August 3th, 2006 - Minyanville.com
Vitaliy Katsenelson, CFA
Jos. A. Bank (JOSB) is up close to 6% after reporting truly unbelievable sales numbers for July: same store sales were up 16% and total sales were up 28%. July's performance has validated my view on the stock that you are about to read.
What does it really mean “being contrarian?” Doing the opposite of what everybody else is doing, all the time? What if you agree with what everybody else is doing? Should you disagree for the sake of being contrarian?
“Being contrarian” means being able to think and act independently of the crowd and not be swayed by the crowd thinking. It means to stay on your own autonomous thinking track, independently of the direction the crowd is taking, even if it requires going against the crowd. It means not accepting (though respecting) the market’s wisdom unconditionally, but attempting to develop an opinion of your own.
Yogi Berra’s saying “In theory there is no difference between theory and practice. In practice there is,” could not be more true when it comes to contrarian investing. In theory it is easy to be able to think and act independently; however, in practice it becomes a very lonely and trying experience. Emotions that we don’t experience in the theoretical state overcome us in "the in-the-practice-state."
Investing in Jos. A. Banks requires the investor to be a contrarian. Wall Street hates the stock for sending share price from the mid 40s in April 2006 to the mid 20s. The stock is trading at a pitiful 12 times forward earnings. The stock has been slaughtered as Wall Street did not care for the earnings miss in the first quarter coupled with higher inventories.
At this price, the market expects no growth from the company, but the market could not be more wrong. Here is why:
In December of 2005, JOSB delivered 20% same store sales; management has likely expected this trend to continue and has built up a significant amount of fall inventory. However, weather was not on the company’s side, the spring ended up being warmer. The 20% same store sales comps of December did not come through in the following months and that, coupled with warmer springs, sent management on a fall close discounting spree. Management admitted that it was too aggressive in discounting fall merchandise, with the benefit of hindsight it did not have to do that.
It is hard to tell what the next quarter will look like, but that would be focusing on the trees in the forest and not on the forest. However, the future (the forest) appears to be bright for this company. I recognize that managing business involves making decisions under uncertainty. In the first quarter, management made a mistake, I believe that mistake will have little consequence in the long-term fundamental picture of JOSB.
Inventory is Not An Issue
Retailers live and die by their inventory; it is the lifeblood of their retailing business. Too little inventory means the company doesn’t have enough goods to sell, too much inventory means the company has to heavily discount merchandise in order to clear the inventory. So here is the perceived bad news about JOSB – its inventory days have almost doubled over the last six years from 173 days to 334 days. It is twice the amount of its most comparable competitor, Men’s Warehouse (MW) whose inventory days have stayed in a very stable range of 153-169 days over the same time frame. That is just bad, isn’t it? On the surface, inventory numbers look terrible.
Over the last six years since the new management team has taken the reins of Joseph A. Banks, it has intentionally increased inventories per store. Why am I not worried about high inventory levels? Not all inventories are created equal. Inventory increases at a grocery retailer, like Kroger (KG) may lead to higher spoilage and thus lower profitability. Teen apparel retailers, like American Eagle Outfitters (AEOS) and Abercrombie and Fitch (ANF) need to have a fairly high inventory turnover, as teen preferences for the size and location of holes in their jeans could change with Britney Spears' new CD. However, when it comes to men’s apparel, the men’s tastes rivals the speed of the ice age. Blue shirts and stripe suits have been in fashion as long as...well, forever.
Instead of looking at JOSB's inventory as a risky, unstable assets which may have to be discounted by the retailer to clear the shelves (which is usually is the case for other retailers), one should look at it as an investment in long term assets, not unlike investment in store improvements. Though increasing inventory per store is counter intuitive for retailers that strive to achieve Wal-Mart (WMT)-like inventory efficiency, JOSB customers come to the stores only once or twice a year. The company wants to make sure that the customer finds everything he desires in the right sizes, knowing they won’t be back for a long time. The inventory increase was mostly done on the availability of more sizes, not in greater variety. As customers found the merchandise they liked and the sizes that fit – they bought more, driving same store sales and operating margins at the same time. Also, reading the transcripts of the conference calls from 2004, management has been constantly saying that raising inventory is a part of the company’s strategy.
This strategy has paid off handsomely since it has been implemented; earnings and sales have grown in double digits, margins expanded due to increased same store sales and most importantly, returns on assets (despite higher asset base due to increased inventories) have more than doubled. JOSB has beat Men’s Warehouse hands down on every aforementioned measure! Despite substantial increases of inventories per store, JOSB more than doubled its store base and achieved that mostly from its free cash flows.
The good news is that JOSB is in the last inning of inventory increases. Although the inventory of new stores will still be climbing as they will be brought to company’s average level, management indicated that they are happy with the inventory levels at the matured stores.
Pristine Balance Sheet
JOSB is allergic to interest bearing debt as it was a byproduct of a leveraged buyout, though it does compare to most retailers' operating leases. The company has almost no interest bearing debt and has an available credit line of $125 million that is used to finance seasonal capital needs.
Management has stated that they plan to bring the store count from 329 today to 500 in 2009, which will be financed by internal free cash flows. But it has been mute about the plans beyond that. Logically, the United States should be able to support more than 500 stores, which are only about 4,500 square feet. There is also life beyond the United States, though it's riddled with more unknowns.
This is probably the biggest risk facing this stock. Economic slowdown, deflation of the housing bubble and a weaker stock market are all risks that could create the headwinds for consumer spending and thus for the stock.
Though not immune to economic slowdown, the majority of JOSB customers make over $100-125 thousand a year and are less sensitive to an economic slowdown. Business suit or slacks purchase decisions could be postponed if one is not certain of what the future holds, however, clothes rip, coffee gets spilled and new ones need to be bought.
One way to gauge how the JOSB customers will behave during a recession is to look at their behavior in the last recession – average same store sales in 2002 were 6.6%, not bad for any environment.
The Hidden Asset
JOSB has a hidden asset which is not apparent to most investors looking at the company’s operations on the surface, half of JOSB stores are less than three years old. “So what?” - You’d ask. It takes close to five years for a store to reach companywide average sales and operating margins of 23%. A store that is less than three years old has a profitability of 10% below company average. This makes sense, as a very large portion of the costs of running a store (rent, salaries, utilities etc...) are fixed. These costs are more or less the same, either sales are at $0.9 million approximate average sales of a new store, or they are at $1.6 million approximate average sales of a relatively mature store. As new stores mature, sharply rising same store sales arrive with much higher margins. Today, company’s margins are depressed with half of its stores being relatively new, but as they mature, margins will rise and earnings and free cash flows will go through the roof.
I estimate the company’s net margins will rise by about 3-4% and the company will earn somewhere around $5 in 2009. Slapping a 10 times P/E (no growth) multiple we get a $50 stock. There is plenty margin of safety in this stock.
Vitaliy N. Katsenelson, CFA
Positions WMT, JOSB
This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.