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ARO: Revisiting a Crowded Debate

It’s rare that Keith reaches out to us and says “XYZ Ticker looks awful” (based on his multi-factor models). Well, yesterday he said just that on ARO. At last count there were 34 published sell-side ratings on Aeropostale.  Wow, that’s a crowded debate!  That puts the “coverage” smack in the middle of the 23 analysts following GE and the 40 following Google.  So what does ARO do aside from selling cheap teen apparel to deserve all this attention?  Over the past year, the company has arguably been the biggest beneficiary in specialty apparel retailing from a confluence of positive events.  Let’s look at the facts:

  • The company’s highly promotional marketing approach and value pricing resonated well with the core 14-17 year old consumer over the past year.  Same store sales are up 10% YTD on top of an 8% increase in 2008.  With an average unit retail of around $11.80, there is no question that ARO’s price-driven merchandising strategy is working as higher priced competitors American Eagle and Abercrombie continued to lose share.  It’s no coincidence that Old Navy, Rue 21, and other deep value apparel retailers also outperformed.
  • Along with the topline, came an outright breakout in the company’s profitability.  With the fiscal year essentially over, ARO’s EBIT margins expanded by 400 bps in 2009- ending the year somewhere around 17.2% (beyond peak).  That puts ARO in the upper quartile of all vertically integrated specialty retailers, eclipsing JCG, GPS, ANF, and pretty much every other mall-based retailer on the planet.  Very rarely, if ever, have we seen a high-teens margin structure exist at a company that plays the in the value arena.  COH, ANF, CROX, DECK have all been there at one point or another, but these are all brands with price points substantially higher than ARO…
  • With 950 stores, ARO is no longer a growth driven story.  In fact, the core store base is pretty close to maturity.  As a result, same store sales leverage is huge. A fixed cost infrastructure pumping more and more units (180-190 million annually) through the same number of boxes is surely going to yield outsized upside.  This is especially true if you consider that one-third of the store base is approaching 10 years old and rents are probably pretty good in those locations.  Add to that some recession-driven cost cutting, and the formula makes a ton of sense.  Customer traffic increases (helped by the economy, supported by ARO’s aggressive marketing efforts) and throughput have been key to the strength in 2009.  But can this continue? And for how long?

Now let’s look at some concerns: 

  • While still in its infancy, the company’s key growth vehicle of the future is P.S. by Aeropostale, a concept aimed at a 7-12 year old consumer.  This makes a ton of sense longer term, as it’s probably cost effective to merchandise the brand as a “takedown” of the older original.  However, any ramp on growth will be a negative based on mix alone.  It’s near impossible for a chain of 40 or so stores to approach company average margins without greater scale.  Yes, it is still early to make a call on the concept’s eventual success, but nonetheless it’s both risky and margin dilutive in the near term.
  • Management cites the company’s past history when AUR’s were closer to $14-$15 vs. $11.80 today.  This is an opportunity according to management, and it surely seems like one on the surface.  However, raising prices (even if done the right way through better quality, trims, features) seems counter to what has been driving the business over the past two years.  Given the company’s strength in driving price driven purchase decisions, it seems unlikely that taking prices higher will be well received.  Yes, adding more fashion product into the mix has been in part a reason to command a higher ticket, but this also adds inventory risk.  ARO has historically been a fashion follower, which makes it hard to believe that they can successfully transition into a fashion leader. 
  • Co-CEO’s will take the helm in 2010.  The combination of an operating executive and a merchandising executive makes sense on paper, but this combo rarely works.  Before you email us with examples of how this has worked in the past, Aeropostale is no Ralph Lauren.
  • The shares have generally stopped responding positively, to positive news.  Even with continued upward earnings revisions, driven by outsized same store sales it appears that even the most aggressive assumptions are already discounted in the stock.  Yes, the shares appear cheap at 10x this year’s earnings, but the reality of slowing comps and potential EBIT margin contraction is likely to keep a lid on the shares at a minimum.  Any hiccups along the way with management’s transition and potential inventory build and this suddenly becomes one of our favorite shorts…

