Aeropostale (ARO) Might Offer Turnaround Value

Posted on Posted in Case Studies

Sometimes in life you’re timing is great. Other times, it can be uncannily poor. But such is life, and such is investing. It keeps things very interesting and fun. Over the past week, I’ve been leisurely reading about teen retailers in general (AEO, ARO, ANF, and others) as the market has done a number on their stock prices over the past few months.

I’ve focused in on Aeropostale (ARO), simply because it has been hit the hardest and I wanted to try and see if there might be some value there.

As I mentioned, my reading in this space has been leisurely because for one, I had other ideas that I’ve been working on that I like better, and two, I didn’t think I had a hard deadline. I had a post that I put together that is over a week old now… it’s basically just some summary notes on the valuation and the business.

This morning, after finishing reading the last two 10-Q’s and reading the most recent 10-K, I was going to post a few notes, and consider taking a position. There are some risks with ARO, but the stock is cheap. I happened to check the EDGAR database just to see if any insiders have made any purchases or sales over the past few days (I like checking these once a week or so for companies I’m following)… and to my surprise and disappointment, I noticed that Sycamore Partners filed a 13-D this morning and disclosed that it took an 8% stake in ARO.

Sycamore is a private equity firm that has done some work in this space previously. They took Hot Topic private earlier this year.

I checked the pre-market trading, and it appears that ARO is going to be up significantly this morning (15-20%). This certainly isn’t ideal, but I think it’s still cheap enough to consider… just not as cheap as it was yesterday!

I decided I’ll go ahead and post my initial basic notes on ARO. Everything here still applies. These are just the numbers… I finished reading through the last few quarters and have a better handle on the business, and might write some more details in future posts. Maybe this 13-D jump will fade and there will be more opportunities to buy at the lower levels. This often happens after an announcement like this.

Here are some initial thoughts on Aeropostale (ARO):

  • Current Price: $8.82 (update: now closer to $10 after the 13-D jump)
  • Now at a 5 year low, below $9 which was below the 2009 and 2011 low)
  • Stock is priced at a level it hasn’t seen since 2005, when there were significantly more shares outstanding
  • Traded as high as $30 in 2010 (Schloss used to like to see when a stock had been priced significantly higher in the past; it’s not a necessary nor sufficient sign that there is value, but it does help to know the market has priced the business there previously)

ARO Chart

  • It’s hated… even value guys don’t like it, retailers are tough….

But…

  • No debt
  • Adequate liquidity despite the cash burn ($100 million in cash plus access to an untapped $175 million credit facility
  • Buybacks-Shares have been reduced from 130 million to 80 million in last 10 years (Munger’s “Cannibal”)
  • 10 years of consecutive Free Cash Flow

Take a look at the average yearly numbers from the last 10 years:

ARO 10 Year Summary

So if management can simply begin to revert their business back to the mean (which even after today’s jump are still single digit multiples and double digit FCF yields), the stock might have some significant upside.

These multiples are of course based on 10 year history, and not the trailing twelve months. The recent year’s numbers are terrible. The business is clearly struggling, but the stock has been decimated. It’s a formerly high valuation business with formerly high returns on capital. If the company can just stabilize, there is upside as the business is priced at less than 10 times the low FCF of the last 10 years. If the business even starts to revert back to historical ROC of 30-50%+ there might be significant upside. Here are the returns the company has produced over the past 10 years:

ARO 10 Year Returns

This was a really good business at one time… it has consistently grown revenue:

ARO 10 Year Sales

And the valuations are close to all time lows.

I mentioned the earnings and cash flow multiples above based on the average annual earnings from the last 10 years. Take a look at the current Enterprise Value to Sales (EV/S) which is near a 10 year low:

ARO 10 Year EV-S Multiple

Just from one comparable that immediately came to my mind this morning, Sycamore (the private equity firm that filed the 13-D this morning) acquired Hot Topic for around 0.7 times sales, nearly double the EV/S multiple that ARO currently has.

Risks:

There are certainly risks… The business is losing money and if they don’t turn the ship around soon, the cash will burn down to the point that the credit revolver will have to be tapped, and the firm’s liquidity position could eventually deteriorate. Most of these investments I make are in businesses with problems, and I like to look for clean balance sheets. I think the company can turn around, but it may take time. The company has no debt, and that will give it more time than a company with a leveraged balance sheet. A ticking liquidity timebomb is not what you’d like to worry about when trying to turn a retailer around.

One other downside is that there is no asset protection… the company leases all of its space, and the only real assets it has is the inventory, and in the event of further deterioration, the likelihood of being able to sell the net tangible assets for what they are carried on the books for (roughly $3.50 per share) is slim. However, I think that the company would get purchased long before it faced a liquidation. Although it’s not an extremely strong brand, my guess is that at some level a private equity buyer would become interested in the firm simply because of it’s name recognition and its current fleet of stores (ARO has around 1,100 stores, including 142 PS from Aeropostale stores, not to mention a small, but growing ecommerce business).

