Saturday, June 21, 2008
The retail industry is getting hit hard as investors anticipate a recession. American Eagle’s stock is down nearly 50% in the past year and a half. The disappointing negative same store sales figures for the first few months of the year sent the stock tumbling. January same store sales were down 12%, February’s same store sales were down 4% and in March they were down 12%. For the first quarter same store sales declined 6%, net income was down 44% and operating margin declined from 18.9% to 10.1%. Abercrombie and Fitch, AE’s main competitor had negative same store sales figures but AE was hit harder than most of its competitors. The disappointing first quarter figures were driven by sales decreases in the girls side and a mistake in styling in the denim business, which is AE’s backbone representing around 20% of sales. AE was forced to take markdowns on denim and girls merchandise during the quarter, taking a hit to margins. Insider purchases have been significant over the year. Jay Shottenstein the founder and chairman has purchased $24 million in stock over the past year and his family owns 15% of the stock.
American Eagle is retailer selling mid priced casual clothes targeted to 15-22 year olds through its 942 American Eagle stores in the U.S. and Canada. In 2006 they launched the sub brand “aerie” targeting 15-25 year old girls and has since opened 55 aerie stores. In 2007 a new concept was launched “MARTIN + OSA” targeting 25-40 year olds. There are currently 21 MARTIN + OSA stores.
American Eagle has been a phenomenal company over the years based on margins, returns on equity and other metrics. Average ROE over the past 10 years has been 28%. With new stores on average producing a return on equity of 65% in 2007. Operating margins have been on average 16% over the last 10 years, which is one of the best in the entire apparel industry which averages 4%
American Eagle’s two largest competitors are Abercrombie and Fitch and Aeropostal. Other competitors include The Buckle, Gap, Hot Topic, J. Crew, Limited Brands, Pacific Sunwear of California, Quicksilver, Talbots and Wet Seal. One thing that distinguishes AE from its two largest competitors is price. Abercrombie & Fitch’s merchandise is much more expensive then AE’s. Abercrombie & Fitch’s average unit retail price is $35 compared to American Eagle’s $20. Aeropostal on the other hand is generally slightly cheaper than AE. I compared jeans, tees and polos from American Eagle to near identical merchandise at Aeropostal, Abercrombie & Fitch and their sub brand Hollister. I found that prices at American Eagle and Hollister were very similar. Prices at Abercrombie and Fitch were almost always around 50% more than American Eagle. At Aeropostal prices were nearly always the cheapest of the four. I also read the latest quarterly and annual reports from Aeropostal and Abercrombie & Fitch. I feel that AE has superior qualities to both of these companies:
First, Abercrombie & Fitch’s prices are much higher than AE’s and both contain very similar merchandise. For example a pair of jeans at Abercrombie runs around $80-$90 while a pair at AE and Hollister runs $50-$60 and at Aeropostal it’s $30-$50. The merchandise is nearly the same between these four retailers. Abercrombie relies much more on the intellectual appeal of their brand to convince customers to pay 50% more for very similar merchandise. Therefore I think Abercrombie is much more susceptible to economic conditions, consumer spending and fashion trends. I personally get all my cloths from AE and fund no reason to spend $90 for a pair of jeans that are very similar to what AE has to offer.
Also, despite the significantly higher prices at Abercrombie, AE’s margins are very comparable. Over a ten year period, AE’s average operating margin was 16% compared to 19% at Abercrombie and 10-12% at Aeropostal. But more recently in the last four years AE’s operating margins were better than Abercrombie’s. Aeropostal’s recent good performance is mainly due to people turning to the cheaper alternative during a consumer spending slowdown.
Finally, insiders at both Abercrombie & Fitch and Aeropostal have been dumping stock recently. At Abercrombie many insiders have been selling large amounts of stock. Including the chairman, Michael Jeffries who has sold nearly $100 million in stock in the past six months or about half his holdings. Jeffries is scheduled to receive $68 million in equity compensation this year as part of his “career share award.” Insiders have also been dumping stock in Aeropostal as well. But, over the past year the chairman of American Eagle Jay Shottenstein has purchased over $24 million in stock and many other insiders have been accumulating stock.
There are currently 868 AE stores in the U.S. and 75 in Canada. The ultimate goal is to have between 1,000-1,200 AE stores in the U.S. and 80 AE stores in Canada. New AE stores are being opened at the rate of 40-50 per year giving AE 5-8 years of growth of its flagship AE stores. Also sales at AE Direct, American Eagle’s website, are growing at 30%+ per year and Jim O’Donnell American Eagle’s CEO said in a recent investor presentation that AE Direct should achieve sales of $500 million by 2010 up from $200 last year. American Eagle expects to open 40 new stores in 08 and to remodel 40-50 more stores. Overall square footage in 2007 grew 12% and will grow an estimated 10% in 2008.