ARO: Revisiting a Crowded Debate - ARO earnings adj 1 10

 

  • Finally, our latest SIGMA analysis suggests that the peak may have already occurred.  Sales are still outpacing inventory growth, but the spread is narrowing.  Margin compares begin to increase meaningfully in 1Q.   With such a heavy reliance on selling more and more units, it’s becoming harder to envision a third year in a row of outsized same-store sales without a commitment to more inventory and/or higher price points.  Both prospects would suggest higher incremental risk…

ARO: Revisiting a Crowded Debate - ARO S 1 10

 

Eric Levine

Director


Continued Sovereign Debt Buildup

I wrote a note a few days ago that summarized some key points from, “This Time is Different”, by Carmen Reinhart and Ken Rogoff.  As they write, global financial crises initiated by sovereign debt defaults are much more typical than most investors realize.  In many instances, the debt to GDP ratio of 0.9 is a metric that signals when many less than mature economies will risk defaults.

 

In the year-to-date, we have seen a massive issuance of global debt as many nations are attempting to plug holes in their budgets.  Below we’ve outlined from press releases some of the key recent issuances and their dates:

 

1/25 – Greece is reportedly trying to sell $32.5 billion of government bonds to the Chinese in a deal brokered by Goldman Sachs.  This deal would be more than 3x the size of the National Bank of Greece.

 

1/26 - Hungary on Tuesday sold $2 billion worth of 10-year debt, mainly to U.S. investors, in a move confirming its plans to come off International Monetary Fund aid this year.  Hungary sold the debt at a discount price of 99.86, bringing a yield of 6.269 or 265 basis points over comparable U.S. Treasuries, Deutsche Bank, one of the lead managers of the deal said.

 

1/26 -Vietnam raised $1 billion from its second global bond sale, offering higher yields than lower-rated Philippines and Indonesia, amid the busiest start to a year for global borrowing by developing nations since 2005.  The central bank set a 7 percent limit on the yield, the minimum amount investors AllianceBernstein L.P. and Western Asset Management estimated would be required to attract sufficient orders.

 

1/25- Greece raised 8 billion euros of a 5-year syndicated bond at a yield of 6.2%. The bond attracted total bids of EUR 25 billion, well above the EUR 3 billion to EUR 5 billion targeted by the government.

 

1/13- Indonesia scaled back an offering of dollar bonds to $2 billion from as much as $4 billion and scrapped a 30-year portion yesterday, people familiar with the deal said. Poland by contrast raised the most ever in a single sale of zloty bonds today, receiving 5.5 billion zloty ($2 billion) after 16.2 billion zloty of orders.

 

1/11 - Mexico sold $1 billion of bonds in the country’s first international offering since its credit rating was cut by Standard & Poor’s and Fitch Ratings. The bonds yield 5.25 percent, or about 1.42 percentage points more than U.S. Treasuries, the Finance Ministry said in a statement.

 

This acceleration of global debt issuances appears to be leading to a bubble in sovereign debt.  While we are not at bubble stage yet, we will be very focused on monitoring the issuance in the coming months.

 

Former Citigroup Chairman Walter Wriston once famously said, “Countries don’t go bust.”  In that case Mr. Wriston we have some Zimbabwean 30-years for you to buy . . .

 

 

Daryl Jones

Managing Director

 


LVS TRANSCRIPT FROM INVESTOR CONFERENCE

From the presentation that just ended.

