Description

While AnnTaylor Stores is poorly positioned in this economic environment as a retailer of higher-end women’s work clothing, these terrible macro conditions will not persist forever for those retailers strong enough to survive them. I came across this quote that I believe is relevant here:

 “Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished. In fact, does anyone think that today’s prices will prevail once full confidence has been restored?” -- Dean Witter in May 1932

ANN is trading for 0.9x TTM EBITDA and over a 50% discount to its 1991 IPO price. It will undoubtedly earn dramatically less in the next year than it did in the trailing twelve months but the company has $80 million of cash and an additional $250m of undrawn credit lines to see it through the current challenging times. While many levered retailers are in jeopardy and fighting for their very existence, I believe ANN’s conservative balance sheet will help it survive whatever the economy throws its way in 2009. In a more normal environment, ANN could earn at least $1.00 per share and trade for 15x representing almost a triple from current levels. Peak EPS in 2007 was almost $2.00 per share and longer term, as the company continues rolling out new stores, new growth avenues within its existing stores and altogether new retail concepts, there is every reason to believe it could earn more than $2.00 someday. 

Business Description

ANN is a specialty retailer of women’s apparel, shoes and accessories targeting the 25 to 55 year-old age demographic. The company has two concepts each of which also has a separate outlet brand. The original AnnTaylor focuses on professional and special occasion apparel while LOFT offers more relaxed and casual merchandise for a moderately younger and more price-sensitive consumer. AnnTaylor Factory and LOFT factory offers factory-direct product in an outlet environment. At the end of 3Q08 (technically 3Q09 because the fiscal year ends January but for the purposes of this write-up I will refer to each fiscal year by the calendar year that proceeds it) the company had 346 Ann Taylor stores, 517 LOFT stores, 92 AnnTaylor Factory stores and 14 LOFT outlet stores. LOFT is approximately 50% of revenues, AnnTaylor is approximately 30% and the Factory/Online channel is roughly 20%. 

The company was founded in 1954 in New Haven, CT. The business was owned by the Liebeskin family through 1977 when it was acquired by Garfinkels which ultimately became part of the Campeau Corporation in 1986. The company grew from 30 AnnTaylor stores in 1980 to 119 by the beginning of 1989 when it was acquired by management and Merrill Lynch Capital partners for $431 million. AnnTaylor IPO’d in its current form in late 1991. In 1995, ANN began testing the LOFT concept and in 1998 decided to roll it out nationwide. 

Over the last decade, the company has been a solid growth retailer but it has not been immune to stumbles including 2001-2 and 2004. In general, several moving parts drive profitability. The overall backdrop for specialty retailers certainly provides the headwind or tailwind for companies like ANN but the other key and related factors include both getting the fashion right in any given season and correctly predicting demand in advance so as to keep inventories in-line. Unfortunately at the moment the trend of all of these inputs are simultaneously negative: 1) the consumer has essentially shut down in this recession; 2) ANN is not perceived as offering cutting-edge fashion and its orientation towards women’s suits seem out-of-touch and 3) it dramatically overestimated demand in light of the previous points. The result is a perfect storm in which ANN has been forced to dramatically mark down its offerings to drive traffic and move the seasonal inventory. Just prior to Christmas, I saw a LOFT store offering “buy 1 item and get another free” in a Midwestern shopping mall. Most recent comps have been simply awful. In the third quarter (before the consumer really fell out of bed) AnnTaylor comped down 25% while LOFT comped down 15%. Its bad out there for ANN and that’s why the stock price has fallen from $20 to below $6 in the space of only three months.

Now of course ANN management is not standing still while all of this is going on.  ANN management began their restructuring efforts in January 2008 but recent macro weakness drove them to accelerate their plans.   In January the company initiated a 3 year restructuring plan and in November it announced that this plan would be expanded and sped up. The program included the closing of 117 underperforming stores, reducing corporate staff and undertaking a “productivity initiative” that included an attempt to improve procurement of non-merchandise goods and services. The total annualized savings are expected to be $80to $90 million and will come at a total cost of $65 to $70 million. Notably, $59 million has already been taken.  The operating income contribution of the 117 stores was negligible so $200 million will come out of sales without any impact on the bottom line.  In addition to this restructuring plan, the company also announced several new hires and reorganized managerial responsibilities to both push down certain functions previously done at corporate as well as free up senior management’s ability to focus on the larger strategic issues.  The CEO had also been running LOFT since its president left in January 2007 until a new division president was hired in November 2008.

