Investing in Retailers

“Retailing is a tough business.  During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly
nosedive, often all the way into bankruptcy.  This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses.  In part, this is because a retailer must stay smart, day after day.  Your competitor is always copying and then topping whatever you do.  Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants.  In retailing, to coast is to fail.”

— Warren Buffett – 1995 letter

On this post, I will share with you some thoughts about investing in retailers – especially after their stocks take a hit due to some kind of disappointment, be it a gloomy forecast or unsatisfying results.

On May 5th, 2011 Aeropostale (ARO) revised its EPS guidance downwards. The stock took a hit in the form of a double-digit decline. Later, on May 19th the company issued a press release of its results for the first quarter as well as a dim outlook for Q2. The stock took another dive.

During the May “episode” the stock price was around 20$ which implies a market cap of 1.64B$. This price could have seemed cheap considering that the company’s share traded near 35$ just the year before and the company already demonstrated that it could show an EPS that is north of 2$. Considering the sales growth, the strong balance sheet, the high cash balance and the tendency of the management to repurchase stock, I found the stock to be attractive when it traded between 18-20$. I have done all sorts of calculations based on the current retail square footage and average past performance per sqf. I also used average margins and other figures that I derived from a decade of data data.
The company also showed average pre-tax growth rate around 20% for the decade and 15% decrease in the amount of stock outstanding during that time period. At a PE of 10 on earnings power that is based on decade-long averages (deducting cash would have lowered the PE even further); this growth seemed to come for free.

Later, during the summer the same episode recurred. First with the business update and then with the quarter results and next quarter’s EPS guidance.
To make a long story short, when the problems first started, the management claimed that it expects to work out these problems by Q3, but in the summer it became clear that this is not the case. The stock took another nosedive and went below 10$.

At this point, the market value was about 800M$ for a company that not too long ago earned more than 300M$ a year (pre-tax) with fewer stores. However, Warren’s quote above echoed in my mind and I started to think that the company is going on the same path as K-Swiss and Pacific Sun. Both, at certain points in time, seemed very cheap based on historical performance basis only to become cheaper later.

Now, with a 20-20 hindsight I can point out few things that could have been done better:

1) The importance of past data in industries like retail, that are prone to sudden changes, shouldn’t be over-estimated. In such industries it is very important to first ask yourself how indicative the past data is before putting it to use.

2) Averaging the margins/earning-power is not always the right things to do. In ARO’s case I can now tell that if I would have used the WORST gross margins I would have derived a “buy” price in the low teens – Just as Benjamin Graham teaches us in “Security Analysis”. Instead, I was satisfied with using averages and concluded that a price in the high-teens is good enough. Averaging is good in cyclical industries on in cases that return to average can be justified. When it comes to retailers that are plagued with temporary problems nothing less than a stress-test has to be applied in order to arrive at a conservative value. Even that doesn’t ensures profit, but it tilts the chances in your favor, especially if you have good business judgement. A good example of when averaging makes sense is in the case of stocks like STC or default rates on loans of banks.

3) Fixing business problems takes time. Don’t be to quick to believe to a CEO who claims a problem can be fixed within 2-3 quarters. ARO’s problems still persist. In addition, low price fashion retailers are very sensitive to cotton prices. When cotton prices were on the rise, ARO’s gross margins plunged.

Also – and this one is well known but worth repeating – Management’s orientation is very important. ARO is an independent company for about a decade. The management doesn’t own much of the outstanding shares. That completely contrasts the situation in companies like “The Buckle” (BKE), where the company exists for over 60 years and enjoys shareholder friendly management that has high stakes in the business.

Although the stock price recovered, I believe that the problems are far from over. The company slashed it’s selling price in order to get rid of the excess inventory. Low prices persisted for several quarters and I’m afraid that it may not be easy to get consumers pay higher prices again. It is very easy to lower your price but the other way usually doesn’t come without pain.

Luckily, I could exit this position without bearing a loss. I hope it will serve other investors before investing with retailers. What are your experiences with investing in retailers?