 

 

LAS VEGAS COMMENTARY

  • Current operating environment in Las Vegas?
    • Supply and demand environment that are out of balance hence putting pressure on rates
    • Still doing good volume but at materially discounted rates than 2 years ago
  • $200/night is still a reasonable but difficult rate to maintain given the competition.  However, they have reduced their expenses as well – despite the lower gross margins on rooms
  • 2010 group nights will definitely be better than 2009 – what’s on the books now is already better than 2009
    • Political rhetoric is over and Vegas is no longer a shunned location
    • Not at all worried about the group business in 2010 & 2011
  • The whole market is seeing more group activity than last year - the problem is getting that business at the rates that they used to have, and that’s not going to happen in 2010 and not in early 2011.  Although 2011 rates are up a little from 2010
  • Are there incremental opportunities to cut more costs here and in Vegas?
    • There are always opportunities, but the low hanging fruit is gone
    • Have 6500 employees in Vegas (casino/hotel level) – so think that they are pretty efficient given that they have 7,000 rooms

MACAU

  • Take on political climate in Macau
    • Government of China has been very vociferous in supporting MICE and tourism business in Macau
    • As far as Visa & financial restrictions, expect that there will be some restrictions to allow for absorption.  Already said that they want Macau’s growth will be a few points above China’s GDP (~15%)
    • Feel like they are perfectly aligned with the government’s policy
  • Have had some success at growing direct play at FS.  However, junkets often try to steal that business
  • Their real success will hinge on a good balance btw VIP and Mass

OTHER

  • Balance of VIP/Mass play in Singapore given the junket restrictions?
    • They are building their business based on the assumption that they will have no junket business.  
    • Will build their business on direct play and bussing programs (Malaysia for example)
    • Don’t think that many junkets will apply for licenses
    • Don’t know the mix right now, but Singapore is very accessible by flights
    • Piaza club (100 tables) Mass floor (600 tables) Slots (1500)
  • US entity is still very highly leveraged, what are the long term plans?
    • $5BN debt in the US restricted group, and $4.5BN of cash… they can meet covenants as long as they have > $3BN of cash in the bank
    • Once Singapore opens they can see what the cash flow/cash needs will be they can make a decision

Q&A

  • Strategy in PA?
    • Disappointed with the numbers so far.
    • They will put in the tables games (80 tables) at a cost of $16-17MM. Projecting roughly a $25MM benefit from tables that open in the fall
    • No plans to start the hotels again until they can see justification from table games.  Will be using a newly opened Hyatt nearby for table players
    • Will have improved results in Bethlehem, slot facilities take about 17 months to ramp
  • RevPAR in Vegas for 2010 & 2011?
    • Guess is that in 2010 RevPAR will be down – but depends on what people put in for their “casino rooms” but that’s a fudged number since it includes comps.  Cash rooms will have lower rates
  • Will finish Sites 5 & 6 on Cotai with $500MM more equity

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SLOTS: DEEP THOUGHTS

With the Big Three already reporting, here are some observations, some of which we will expound upon in more detail in later posts.

 

 

REPLACEMENT DEMAND

NA replacements for the industry seem closer to 10,000 than our 7,500 estimate but that doesn’t mean replacement demand is necessarily spiking

  • December is usually the seasonally slowest quarter for replacements but seasonality didn’t seem to hold up this year
  • It appears that some operators, having under-ordered all year decided to go the “use it or lose it” path and spent their previously allocated budgets rather than losing them.
  • Anecdotally, almost all the manufacturers stated that they weren’t seeing a big pick up in replacement orders yet despite positive sentiment.  Seems like operators are taking a cautious approach to utilizing their budgets.

 

 

NEW/EXPANSION UNITS

New and expansion shipments in the December quarter were lower than our estimate.  We crossed checked our numbers with several suppliers and don’t yet have a great explanation as to why, since our original estimates weren’t far off of their estimates.  So what happened?  We don’t know exactly but here are some preliminary thoughts:

  • Our estimate included shipments of some participation units
    • The 1,700 units shipped to Alabama’s County Crossing almost all participation/lease
    • Generally 8% of total shipments are participation or lease
    • We estimate roughly 1,000 quarterly shipments into Washington State (replacements) & Florida (conversion to Class III) - these units may be accounted for in replacement demand by operators
    • There is always the issue of timing.  We generally assume that large openings & expansions ship one quarter in advance while smaller ones can go either way depending on timing of opening. Looking back at last quarter it does appear that close to 1,000 units that we accounted for in the 4Q09 were actually shipped in 3Q09.  It’s also likely that perhaps 1,000 units that we accounted for in this quarter won’t be recognized until next quarter
    • Not all the units that go into a new facility or expansion are actually new units, many casinos have some used machines or machines relocated from other facilities to the extent they operate more than one casino. (River City is a good example)
    • Many facilities open with less units than what they announce to name a few (Parx Casino, River City, Choctow Durant expansion)

 

CONVERSIONS

All 3 manufactures reported lower conversion kit sales, why is that?