During Fiscal 2006, American Eagle launched its new girls intimates brand, “aerie.” targeting girls aged 15-25. “The aerie collection is available in aerie stores, predominantly all American Eagle stores and at aerie.com. The collection includes bras, undies, camis, hoodies, robes, boxers, sweats, leggings, fitness apparel, and personal care for the AE girl. Designed to be sweetly sexy, comfortable and cozy, the aerie brand offers AE customers a new way to express their personal style everyday, from the dormroom to the coffee shop to the classroom” (2007 10-K). The aerie stores have been very successful so far with 55 aerie stores already opened and 80 more planned for 08. aerie seems like a natural extension of the girls section of the American Eagle stores given the synergies and brand recognition already established. Despite that AE stores get 60% of their sales from girls, the addition of an aerie store in proximity to an AE store doesn’t cannibalize sales away from the original store’s sales. Many other retailers have opened stand alone girls intimate stores targeted to the teenage girl. Abercrombie is starting the new concept Gilly Hicks targeted to teenage girls. Victoria’s Secret started the sub-brand Pink in 2004 and last year Pink achieved sales of $900 million. American Eagle’s CEO said that he thinks aerie will eventually achieve sales of $1 billion with over 500 stores possible.
The Company also introduced MARTIN + OSA during Fiscal 2006, a concept targeting 28 to 40 year-old women and men, which offers refined casual clothing and accessories. At first M + O appeared to be struggling badly and in 2007 Jim O’ Donnell said he was optimistic but he would close the stores if it didn’t return to profitability. More recently the stores have improved with same store sales increasing over 50% but the brand is still losing money, about 15-17 cents in annual earnings per year. For the first quarter the CEO said he is pleased by the performance of the new concept. The CEO said on the conference call that the brand is doing better with store traffic increasing. Also the brand has specific goals it has to make otherwise they will consider closing the stores. The CEO expects M + O to be profitable by the 4th quarter this year. Either way it will be good for shareholders; if the stores are closed 15-17 cents in losses per year are eliminated or if the brand becomes successful it will be a new avenue for growth. There are currently 21 MARTIN + OSA stores with 15 more planned for 08.
Last year AE announced a new concept 77 Kids, which will sell apparel for kids aged 0-10. The new concept is currently being developed with the website going up this year and stores are planned for 2010. It’s hard to forecast what will happen. It appears as though this is a pet project of the CEO’s. Jim O’Donnell helped start Gap kids and turned it into a $400 million business in six years before coming to AE..
American Eagle is down over 50% in the last year and a half. With a market capitalization of $3.3 billion, American Eagle’s trading at 8 times last year’s earnings. With $338 million in cash and $367 in investments, enterprise value divided by EBITDA is an appropriate way to value American Eagle. Cash and investments are equal to $3.50 per share. Earnings for 2008 will come in lower than 07 but, when the retail environment improves in a few years American Eagle will be worth much more than it’s trading for currently. First, the company has repurchase plan with up to 41 million shares available for repurchase. With cash on hand 22 million shares could be repurchased or over 10% of the stock. The share count has decreased by 23 million shares since 07. Options issuances continue to be large as they are in this industry with about 12 million shares available for issuance. On average option dilution has been about 1-1.5% per year. Second if either MARTIN + OSA will return to profitability or the stores are closed. The loss from M + O held earnings down by about 16 cents or $36 million last year nearly 10% of net income. With a market capitalization of $3.3 billion net of $370 million in cash and short term investments and $75 million in notes, American Eagle is trading for an enterprise value of $3 billion. Based on 2007 figures American Eagle is trading for an enterprise value/ EBITDA ratio of 4.2. Looking at any valuation metric, AE is significantly cheaper than its competitors. Cash flow from operations has been strong with $480.4, $749.3 and$464.3 million generated in 05, 06 and 07 respectively. With capital expenditures north of $200 million a year, free cash flow generation has been $398.9, $523.3 and $213.9 for 05, 06 and 07 respectively. I think AE is worth twice what it’s trading for and the value will be unlocked once the retail environment improves, share repurchases boost EPS and aerie and MARTIN + OSA begin to make meaningful additions to AE results.
Wednesday, June 11, 2008
Of all the articles/speeches/interviews of value investment managers this is one of the best speeches I’ve ever watched. Klarman discusses how he made over 5 times his money investing in Enron debt, what his investment principles are, his thoughts on the investment manegment industry, why he doesn't go short and why he uses derivitives.
This speech is not posted any where else on the internet. Here is my summary:
Thoughts on Investment Manegment Industry
- The investment Manegment industry is not set up to achieve market beating returns. Instead they are incentivized to get big and act like asset gatherers. At the same time there is little incentive to take risk and deviate from the mean because if they strike out and underperform for even a short period clients will be lost quickly. It’s an enforced mediocrity (if you want to get big just do what everyone else is doing and settle for average results).