So what happens next? The most important action item is bringing inventory “in line” with lower sales. When management bought its fourth quarter inventory earlier in 08, it was expecting single digit comp declines versus the closer to 25% declines it is experiencing; therefore, it has been forced to dramatically mark-down its merchandise to move inventory. The company stated on its most recent earnings call that it was able to buy for the first quarter (in which it underordered) and second quarter (bought in November) according to the recent terrible sales levels. And ANN will not have to order for its third quarter until February so it will be able to see the magnitude of the downturn in 4Q08 by then. In short, management believes inventory will be in-line with lower sales levels by the beginning of 2009. 

From a product repositioning and rejuvenation perspective, ANN management believes there will be evidence of improved styles by Fall 2009. The reasoning behind this time frame coincides with the first complete season post the hiring of the new management team. This new team includes new division presidents and senior design staff. While it remains to be seen how effective all of these efforts will ultimately be, at least management seems optimistic about its chances. 

Financials and Valuation

The following table illustrates just how cheap ANN looks off trailing metrics. Of course, EBITDA will be much lower going forward and tangible book value is likely overstated given the needs to mark down inventory:

I think it is extremely difficult to accurately model the near term future performance of ANN but the historical financials (and a one quarter forward estimate) can provide a sense for how the company has grown over time. Note the operating leverage in the business as EBITDA margins are projected to nearly halve this year on a relatively small decrease in the sales base:

One way to assess how the market is pricing the company’s future is to look at an LBO analysis. Obviously today this is not a relevant exercise in the absence of credit markets but at some point sanity will return. I used the following assumptions:

• Annualizing last quarter’s EBIDTA of $25 million and holding it constant for 5 years (conservative as it gives no margin benefit for in-line inventory or for a portion of the cost savings)
• 40% tax rate
• The financial sponsor is able to get 3 turns of leverage at a 10% interest rate (not aggressive)
• $50m of excess cash can be used to fund the transaction
• Depreciation is $100m and capex is $25m in the first year, $50m in the next two years and $75m in the next two years as on the last earnings call management indicated maintenance capex was $25to $30m in 2009 but clearly with depreciation so much higher this is not sustainable.
• The financial sponsor pays 4.25x $100m EBITDA which would be 30% equity in the deal (a metric which many banks look to and in less heady times seemed to be appropriate)
• In five years there is no multiple expansion but the sponsor is able to sell the company at the same multiple it paid for it.

Collectively, this scenario suggests a sponsor could earn a 20% 5-year IRR on $125m of equity by paying approximately $7.50 per share. Given these attractive dynamics, I believe at a minimum the stock will move to some degree with the recovery in the credit markets as financial buyers regain some ability to finance transactions.

Another valuation yard stick tries to build a bottoms up analysis of the store base to determine potential earnings power in a normalized environment free of markdowns. This is a very imprecise look at how flexing the sales per sq. ft metric across the store base:

Could the stock trade to 6x the low case or $3.00? Potentially -- although that would seem to be a low multiple on trough earnings. But clearly there is a lot of potential for earnings to recover. Even if the company only earned a dollar the stock would likely offer substantial appreciation potential from here. 

Investment Positives

Very strong balance sheet: ANN’s $80 million of cash and $250m of undrawn debt facilities available until April 2013 will enable the company to survive this downturn while other more levered retailers may find themselves going the way of Linens and Things or Circuit City. Specifically, the debt has no covenants provided total available liquidity remains above $37.5 million (liquidity is defined in the credit agreement as cash - $37.5m + 85% of inventory + $15m). Moreover an apparel business model should never burn too much cash as long as inventory is in line which leads to the next point.

Excellent history of free cash flow generation: Backing out growth capex, ANN has never burned cash from a free cash flow perspective for as long as it has been a public company. This should give value investors confidence that the company has a business model that can weather the storm even if the company burns cash for the first time in the next few quarters as it takes a hit to its margins as it adjusts its inventory levels to the new consumer reality.

