Let’s start by examining Aeropostale’s earnings power value – the value of its earnings assuming no profitable growth is possible.
EPV = (Net income) * (1/WACC)
Net income (TTM) = $248M
WACC (all equity) = 9.52% (going by Damodaran’s industry estimates here, making the assumption that ARO’s cost are roughly average)
EPV = 248 * (1/.0952) = $2605 billion
Now, ARO’s market cap at the moment is $2.21B, meaning that with zero future growth ARO is undervalued by about 18%.
Zero growth is a wildly conservative estimate though. In recent years the company has seen continuous rapid growth [numbers to follow from Morningstar]. Aeropostale experienced yearly revenue growth of over 18% in both 2008 and 2009 in spite of extremely adverse economic conditions (and actually it has been averaging about 18% for the past five years). EPS growth has been in the 30% range since 2007, with the company posting an EPS increase of 54% for the 2009 fiscal year. Some of that comes from significant stock buybacks, but net income growth has outpaced revenue growth as well (five year average of 22%).
Aeropostale’s growth has been fueled by both new stores and increasing same-store sales. The company’s pace in opening new stores is beginning to taper off, which suggests that the company’s rapid growth will not be permanently sustainable at such a high level. Luckily, the current valuation doesn’t even factor in the retailer’s present value, much less the value of any future growth.
The company’s substantial increase in earnings during 2009 (a year when it opened fewer new stores) suggests that it could however continue expanding its market share at the expense of less efficient competitors. Even before the recession (in 2007) Aeropostale was increasing its operating margin and net sales/sq. ft. Sustained economic sluggishness might not impair the company’s growth, as it has actually improved upon the aforementioned figures during the recession and – this is getting repetitive! – every year for the last five years.
Some might contend that Aeropostale’s current success is temporary and that customers will return to other pricier/more stylish brands when the economy improves…buuuuut this assertion overlooks two important factors about Aeropostale’s performance in recent years. The first is that the company’s strong earnings and revenue growth preceded the recession by several years. Consumers were clearly embracing the brand even during a period of apparent prosperity, which undercuts the argument that customers shifted their business solely due to economic circumstances. Second, arguing that lower prices alone sufficed to lure customers during the recession ignores the performances of other lower-priced brands. Abercrombie and Fitch’s Hollister brand, for example, saw its sales decline in 2008 and (more sharply: -15%) in 2009. As a result it seems clear that consumers found Aeropostale appealing for reasons other than (or perhaps in addition to) its prices.
Taken together, that blob of text suggests that, despite the best efforts of its competitors, there is some value to the company’s growth. Greenwald‘s growth factor (f) basically compares a ratio of return on capital to cost of capital. If ROC > WACC, then growth adds value. Since Aeropostale’s cost of equity above was 9.52% and its ROE hasn’t dropped below 30% since 2003 (58% last year), that’s a pretty safe bet.
If you’re into that sort of thing, ARO also pops up on Joel Greenblatt’s “magic formula” screen (and, if you can believe everything you read on the interent, was once the subject of a sizeable investment by the man himself).
The only red flag valuation-wise is the above-average P/B (4.4x). Part of that seems to come from substantial stock buybacks, and part from better working capital management. The company appears to keep substantially less inventory on hand than its competitors.
A comparison of efficiency and growth statistics of Aeropostale and two major competitors briefly illustrates its superior management and competitive position:
|Days Inv.||Asset Turnover||5Y Rev. Avg Growth||5Y EPS Avg Growth||5Y Avg. ROE|
The numbers suggest that, given their relatively similar levels of financial leverage, Aeropostale owes its immense – and unlike its competitors, consistently growing – return on equity to its significantly greater efficiency and higher margins. Efficiency (along with consistent and well-managed growth) suggest that high-quality management is in place that will continue to make excellent use of the company’ s retained earnings to build an increasingly strong competitive position.
So, what’s it selling for? Current P/E of 9.73 is 36% below the S&P 500 average of 15.1 and also below competitors like ANF (35.5), American Eagle (19.16), or GPS (11.89).
What’s the catch? The stock has been knocked down recently for missing analyst expectations and suffered a few analyst downgrades. That unnerved me a bit at first, but if it pushes down the price farther it ought to make this a safer investment by widening the gap between its intrinsic and market values. From what I can gather some analysts seem concerned that the company is operating at peak profitability. To some extent, that’s true: operating margins and COGS are at high/low points respectively.
Without seeing the reports it’s hard to say how they address ARO’s improving efficiency or the ability of its smaller-margined competitors to continue to squeeze prices, but the encouraging thing is that even if those concerns are valid and the company merely treads water earnings-wise then it continues to be undervalued and if these concerns push down the price it becomes even more so.
It’s not quite a slam dunk, and there will probably be a lot of short-term volatility concerning quaterly earnings estimates, but ARO looks like a good long-term bet.