- Klarman said he would rather hold treasury bills then invest in many of the hedge funds out there. If stocks do 10% going forward and a hedge fund that charges 2 and 20 takes 3% of your money in fees you’ve only got 7% left, plus it’s leveraged, holds illiquid securities, etc. He would much rather get 4.5% risk free.
- Tweedy Brown is today’s manifestation of Benjamin Graham
- Value investing is risk aversion
- Baupost charges a 1 percent management fee plus 20 percent of profits.
How Baupost Invests
- Rule #1: Don’t lose money. Rule #2: Never forgot Rule #1.
- Baupost always looks for catalysts in its investments. If you find a stock trading for 50% of what you think it’s worth you want there to be something that will trigger it to reach fair value.
- Baupost will always sell an investment as soon as it near their estimate of fair value. Baupost has analysts focused around the type of opportunity; Baupost has a spinoff analyst, index fund deletion analyst, post bankruptcy analyst, distressed debt analyst and an analyst looking at companies that are depressed because of a bad earnings announcement).
- Baupost invest in: Both public and private distressed debt, Real estate (Baupost has done over 200 real estate deals including biding on RTC auctions), U.S. and foreign equities, LBO’s and Derivatives.
- The portfolio is 45% cash, 20% equities, around 17% distressed debt, 11% real estate, 7% private investments (distressed debt, small LBO’s, financial restructurings), 6% in South Korean equities and a small % in hedges.
- Baupost looks at every merger, rights offering, privatization of government business, spin off, major share repurchase, dutch auction tender, thrift conversions or anything else that could cause mispricings.
- Post bankruptcy situations are a good place to look for bargains because people avoid them and don’t understand them. A lot of good things can happen in bankruptcy such as terminate overpriced contracts or leases, shed extraneous business units or, deal with union problems or settle contingent liabilities; all under the protection of bankruptcy court. Then all the debt holders have equity and they will want to sell.
- Baupost opened over 1,000 savings accounts across the country to take advantage of thrift conversions
- Baupost doesn’t go short because unlike going long when you can take advantage of a drop in the value of an undervalued security by just buying more, if your short even though you may be right that it’s worth less then the trading price you can still go broke. It’s way more risky and you can lose infinity. Think tech stocks if you shorted them in 97, 98 or even 99 you would have been killed. It works for a while and then the market goes berserk and you get killed.
- Baupost uses hedges to reduce risk. For example they use derivatives to hedge the interest rate risk in their real estate holdings. They hold credit default swaps on the government debt of countries they have investments in (S. Korea). They also hold credit default swaps in a bunch of European countries not necessarily because they have holdings there but because it reduces risk and they were very cheap ($60, 000 a year for $100 million in insurance).
- Baupost does best when there is high uncertainty and little information. When they research a company they do what ever they can to find information; they talk to every one to get information including, manegment, industry people, former executives, customers, suppliers, they sometimes hire consultants and talk to analysts on buy and sell side.
- They constantly reassess to find new information, if they’ve overlooked something or if something has changed.
- Employees own second largest position in Baupost.
Baupost’s 3 investment principles:
1. Focus on risk before return. This is why Baupost has so much cash, currently 45% of the fund is in cash. If they could find undervalued investments they would put all their money to work tomorrow. If they had to they would have no problem holding 100% cash. People fail to have sell discipline because they can’t hold cash.
2. Focus on absolute returns. Institutions focus on relative returns but Baupost doesn’t because Klarman can’t imagine writing a letter to clients saying "we performed well during the year, the market was down 25% and we were down only 20%" also clients will pull money out at the wrong time and it has a strong psychological effect.
3. Only focuses on bottom up investing. He has views on the macro but doesn’t think he has an edge in that type of investing. Klarman said that it’s really hard to turn a macro idea into an investment.
Klarman's 5 fold investment in Enron debt
- Baupost invested in Enron’s senior debt and he said that would be an example of his favorite type of investment. The situation had a lot of complexity, hard to analyze, a lot of litigation, uncertainty and no one wanted to be associated with anything Enron creating a huge mispricing. Baupost bought the debt for 10-15 cents on the dollar. It comes down to assessing assets minus liabilities. After a few years most of Enron’s assets were cash $16-18 billion but the liabilities were extremely complicated, with over 1,000 subsidiaries. Baupost had one analyst focus solely on Enron for over 4 years and try to figure out its liabilities and how much they would get back on the bonds. Baupost believed that the people liquidating Enron were low balling what they would get back on the bonds. The people liquidating Enron were very pessimistic and they originally estimated that the bonds would get back 17 cents on the dollar at the same time the debt traded for 14-15 cents, Baupost estimated that the debt would recover 30-40 cents and as of now they believe it will be more then 50 cents.
- Investments like Enron debt are possible because the market doesn’t assess risk correctly by relying on volatility (beta).
More about Seth Klarman:
Business Week: The $700 Used Book
Seth Klarman at MIT October 20th, 2007
Baupost's Portfolio Holdings
Great Article About Klarman: Manager Frets Over the Market, but Still Outdoes It