  • One of our takeaways at G2E was that while manufacturers weren’t explicitly discounting they were throwing more in – like more themes with each title
  • Perhaps content is just better and therefore lasting longer on the floors… we did walk away thinking that all the manufacturers had stepped up their game

 

EARNINGS MANAGEMENT

All three manufacturers have learned to manage expenses to meet guidance and there’s nothing like lower tax rates to save the day.  Tax rates were low across the board.  IGT and WMS reported SG&A and R&D that was below trend and expectation.  BYI posted a very high product gross margin and also lower R&D than we thought.  Revenues were light for each of the Big Three.


HBI: A ‘Do Nothing’ Stock

 

Near term visibility is good, and momentum picking up. But the company should be paying down debt instead of taking acquisitions. Also, we need to bank on seamless production out of new Asia plant and a healthier US consumer to offset headwinds 3 quarters out. Translation = do nothing…for now.

 

Overall, we’re no more or less inclined to own HBI in the wake of its 4Q. Is business getting better? Yes. Inventories are cleaning out while sales accelerate and margins appear healthy. Cash flow looks good – to the point where management is starting to mention ‘the A’ word’ (acquisitions).   The fact that it can think about acquisitions is good, but actually conducting them is not. Let’s face some facts here, HBI has too much debt in a commodity business that is undergoing a massive offshoring change while we’re seeing the greatest Macro cross currents in – well, just about ever. Let’s pay down some debt boys.  Earnings over the next 2-3 quarters look good, as higher cotton costs seem to be offset by previously announced cost cuts. But by 4Q, cotton exposure remains, and we need to bank on the Nanjing textile facility (which started up in 4Q) to be a fully ramped contributor to the business in order to give certainty for 4Q and 2011. In the meantime, the stock is not particularly cheap at 11x earnings and 8x EBITDA based on F10 estimates. For now, this is a ‘do nothing’ stock.

 

 

HBI 4Q FY09 Earnings Call

 

Quarterly Highlights:

  • Reaffirmed 2010 outlook
  • 5% sales growth
  • FCF of $300mm+
  • EPS 25%-35% growth yy
    • Strength in Innerwear - sell-throughs up end of Dec and in first 3 weeks of Jan
    • Pricing likely if cotton stays above $0.70

 

P&L Notables:

  • Sales down 4.5% (up 1% excluding 53rd week in F08) reflecting:
  • Innerwear +5%
    • Innerwear retail sell-through was flat for the quarter: slightly down in Nov, turned positive in Dec with the last two weeks particularly strong, seeing slightly positive sell-through for the first three weeks of Jan.
    • Direct to consumer +5%
    • International +2%
    • Hosiery -1%
    • Outerwear -6% 
  • Gross margins up 181bps reflecting:
    • price increase, cost savings initiatives, and lower cotton costs
    • more than offset the $13 million in incremental trade spending
  • Cotton costs for the fourth quarter was $0.47 per pound, ~$18 million benefit
    • Expect cotton costs to be $0.52 in Q1; $0.59 in Q2; and $0.73 in Q3 (should be able to offset with cost red.)
    • If cotton stays in mid-$0.70 in 4Q of 2010 - pricing in play as they have done before  
  • SG&A up 1.5%up 140bps yy reflecting:
    • Media + incremental $4mm ($10mm higher than last year)
    • $9mm benefit from cost savings offsetting $9mm in pension exp. 
  • Tax rate reduced to 12%, due to a higher mix of offshore profit
    • primarily as a result of domestic restructuring charges and the fourth quarter debt refinancing costs
    • Income tax rate, excluding actions, in 4Q was 3% 

