RTCrawford's Weblog

I don't make this stuff up. I'm not that smart.

Response to AEO Board Issues

with 4 comments

There have been a number of responses to my earlier post – expressing different objections – so, I’d like to address each in a single response, as a time management convenience.

Misanthropope writes, “You could find plenty of companies that are worth less than their book value- most of the S&P 500 as a matter of fact.” I am not sure what source Misanthropope is referencing, but I just ran a query using the Yahoo finance stock screener using two query criteria – all the stocks in the S&P 500 and a price-to-book ratio that is less than or equal to 1.0 –, and there are just 53 that meet the criteria (roughly 10%). Strong and stable companies selling at less than their book value are exceedingly rare. In fact, the list of those 53 stocks meeting the criteria represent a who’s who of banks and financial institutions considered at risk from the current financial crisis (along with a number of non-financial stocks). The use of this metric (stocks selling at less than their book value) is a criteria identified as desirable by Benjamin Graham immediately following the market crash of 1929. Even then, Graham noted the difficulty of finding such companies.

Bostonkenmore notes that a portion of the company’s book value is attributable to auction rate securities, which he anticipates will ultimately be valued at less than face value. The amount held in auction rate securities was originally something on the order of $300 million (if memory serves), which represents a a comparatively small amount for this $2.91 billion market capitalization company (with an enterprise value of $2.57 billion). Moreover, while the negotiated settlements concerning auction rate securities seemed destined to leave individual (i.e., small) investors less than whole, the settlement provides for return of the full face value to the remainder. Under the terms of the original agreement, interest paid to the lender (i.e., American Eagle) during the interim is abundantly attractive (strongly exceeding the risk-free cost of capital – i.e., the yield on the 10 year bond). It is, in my opinion, premature to mentally write down the value of the auction rate securities when it comes to valuing the company and its stock. Until, however, the company has the cash in hand, it is fair to assert that this remains an uncertainty.

It should, however, be noted that the auction rate security issue is only a concern if those funds are necessary to sustain operations and prevent the company from entering into a death spiral due to losses. For the trailing 12 months, however, the company’s interval measure comes in at 270 days survival with current assets. This calculation does not include the auction rate securities, which, as Bill noted earlier, have been moved into the long-term assets bin. The current ratio and acid test for the trailing 12 months comes in at 2.30 and 1.55, respectively. And, at $231 million for the trailing 12 months, free cash flows remain positive. In other words, there is nothing in the financials to indicate imminent bankruptcy, much less significant losses that threaten the viability of the company.

Bostonkenmore also references goodwill, which, as he asserts, would be written down if the company were to perform “very badly.” This, of course, is true of any company, but it seems somewhat less likely with American Eagle. One of the most prominent contributors to “goodwill” is the excess a company pays to acquire another company, above and beyond the acquired company’s book value. American Eagle has an established history of growth through internal expansion, rather than acquisition.

In a separate comment, Bostonkenmore notes the necessity of making certain accounting adjustments when calculating ROIC. While I do provide a run chart of ROIC, the purpose of that chart is to compare the most recent five years data with five years of data at the start of the prior decade. This is why I have overlaid the 1, 2, and 3 standard deviation control lines above and below the mean for both periods, with the most recent five years evidencing a trended/sloped process control chart overlay. The purpose of doing this is to display the statistical significance of increases or decreases (i.e., are the most recent results three standard deviations above or below the norm).

It may be argued that the accounting adjustments are necessary in order to achieve validity. Those adjustments, however, strike at the company’s capital structure as its core foundation. Capital structures typically do not change significantly from one year to the next or, for that matter, during the span of a single decade. Nevertheless, it is necessary to check for this in order to employ the chart as I have done. The capital structure can be analyzed based on a breakdown of return on assets, segregating ROA into capital structure and common earnings. In the case of American Eagle, the capital structure contribution over the past decade has fluctuated marginally between1.31 in 2003 and 1.41 in 2001 – with the other years falling in a more narrow range between 1.35 and 1.40. This relative level of low variation is important, because the chart is not designed to calculate the results with absolute precision but, rather, to calculate the results consistently and note whether the results are increasing or decreasing by a statistically significant degree.

Moreover, this singular chart focusing on return on invested capital is accorded less importance than the earlier chart focusing on cash return on invested capital. Return on invested capital is net income (net of dividends) divided by total capital, while cash return on invested capital is earnings before interest, taxes, depreciation, and amortization divided by the total value of equity. More importantly, cash return on invested capital, as I calculated it, is based on free cash flows (cash from operations minus capital expenditure). The intent of that chart serves two purposes that are unrelated to BostonKenmore’s expressed concerns. Namely, to serve as a comparison against weighted average cost of capital and to determine the degree to which cash return on invested capital is capable of accommodating economic downturns. As explained more fully in the various blog entries, American Eagle provides a healthy margin of safety on both accounts.