Vendors not likely to freak out: Though Circuit City had a net cash balance sheet it still ran into liquidity issues because its sophisticated vendors like Sony and Panasonic grew concerned and demanded cash on delivery. This is far less likely to happen in this situation as small sewing companies will not be able to impose such strict terms nor would they be as likely to grow concerned. No vendor makes up more than 4% of merchandise purchases; 38% of merchandise is manufactured in China, 17% in the Philippines and 5% each in Hong Kong and Thailand.

Restructuring should provide savings: Management’s accelerated plan to close 117 stores in three years, trim its cost structure and cut back on capex is estimated to provide annualized savings of $80 to $90 million overall and $35 million in 2008 alone. This is significant as it 350bps of margin improvement of 2007 sales levels when the operating margin was itself 4%. The total costs to achieve this restructuring are estimated to be $65 to 70 million of which $59 million has already been taken through 3Q08. 

New management complements a successful CEO: ANN’s CEO Kay Krill originally led the roll out of LOFT before ascending to the helm in 2005 and she clearly knows how to grow a retail concept. New CFO Mike Nicholson who joined in late 2007 is also excellent and lends confidence to the likelihood of success in the restructuring. He came from the Limited where he served as CFO and COO of Victoria’s Secret Beauty. CEO Krill also indicated that the final pieces of her management team were recently put into place with the hiring of two new division presidents. Christine Beauchamp, who also was with Limited Brands, most recently as President and CEO of Victoria's Secret Beauty (where she worked closely with Mike Nicholson) will run AnnTaylor while in November 2008 former Gap executive Gary Muto was hired to run LOFT. Gary had most recently served as President of Gap Adult & GapBody. Prior to that, he held the positions of President of Banana Republic, President of Gap N.A., and President of Forth & Towne.   As a final step in the management build-out, ANN recently hired a new design head for AnnTaylor after a vacancy in the position since January. 

Growth avenues could be turned back on: Management has deferred indefinitely its plans to roll out a new retail concept while also holding back on other growth drivers within its existing stores such as bridal and maternity clothes. Whenever a normal environment returns, these growth levers can be pulled but in the meantime nothing is lost by waiting. 

Sarah Palin shops there with taxpayer money: self-explanatory

Investment Concerns

No visibility into upturn: things could get worse before the get better. It could be a very long time before the consumer recovers. In the meantime, results will likely continue to be poor in the near future as the company tries to bring its inventory in line. Perception of weakness also hurts somewhat: ANN was named in an email chain was going around with an inaccurate list of which retailers to avoid buying gift cars because they were going bankrupt. (My mother the uber-consumer received it).

Poorly Positioned: Related to the point above, higher-end women’s work clothes are discretionary items so the AnnTaylor division is particularly poorly positioned today although LOFT is also impacted. I am told by those with far more women’s fashion sense than I that suits are out these days: suits and separates are a third of ANN’s offerings (to be fair the dresses at ANN have been holding in better). While these trends tend to move in cycles (think about the impact of the rise of casual dress during the dot com era on companies like Men’s Warehouse which sold a lot of men’s dress suits), there is also a chance that women’s suits never come back into fashion. In this event, ANN will likely continue to experience difficulty and will have to change its focus which leads to the next point: 

Historically changing the focus has caused problems: ANN’s been seasons have been characterized by two main factors. First, assortments have been composed of primarily refined separates, suiting, dresses and special occasion product. Second, these offering have been designed so that customers can max and match items to build a wardrobe. Meanwhile, the worse seasons have generally been when management attempted to “tinker” with the core offering. As management today attempts to combat the market’s movement away from their traditional product, they risk being out of step if and when the world returns to looking for AnnTaylor clothes and doesn’t recognize what is in their stores. 

Forecasting is always a guess: it is hard to know if ANN will get its inventory levels exactly right which makes it difficult to model the company with any precision even in better times. This is no doubt why store comps are so important. 

Limited real estate: in an ideal situation the company would own all its real estate but in this case all the stores are leased. ANN does own its 256k sq foot distribution center on 27 acres in Louisville Kentucky. 

Catalyst