 

  • Nanjing textile facility started production in Q4 and is right on plan
    • plant takes 18 months from start to be up to full production
    • will see impacts beginning in Q4 10 and all thru 2011 
  • Haiti is causing some short-term disruption in incremental costs - will not have a material impact on growth 
  • If inflation becomes systemic, strong brands give HBI the ability to price
  • Have already seen prices move in the industry and this trend may continue  
  • Beginning to think about acquisitions much more seriously and will share thoughts on criteria, priorities, and timing in February
    • Target acquisition price between $100mm and $300mm, must be domestic due to credit term  
  • Direct-to-consumer was previously included in innerwear chg'd with HBI’s strategy to drive retail sales with both the Hanes and Champion brands
    • Direct to Consumer in 2009: 1Q = $38 mil; 2Q = $49mm; 3Q = $53mm; 4Q = $48mm

 

Balance Sheet:

  • Inventory down $242mm (18.7%)
  • Paid down $284 million of debt despite cash outlays of ~$75 mm related to refinancing
  • Flex in leverage covenants - no restrictions on domestic acqs. Or share buyback
  • Pushed debt maturities out to 2013 to 2016

 

 

Outlook:

FY2010:

  • Sales growth of approximately 5% due to shelf space gains
  • Began shipping the new retail programs for 2010: These programs should result in 5% sales growth or approximately $200 million
  • Space gains should generate sales growth of approximately 6% in the 1H and 4% in the 2H
    • If consumer spending picks up, there could be upside to the 4% 2H est.
    • 2 months with the largest increase are March and April
    • growth by quarter is challenging because $20 million to $25 million can easily shift between months
    • By segment, 2/3 of the increases are to come from innerwear, and most of the remainder in outerwear
      • Innerwear gains will come from men’s underwear and intimate apparel. The new programs in men's underwear have already begun to ship, with the new intimate apparel program starting to ship in Q2.
      • Outerwear segment growth will be driven by the expansion of Just My Size in 1H. In 2H, Champion has confirmed space and distribution gains in fleece, performance apparel and sports bras across a broad set of accounts. Production capacity has increased to support growth
      • Both direct-to-consumer and international businesses should also see mid-single-digit growth and both have the most long term growth potential.
      • The remaining growth in the back half of the year will be driven by replenishment of these new programs
  • Goal to improve OMs 50 to 100 bps through costs savings (even with potential commodity price inflation), SG&A savings, and pricing
  • Goal to partially restore media spending from $80mm in 2009, to $90mm in 2010 and eventually back to historical $100mm
    • Interest expense should decline $20 million to $25 million
    • EPS growth of at least 25% and up to 35% or more in 2010
    • To reach the higher levels, HBI will need a little help from the consumer, possibly a little price, and an effective use of the potential $300mm or more of cash flow (domestic acquisitions)
      • See the potential for over $300 million in free cash flow
      • Expect tax rate to be in the 20% to 25% range for 2010 

 

Q&A:

 

  • Top line guidance: “feeling really good about 2010 and growth” retailers are in line right now, and increase in consumer spending would result in more inventory demanded by retailers 

 

  • Late 3rd quarter, early 4th quarter potential acquisition. 100 million to 300 million purchase price, not in negotiations, but looking out for the year

 

  • Era of apparel deflation is over, expect inflation, summer or by 4Q will see pricing take effect

 

  • Nanjing plant doesn’t contribute to production until the back half of the year, the process takes 18 months to get fully running and will only begin to see impacts of supply chain at the very end of 2010.

