RTCrawford’s Weblog

Max at the AEO board asked that post my analysis of the stock, which I’ve done. In reviewing those postings, there are a small number of charts that were left out, in order to make those postings more palatable to the average reader. I’d like to take a minute to provide them here, starting with the common ratios:

There are to items worth noting. First, the days inventory number over the trailing 12 months is consistent with management’s comments — indicating efforts to reduce this figure during this market decline. The second is the change in the long-term debt position of the company, which increased a scant 0.05 and is consistent with the ARS issues (which should be resolved shortly).

In my AEO board posting, I referenced the use of sensitivity analysis as the best available tool for overcoming the uncertainties associated with identifying intrinsic value. In other words, we can calculate intrinsic value by a number of different approaches, but no approach entirely eliminates some measure of imprecision. The above chart indicates the degree to which the company is overvalued or undervalued (y-axis) in comparison to various growth rate assumptions for the next decade (x-axis). This is based on discounted cash flow analysis, using a 15 percent discount rate, assumes a 5 percent growth rate during the second decade, and applies current shareholder’s equity as the residual value of the company. As indicated here, the company is fairly valued if expecting that the company will growth at 5 percent per year over the next two decades. Any growth rate greater than that would indicate (to varying degrees) that the company is undervalued at today’s market price.

In the “Did I Goof” posting, reference is made to Replication Value, Earnings-Power Value, and comparing the two. Here is a chart that displays each:

This indicates that a new entrant into the market would need to spend the equivalent of $10 per share to replicate AEO’s current standing and that the company’s franchise value is worth an additional $8 per share, for a current value just over $18 per share. Neither, measure takes into account the value of future growth initiatives (which would increase the value of the stock further). That Earnings-Power Value exceeds Replication Value in each year of the prior decade indicates that investment in growth is warranted and benefits the shareholder.

The company’s Piotroski score is an 8 — which indicates that the share price appreciation prospects are significant, based on the research of University of Chicago Business School Professor Joseph Piotroski. It is important to understand the rarity with which company’s achieve the buy recommendation levels of an 8 or 9.

Our recent AEO Board discussions have centered around conjecture over whether the company is ripe for bankruptcy or likely to witness a stock price decline down to the company’s book value (according no premium for future growth and tacitly arguing that current profits will disappear and never return). There are two measures of the company’s short-term bankruptcy risk. The first is the Interval Measure (i.e., days survival) found in the ratios chart (above), and the second is the Altman Z-Score (chart immediately above). The first measure indicates the company could survive for just under 270 days on current assets alone. The second measure, at 8.6, significantly exceeds the bankruptcy threshold of 1.81. In other words, this company is not destined for the bankruptcy courts anytime soon, despite assertions to the contrary by those with short options.

This chart (above) provides the Dupont breakdown of Return on Assets, along with the isoquant curves. In recent years, the company has reduced asset turnover in favor of profit margins — focusing on quality above quality. This is a point that has been made often on the AEO board, and it explains the company’s performance in comparison with several of its low-cost competition — where competition of quality has not been a contested issue. While not the most expensive provider of teen clothing, this mid-market company is not the least expensive, either.

There are several interesting items in the previous graph. First, note the decline in Cash Return on Invested Capital (which is just around 15 percent, after a decline from roughly 30 percent). This is why the normal threshold requirement for new investments is set at 13 percent for reputable firms. Things may decline further in this market, but the investor still enjoys a substantial margin of safety on this front. The second item is the relatively small decline in shareholder’s equity in the most recent reported year. Personally, I am of the view that the stock was overvalued at its peak and is presently undervalued. If, however, of the view that the peak value was reasonable, the decrease in stock price of greater than 50 percent would seem unwarranted if based on the actual results. So much for the efficient market theory.

And the last chart provides the compounded rate of return if expecting that the company will grow at 15 percent over the next decade (5 percent in the second decade, 15 percent discount rate, and shareholder’s equity providing the recurring value) and believing that the market will eventually value the the company at its estimated intrinsic value. The rate of return is provided along the plotted line, while the number of years holding the stock prior to realization of intrinsic value is provided along the x-axis.