Bill Ellard, for whom I have great respect, asks about adjusting return on equity to account for leases. I’m afraid I don’t have a great answer for this legitimate concern, beyond noting that lease expenses are accounted for under expenses (in the aggregate). Because leases tend to cover multiyear periods, there is a certain element of total same-store stability for this portion of the company’s cost structure. Because leases start and end at different times (i.e., years), significant shifts in lease expenses (increasing or decreasing) tend to occur over several years – providing the attentive investor with extended prior warning if the trend turns against the company. This is, typically, less of a concern during economic downturns, when lease pricing flexibility is undermined by reduced demand. Of course, this is counterbalanced by inflation for the property owner, if that inflation increases the cost of production (i.e., maintenance of the facility, staff wages, etc.). In the current environment, there is concern that we may be entering a period of stagflation – with the primary inflationary forces attributable to petroleum and commodities. Neither strike me as a significant contributor to the property owner’s operating costs, even though increasing petroleum prices will unavoidably impact the property owner. Commercial real estate, however, is not a transportation-Fleet-intensive operation.

Having addressed these concerns individually, lets turn to the collective tone. During periods of economic uncertainty, there is a tendency to view the glass as more than half empty. Just as it is wrong to adopt the market’s exuberance during Bull markets, it is an error to adopt its depression during Bear markets. At either extreme, mispricings are common. Recently, I’ve been less active on this board – primarily due to work obligations but, also, because I recognize that much of the commentary by new arrivals delves no deeper than a simple expression of opinion in support of their market wager (long or short). This is akin to rooting for a favored sports team or rooting against a despised team (personally, I support any team playing against Duke). Well, opinions are fine, and they make investing fun, but responding to them invariably takes the exchange into a recurring loop of “yes, it is” and “no, it isn’t.” In this case, I responded because the low-end price target went beyond what a reasonable investor would conclude (given analysis of the fundamentals). Of course, an extreme prediction is not wrong simply because it is extreme, but it is not right simply because it was asserted, either. And, having been challenged on my position (for which this and my blog entries serve as my response), perhaps it would be beneficial to have the original poster defend the $7 per share target.

So, lets analyze Bostonkenmore’s original posting.

Paragraph 1: “Its certainly possible that AEO could have a string of very bad years with no end in sight. This has happened to many retailers in the past and will probably happen to more if consumer spending really does fall in the tank and doesn’t recover.”

In philosophy, there is a fallacy of logic known as “Strawman” – starting a position with assumptions or “givens” that lack validity, in order to easily defeat it. In this case, the strawman resides in the expression “… with no end in sight.” Most recessions last no more than 18 months, and the worst recessions since the market crash of ’29 ran marginally longer than three years. Of course, “… with no end in sight” is largely a function of the observers vision (some have it, others don’t). Regardless, “years” is a plural term (implying more than one), and 18 months is less than two years.

The second strawman is the assumption that consumer spending will not recover. At no time in the history of this country (or any other industrialized nation), has the consumer gone down for the count and been carted off in a pine box. So, the assumptions seem abundantly unrealistic if taken literally, and gratuitously alarmist if taken figuratively. Besides, the consumer accounts for 70 percent of the US economy, and the other 30 percent derive their health and well being from that 70 percent. If the scenario comes to pass, no investment (regardless of sector) is likely to survive, much less thrive. Not even healthcare or the pharmaceutical industry could continue under such a steep depression. And, given the role of the US economy internationally, foreign stocks seem unlikely to represent promising investment opportunities.

Paragraph 2: “In that case you are probably talking about EBITDA margins in the 12% range. Which means they earn about 40-50 cents a year or so. Of course if they did that, Schottstein would probably stop spending so much on capex and opening new stores. What’s the point of keeping up on spending that doesn’t make your cost of capital?”

This paragraph represents a hyperactivity of unrelated ideas and undefended assumptions. Allow me to support both criticisms.

First, current capital expenditure levels are unrelated to such an extreme estimate of earnings. If the company were to witness a 40 cent EPS, it is unlikely the company would maintain the current level of CapEx. So, why is it relevant. That is like saying I would have to resign from my current job if I died in a car crash. If dead, the formality of resignation would be the least of my worries, just as sustaining current CapEx would be a non-issue if on the verge of bankruptcy.