 

  • Great global low cost supply chain and can leverage it with adding volume from acquisitions
  • Small acquisitions of a couple million dollars are definitely possible and HBI is actively seeking it

 

  • Price increases: starting to see this and could raise prices in the back half of 2010, competitors are increasing prices which are matching HBI’s price increase from last year.  Men’s underwear industry pricing: Fruit of the Loom is $0.50 lower than HBI, private label is $0.50 cheaper than Fruit of the Loom. Oil and Asian wage pressures are potential risks that management is focused on for cost push inflation.  Relative to competition, HBI is very comfortable going forward if apparel industry experiences moderate cost inflation. Mix is favorable in 2010 with innerwear increasing.  Mix is one way to offset inflation cost pressures.   

 

  • Consumer Spending: watch weekly sell thru, inner wear category is their best read on the consumer, saw inner wear stabilize in September, weak in November, strong in December, especially on the back end.  1st 3 weeks of January are slightly positive, appears to be maintining the positive momentum from December.  Summer and beyond is when they are “hopeful” of consumer spending really pick up.  Starting to see a small but noticeable shift from low tier department store sell thru to mid-high tier, not a large move, but consumers are starting to pay up a tiny bit.

 

  • Shelf space gains: Good strong positive momentum. “Momentum breeds momentum.”

 

  • Long Term Growth Rates: will discuss in February at investor day conference

 

  • Gross Margin: additional volume increases will leverage supply chain, but management said to wait until February for more comments there

 

  • Strong shares in mid tiers, mass, and department stores: JCP taking men’s underwear for the first time, any channel shift is not a disadvantage because they have about equal share in mid tier and mass.

 

  • Categories: international and direct to consumer business are the 2 categories with the most room to grow long term. 

 

  • 8% of sales is traditional department stores, Macys is an opportunity, in JWN with hosiery

 

  • 5% revenue guidance is due to the space gains HBI has to make, if there is consumer spending gains that will be to the upside. 

 

  • Cap ex is much smaller than it ever has been because they have built out so much over the time.

 

  • Haiti: 2 buildings are structurally sound, 3,200 employed, 2,000 back today, 40% levels back up, will recover by early March, other plants across multiple hemispheres stepped up to cover the difference so there was no material impact.  Flow of goods is functioning out of a different port for the short term.  Only t-shirt production occurred in Haiti and only 5% of total sales.  Donated $2 mil of product to Haitians to aid the situation.

 

HBI: A ‘Do Nothing’ Stock - HBI S 1 10


GREECE: A VICTIM OF RUMORS?

It was not until it was too late that most people realized Dick Fuld was out of touch with reality.  As late as September 10, 2008, days before Lehman’s bankruptcy on September 15, Dick Fuld proclaimed Lehman was solvent and fully capitalized. 

 

Fact is, Mr. Fuld was not accountable, and had a laundry list of excuses, from naked short sellers, to credit rating agencies, to credit default swaps and the rumor mill.  The sad reality is, he probably thought that the then Treasury Secretary Henry Paulson would bail him out since he was bailing out AIG.

 

As we’ve been focused on over the last weeks, Greece CDS swaps are blowing out to the up side, while just today Prime Minister George Papandreou said Greece is being victimized by “rumors” in financial markets.  Further, he’s on the tape denied that Greece is seeking to borrow from the European Union to finance the country’s budget deficit.  While suggestions of international assistance are, according to the Prime Minister, “unfair”, I’m sure Dick thought the same thing....

 

Greece, which has a culture of levering debt upon debt that dates back centuries, is dealing with a credibility issue in a period of weak GDP (see chart below), which only further exacerbates its leverage issues as the government is hampered with cutting spending while attempting to stoke growth. Greece’s budget deficit is at 12.7% of GDP (four times the EU’s limit), as European Central Bank president Trichet says he’s “confident” that Greece will fix the problem.

 

We’re less confident in Greece’s leadership to fix the problem and are calling this spade for what it is, a sovereign debt crisis in the making.

 

Howard Penney

Managing Director

 

Matthew Hedrick
Analyst

 

GREECE: A VICTIM OF RUMORS? - GR1

 

GREECE: A VICTIM OF RUMORS? - GR2

 


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