Catalysts:

The first catalyst is the fact that Aeropostale has hired some key decision makers and has put in place a new product development team. I have no idea if the team will improve ARO’s operations, but often times new decision makers can act as a catalyst for improvement. I think with a proper game plan, the business survives, and potentially could improve. Survival means upside from here…

The other catalyst that I mentioned above is the private buyer or some other takeout transaction. With Sycamore filing a 13-D, that catalyst may rear itself earlier than I initially expected.

Pessimism and Downside Priced In?

This is a hated name at the moment… retail investors hate it, and value investors (especially Buffett followers) often don’t like retailers to begin with (it is a very difficult business). But I like situations where survival means upside. More companies survive at this level than don’t, especially with a good balance sheet. “Most turnarounds don’t turn” is a common phrase, but I haven’t seen any numbers to back that up. That might be just empirical observation on a few samples… and it very well might be true. How do you define a turnaround? At what point do “most turnarounds don’t turn”? I’m not sure… But with a beaten down stock in a tough industry that people don’t like at the moment, just a bit of improvement could mean good things.

Linda Greenblatt’s Retail Experiences

Linda Greenblatt (Joel’s sister) ran a partnership that produced outstanding returns for 10 years or so (“upper 20’s” annual returns according to Joel). She gave a guest lecture at Columbia where she talked about buying retailers when they looked the worst after a miss, or a series of misses. Her general point was that retailers get unduly punished by the market, due to the short term nature of thinking about the next quarter or two. If you can look past the next few quarters and look out a few years, can you visualize a company that reverts back to its former profitability? It’s an interesting way to generally think about it:

“Again the answer is that people love to beat up these things up. People love to write off retailers. Everybody’s thing with retailers is–because what is their reason for being? If another retailer fell by the wayside, who would care? When people see things on a negative trend, these things (retail stocks) just get battered. So having followed retail for as long as I have, the low end of multiples is 8xs to 10xs and the high end is 20xs time range—P/E multiples. A lot of retailers these days carry a lot of cash. So that also gives us some security to last through the bad times.

Psychologically when you are seeing month after month of negative numbers it is tough not to panic. I can tell you having lived through when a comp sales posts a negative 15% comp, not to say, maybe they are going out of business, maybe no one will go back into the store. It really is tough to take a step back and say it is a one season thing, or one year thing, but when they get it right, there is so much potential and the operating leverage is huge.”

She talks about the case study of AEOS… and how it went from 5 to 30, but when it was 5, the margins were depressed, earnings were depressed, management wasn’t executing, and things looked bad. Thus the low price:

AEO from Linda Greenblatt CS

It’s easy to understand this reading through a case study, but hard to act. ARO looks bad. Margins are down, earnings are currently negative, who needs it to survive? It might not, but the likelihood of bankruptcy is low. It has a strong cash position. It’s burned through some cash, but it has more of it if needed. The clean balance sheet that it has maintained will increase the odds that it weathers the storm.

To sum up Linda’s general points about retail investing:

  • Buy retail stocks when they are depressed and hated
  • Look for clean balance sheets
  • Former good returns and good margins (reversion to the mean if things improve)

One of the things I noticed while reading through Linda Greenblatt’s comments is that over and over she said (and Joel chimed in as well) that management doesn’t even have to get back to where they were… they don’t have to bat 1.000, if they just improve a few things, the stock has huge upside. The key is to buy when no one likes them, and when earnings and margins might be at low levels.

I’m not sure if this is what is currently going on at Aeropostale, but it does look similar to the case study above, and I think that there is real value at the current price. I have some more detailed notes about the business from the 10-K’s and 10-Q’s, as well as some thoughts on competitors and some other ideas, but will save those for another time.

Have a great week!

Disclosure: I don’t currently hold shares of ARO but I am considering taking a position for myself and for clients. This may happen in the near future and without further notice. Please conduct your own due diligence on this, and any other idea I mention. This is not a recommendation and should not be considered investment advice. 

15 thoughts on “Aeropostale (ARO) Might Offer Turnaround Value

    1. Thanks Marshall. We’ll see about ARO. It’s an interesting situation. I was reviewing more notes today and it really comes down to whether management can execute. Even if the sales stablize at say $2,000mn (about 15% lower than where they are now), and management can get back to a 10% operating margin, assuming a 40% tax rate, that’s still $120mn in net income, or around $1.50 per share. Of course, these assumptions could be off, and sales might deteriorate more, or margins might not get back to 10, etc… but even if sales are slightly higher and margins are at 8, etc… you can paint various scenarios that would lead you to values pretty significantly above $10. I think it’s probably worth $17-$20. If management doesn’t execute, that value will erode. So it all hinges on how they do.

