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Aeropostale Inc. (ARO)

|Includes: Aeropostale, Inc. (ARO)

 In a previous article, I explained Joel Greenblatt’s Magic Formula. A screen I performed showed the clothing retailer Aeropostale in the results, so I thought I would test out Greenblatt’s Magic Formula to see how compelling this opportunity is.

Aeropostale has an Earnings Yield of  19.86% (= 411 TTM EBIT /2070 Current EV) and a ROC of 73% (= 411 TTM EBIT / 562  average of Net Fixed Assets + Working Capital over TTM). The first problem that arises is that, while it is appropriate to look at Earnings Yield at a single point in time (since this is measuring how “cheap” the company is presently), ROC is an inappropriate measure for making a conclusion about the quality of management – it would be more useful to look at how consistent management is in generating returns on capital by looking over a full business cycle. So, here is Aeropostale’s ROC for each of the last five years (through the depth of the recession):

  FY2009 FY2008 FY2007 FY2006 FY2005
EBIT 383 249 209 175 139
EV 1712


1756 1580 1496
Capital 540 467 301 410 373
Earnings Yield 22.3% 21.0% 11.8% 11.1% 9.9%
Return on Capital 70.9% 53.2% 69.4% 42.7% 37.3%

These numbers look good, but they are missing a key element. Aeropostale is a retailer that leases its locations using off balance sheet operating leases. In order to get an accurate picture of Aeropostale, we capitalize these operating leases (and associated CAM and Property Taxes, as disclosed in the company’s 10-k’s), which means we record an asset and a corresponding liability (equal to the present value of the operating lease obligations) for the leases (which affects both capital and enterprise value), then we add back the interest portion of the lease payments already eliminated in EBIT (the remainder of the lease payment represents amortization of the principal, which we do want to remove from EBIT). How does including the operating leases affect the earnings yield and return on capital? Let’s see:

  FY2009 FY2008 FY2007 FY2006 FY2005
EBIT 431 292 248 208 167
EV 2682 2049 2554 2246 1967
Capital 1508 1332 1091 1076 932
Earnings Yield 16.1% 14.3% 9.7% 9.3% 8.5%
Return on Capital 28.6% 21.9% 22.8% 19.3% 17.9%

Clearly this has a big effect on the perceived attractiveness of Aeropostale. Additionally, we see the company’s leverage ratios increase profitability ratios decrease (in early years, though higher in later years).

Lesson: the Magic Formula may be a good place to start screening for investment opportunities, but you have to investigate each opportunity further.

Author Disclosure: At the time of publication, the author DOES NOT have a position in securities of this company.

Read more: Aeropostale Inc. | Frankly Speaking 
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Disclosure: No Position