Second, 40 cent earnings represents a 75 percent reduction in earnings if compared to the trailing 12 months. Yes, 40 cents would hold some validity if the depressive assumptions in the first paragraph came to pass, but no support (logic, economic, or otherwise) is offered in support for that extreme scenario. We would all behave differently if the sky were falling.

Third, there is no distinction made between maintenance CapEx and growth CapEx in the criticism of AEO’s expenditures – both are treated as if they were one and the same, and this is a mistake (provably so). Maintenance CapEx includes sustainment of current operations (replacing cash registers and displays when needed). Surely this is not indefensible. Maintenance CapEx also includes upgrading the computer systems designed to reduce inventory tracking and operating costs. This, too, is not unreasonable, unless arguing that the company should fall behind the industry’s professional standards and incur unnecessary operating expenses. As for growth CapEx, the company is undertaking several different growth initiatives. Of them, M&O is the only one that has recurrently failed to cover the cost of production, and the marginal difference between the two (earnings and cost) has narrowed significantly, with indications that the improvement will continue and, if not, that management is prepared to pull the plug. There are, however, only 19+ M&O stores, compared with 929 American Eagle Outfitters stores. The AEO stores, the 39 aerie stores, and the 77 Kids online presence exceed their cost of capital.

Of course, just as a little brain cancer can kill the larger patient, it is entirely possible that the M&O costs (regardless of M&O’s small number of stores), could prove sufficiently detrimental to the company’s overall performance to warrant such a derisive criticism. But this doesn’t seem to be the case. Cash return on invested capital for the company exceeds its weighted average cost of capital, even in this recessive economy, and the company’s Earnings-Power Value exceeds its Replication Value … not just this year but for every year over the past decade. In other words, this criticism is akin to declaring your mother unfit because she has a pimple. If perfection is the basis of critique, the investor is best advised to short the entire market.

And that is my take on all on all this. Feel free to pot-shot it to your heart’s content, but, having provided the logic and supporting data, I don’t see the utility in an ad nausea dispute over trivialities. Yes, every model can be made more perfect and every strength can be analyzed until an imperfection is identified. The financial statements, however, are audited … which means the analysis of them is unavoidably imprecise. An audit is a random assessment of the entries to determine whether the larger system of accounting is sufficient. It is not a thorough scrubbing of each entry. Consequently, small inaccuracies abound, and they can be magnified or made less accurate with an abundance of altering adjustments – making the good the victim of the perfect. The best that can be hoped for is to consider the strengths or weaknesses of the components in order to seek corroboration (consistency) between them and to assess the value of the whole. Otherwise, to borrow from MLK, the exercise degrades into the “paralysis of analysis.”

So, the question becomes one of whether the company is profitable, can that profitability be sustained, and is the stock selling cheaply in comparison to the value of the whole? For the reasons provided, I’ve concluded that it is, and I’ve provided the numbers and the analysis in support, without devolving into alarmist scenarios lacking even minimal evidence that they are likely or looming. To counter that position, it will be necessary to exercise the intellectual courage of putting up the opposing numbers, support the underlying assumptions with content and data, and exposing such a model to the same critique of the specifics. And, even then, it all boils down to the judgment of individual investors. I’m comfortable with my analysis, and I am abundantly dissatisfied with the opposing analysis … because there has been none offered. WordPress, my friends, is free, and, pro or con, only one side has been presented.


Written by rcrawford

August 23, 2008 at 6:42 am

4 Responses

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  1. i think you just refuted the inverse of my comment:

    “Misanthropope writes: “You could find plenty of companies that are worth less than their book value- most of the S&P 500 as a matter of fact.” I am not sure what source Misanthropope is referencing, but I just ran a query using the Yahoo finance stock screener using two query criteria – all the stocks in the S&P 500 and a price-to-book ratio that is less than or equal to 1.0 –, and there are just 53 that meet the criteria…”

    i didn’t say there were lots of good companies you could buy at book value, i said there are lots of companies that wouldn’t be worth buying at book, even if you could.


    August 25, 2008 at 3:29 am

  2. Hey Robert!

    Its Amit from F*ckwallstreet,

    I just wanted to say I really admire your work on this website and your in-depth study of Investing sensibly.

    Best wishes! Have a joyous new year!


    December 29, 2008 at 10:35 pm

  3. Thanks, Amit — especially, for the reference to Joe Ponzio’s FWallStreet.com. Joe is an old friend and, in my view, the most cogent educational voice when it comes to value investing on the web.



    December 30, 2008 at 2:07 am

  4. Hello.
    I’m new there
    Nice forum!


    February 15, 2009 at 11:44 am

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