS next year.

Even if I’m wrong, a slight rebound in earnings should see 90 cents or more in EPS on the higher sales value into next year, which I see as overly bearish. Assuming only 90 cents of earnings, At Home’s forward P/E is 8x for a company that is growing sales nearly 20% a year with a long runway for growth.

Q1 was nasty and I won’t try to downplay it. However, the long-term outlook is intact for At Home, and selling into the $7 area is the wrong way to go. If we get close to a dollar in earnings-per-share next year, At Home will trade back in the mid-teens, which is double the current share price.

Disclosure: I am/we are long HOME. 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.