      Now with Sycamore involved, that might happen.

      Will be interesting to follow this one. It’s hated by a lot of investors, even value guys. Many value guys held this when it was between $15-$20, and since sold, so it’s hard to look at it again after management eroded so much value over the past couple years. So much pessimism has really created a situation where there are still risks, but I think they have been discounted significantly by the market. We shall see. Should be interesting. Thanks for the comment. I’ll check out you post.

  1. John,
    Good timing. We had communicated a few weeks back about ARO and retail, so I can vouch for the fact that you were already looking into this. I think it is nice to see your research validated this quickly (if not a little too quickly). One note about Sycamore, you might want to go back and read how they approached their investment in Talbot’s, which they eventually took private. It was a long saga, took over a year, but I think reading about their approach there will help you here. Good luck!

    Matt

    1. Great… thanks Matt. Appreciate that. I’ll take a look at some of the Sycamore investments. I checked out their website yesterday and made a note to take a look at them when I have time. Thanks for checking in and talk to you soon…

      1. John,
        I get the pain. I had a GTC order at $8.50 before Sycamore filed their 13D. Too bad I got greedy and missed it this time ( I had earlier bought ARO at ~$10 in Oct’11 and sold it when it hit $17) but will be waiting for a better entry point, As for Sycamore’s buyout of Talbots. Here’s a summary

        http://riskarbitrageinvesting.com/wp-content/uploads/2012/08/Talbots-Case-Study.pdf

        If Sycamore has the same plan for ARO, my guess is that the buyout offer will be somewhere between $16-$18 ( I would be surprised if the pay much more, although it can happen. I think they paid a meager ~0.2 P/S or lower for Talbots, but TLB was in far worse shape than ARO)

        Ranajit

  2. John,

    Reading and nodding here. Two interesting corollaries – CTRN is just coming out of a similar trough (horrible couple of years, but 500 stores and no debt + >$100M in cash). Their comps edged up slightly in last Q. The stock has done well over the last 6 mos not because the management is executing so well, but because the sentiment about the business has changed.

    To some extent, I think RSH is in a similar boat. Once left for dead, people are not so sure anymore – with 4300 stores there’s lots of option value and leverage to an even modest uptick. With BBY turning around, there’s a renewed interest and insiders are buying. But this is a tougher story.

    Stan

  3. John,
    I am trying to keep an open mind about value opportunities in retail, despite my reservations. I was an investor in TLB during the process, mainly when Sycamore walked away and the price fell 50% (I didn’t think Sycamore was going to let their 10% investment be cut in half after a year of dancing with Talbots–as a side note that was Sycamore’s first deal as a new private equity fund). One interesting note that I forgot to mention was that the final price Sycamore paid for Talbots was actually lower than their original price they paid on the open market.

    Here is the SEC filing showing their original investment.
    http://www.sec.gov/Archives/edgar/data/912263/000110465911041970/a11-23244_1ex99d2.htm

    The final deal was priced at $2.75, but they paid an average price of $3.26.

    That being said, Talbot’s was burning cash throughout the entire year, but I do think it does give some indication of Sycamore’s patience and maybe discipline in terms of not over-paying. Right now, Sycamore probably see two outcomes, things continue downhill for ARO and they are in a good position to take the company private and try their hand at turning things around out of the public eye. On the other hand, if ARO can stabilize the ship or just turn things around slightly, their stake in ARO could appreciate substantially.

    This all being said, I am not a fan of either retail or merger arb situations. But they are interesting to follow from a spectator’s view.

    Looking forward to hearing your thoughts as you follow it–or reasons why you are walking away from the idea.

    Matt Brice

    1. Yeah I decided to take a position in ARO, but it really had nothing to do with Sycamore. Although my guess is their involvement will add value, but I’m not sure. Listening to a few past calls, the management team (which has some major changes at key spots over the past year or so) has really acknowledged their weaknesses and their mistakes (which I always like to see). Now that they’ve admitted what they’ve screwed up on, I think they are in a position to solve the problem (doesn’t mean they will, but it seems like they have a good plan in place).

      I like the asymmetric profile of the investment. Just a few things right means very positive results. Even if revs decline to about $2,000mn (they are at $2400mn TTM, so that’s a big decline), if they can stablize operating margins at 10%, that means $200mn in operating income, which implies about $120mn or so net income after tax. The business still has some growth opportunities… but even at no growth in store count (which means very little capex), and no growth in bottom line, the company would likely be generating close to $120mn in FCF (without much investment in new stores, I’m assuming the depreciation would roughly equal maintenance capex). A good business with decent margins and above average ROC would likely see a double digit multiple on this type of cash flow, so I think the business is worth at least $1.2 billion, which would be $15 per share. That is my guess of where a private buyer would be interested in buying this at.

