In the last post we looked at several assumptions that, when accepted as more-likely-than-not correct, paint a picture of Aeropostale as a business with a market that’s not going away and seems to benefit from barriers that would prevent competitors from encroaching. On those fronts, it shows real promise as an investment opportunity.
Now I want to look at a few scenarios for thinking through its value. When we initiated our ownership position in late-October, ARO was trading just below $14 per share. Today it’s nearer to $18, and we’ll use the more current price in considering a range for its intrinsic value.
For the following, we’ll use these given assumptions:
1. ARO has 4.2 million square feet of retail space across its store base,
2. It will be taxed at 40 percent of operating income,
3. It has about 82 million shares outstanding, and
4. Its current share price is $18.
Now, let’s plug in some variables to see how the business looks on a price-to-value basis.
Scenario I: Ugly Forecast
Here we assume that ARO continues taking a licking. Sales drop 20 percent from its 2010 high of $626 per square foot. Gross margins match the lowest of the previous ten years. And SG&A expense are the highest in ten years.
At the conclusion of a year with this sort of performance, the market would certainly punish ARO further. Unless this was clearly the bottom of the business challenges, the drop may be warranted. If it were the bottom, it would represent an excellent buying opportunities if we continued to believe in the assumptions from the previous post (i.e., that ARO is a strong business in a niche market with long-term protection against competition). Indeed, the scenario reflects what happened to ARO in October 2011 when it dropped to a long-time low of a little more than $9 a share.
So, if performance continues to deteriorate and key metrics revert to multi-year lows, there is easily the potential that the investment loses 50 to 60 percent of its value. That would hurt, but (again) if you believe in the assumptions, you would see this as a temporary set-back and an opportunity to jolt your returns by buying more shares.
Scenario II: Rosy Outlook
Here we assume that ARO reverts to its best performance over the previous ten years, though I only assume a 12-15x multiple on its earnings. (It’s worth highlighting the multiple is probably on the low side of what the market would do. I believe buyers would be energized and optimistic, rewarding the stock with an multiple around of 20x.)
That might be fun to think about, but I wouldn’t put money behind it. Suffice it to call this the upside scenario and leave it there.
Scenario III: Going By the Averages
Not too hot, not too cold. This is the one I put my money behind. The plug-ins are conservative based on ARO’s actual average performance over the past six or so years. The multiple range remains below the S&P 500 market average, despite ARO being a business with excellent returns on invested capital and a history of compounded earnings growth in excess of 20 percent.
To build an intrinsic value calculation for the business, I would take this “averages scenario” with $191 million net income, grow earnings at a conservative five percent compounded, and pay out excess cash in the form of share repurchases. At an 11x earnings multiple, it’s not difficult to see the business worth nearly $60 per share five years out for a 27 percent compounded gain on the investment.
If you have the conviction that your analysis is roughly accurate and your assumptions sufficiently conservative, $18 per share is a great place to build a position.