      There are certainly risks that the general scenario I laid out doesn’t materialize, but there is also a chance that it is much better. What if margins stablize and sales don’t go down? What if they increase at some point? Maybe they won’t, but I think the odds are that something goes right at some point, and there is a huge margin of safety here thanks to the clean balance sheet and adequate liquidity. ($100mn cash and $175mn untapped credit facility). The other thing is that the fleet of stores probably is interesting to private equity firms like Sycamore. The footprint and brand name is strong. It doesn’t have a moat around it, but the brand is well-known, and that’s worth something.

      I’ll be interested to see how this situation plays out. I’ll keep you posted on how my thoughts evolve with this. It’s a small position, but will be a good case study going forward.

      Thanks for the comment Matt.

  4. Dear John,

    I’m just starting out as an investor. I got interested in ARO after reading Joel’s notes and found the current situation similar.

    I would like to ask when you go through their 10K and 10Q, what exactly do you pay attention to. I went through their latest 10K and 10Q, they include things like their compensation program, stock reward programs, deferred assets and stuff. Those seem to be irrelevant to whether we should invest in the company. But did u really just skim those through when u read those documents?

    Thanks.
    Dickson

    1. Hi Dickson, I always like to read the entire document… I think the big picture is always the most important, but often times you’ll find some key information in the footnotes, tables, and other parts of the filings that many don’t focus on. The compensation section is an important part, as you can determine not only the pay scales, but how aligned the incentives of management are with shareholders.

      Thanks for reading and Happy New Year.

  5. Hi John. I love the site. As a new investor I am reading everything I can get my hands on and your site is one of the best things I’ve found. Great work and please keep it coming

    Now on to ARO. I wonder if you could share your latest thoughts on ARO? We have the recent 10-K, financing/board seat deal with Sycamore, new sourcing agreement with MGF, and some new large shareholders.

    I can try first what I am thinking. The latest company results were overall pretty ugly and their guidance is equally ugly. I think the new sourcing agreement should be a positive and it does address one of the potential risks they’ve disclosed. It sounds like the new collections (Pretty Little Liars, Live Love Dream, Bethany Motta) are going well. If these collections continue to do well I wonder if the company would consider making them a larger part of their portfolio of clothing. Board seats for Sycamore could be a good thing if that helps to push the company in the right direction and at least means a voice from shareholders. I don’t know what the Sycamore deal means for chances of a buyout though. The added capital from Sycamore is probably a good cushion to have as they turn things around. Overall it sounds like there is pain now but the company is moving in the right direction to bring things back over the next few years.

    For disclosure I bought up some shares in February. I liked this post when you first wrote it but was not sure that it was for me and had no cash at the time. As it kept dropping and I sold some other things I went in.

    Thanks,

    Dan

    1. Hi Dan,

      Thanks for the nice words. Yeah at some point in the next year or so, I’ll probably do a follow up post on ARO. It’s an interesting situation. I have a small position and haven’t sold anything yet, but the business is doing worse than I anticipated so far. However, these types of situations can take a long time. It will be a good case study when it’s done. One thing I’m learning through this particular idea is how difficult it can be to recapture teen customers in this type of business. I understood the concept of the teen customer being fickle, but owning this stock and really diving into more details has solidified that fact. Listening to management on the calls, and reading the filings, you can really tell that it is a very difficult business. I was extremely impressed with the business’ ability to produce high ROE with little leverage when times were good, and I think if they can stabilize it, this is extremely cheap. The issuance to Sycamore will provide some liquidity, as they are burning through cash at a faster rate than I anticipated. Initially, I was attracted to the fact that if management can do one thing right and just stabilize the business, then the stock was very cheap. I thought the clean balance sheet with plenty of cash would give them enough time. We’ll see if my thesis was flawed. There is still enough time for them, but they are burning more cash than I expected. It goes to show you how difficult these types of retail turnarounds are…

      As Buffett says, most turnarounds don’t turn. We’ll see if this is the case here. I have a feeling ARO will survive, which means they’ll be able to be profitable (although at a level not near the former high water mark), which means it’s really cheap. But at $5 per share, the market is basically putting a pretty significant probability that ARO doesn’t survive. That might be correct, we’ll have to see.

      When I have some time, I’ll probably post some details on where I think we are with this. And in the next year or two, it will be a good case study to review.

  6. Hey John,

    Was wondering if you are still following this story, and wanted to hear your thoughts after 6 months. I’ve been following this story ever since you posted this. Also, been going through different ARO stores in different cities of California to get a feel for it.

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