Jos A Banks JOSB
July 10, 2006 - 1:52pm EST by
2006 2007
Price: 26.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 477 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Jos. A Banks is as an up and coming specialty retailer of men's business apparel. The company's high quality product, strong service, and unique effort to insure in-stock selection are building the company's brand reputation and developing a loyal customer base. In coming years as the company increases its store base from its current 331 stores to its target of 500 stores, and then as those stores mature and operating margin expands, earnings should rise from the $1.95 achieved in 2005 to earnings of up to $3.69 in 2008 and $4.92 in 2010. A 15 multiple on those earnings yields a stock price between $55 and $74, or 100% to 180% above where it trades today. This potential price appreciation makes JOSB an excellent long-term holding, at least, that is, after it clears some near-term hurdles.

After trading around $9.00 at the end of 2002, Banks stock reached a high of $48.00 in March of this year. Then the company missed Q1 numbers (Q1 eps down 15% yoy) knocking the stock down to around $26.00 and a trailing P/E of 13.6. (Market cap is $475M; debt is minimal though they have a line of credit for capex and WC that they run up and pay down by the end of each year.)

In addition to the miss, the street is concerned about rising inventory levels, although I hope to show that much of the inventory increase is justified. In any case, it is reasonable to believe that the company may need a couple quarters to work through the issues. And, like any retailer it must deal with any slowdown in consumer spending. However, as the company addresses the issues (and we already have some data that suggests progress) I believe the stock will begin to appreciate again and over the next few years will rise significantly.

Unlike department stores or Men's Wearhouse, Banks sources all their own clothes and only carries their own brand. (Shoes is the exception, but they are in the process of adding their own line of shoes) Sourcing their own clothing allows the company to better maintain and control quality and costs. Inventory availability is emphasized in order to insure customers can purchase merchandise when needed. The company markets not only through stores, but via the internet and catalogs (10% of sales). Customers can buy and return in any channel.

Product innovation also drives sales. For instance, the company's TRIO collection allows men to purchase one suit jacket, a matching pair of pants and another pair of pants in a coordinated pattern enabling one jacket to be used as part of a suit or jacket/pants. It also allows a gentleman who has a normal size chest/shoulders, but a large waist to purchase a suit by selecting the suit jacket and suit slacks separately, something one can not do at most men's stores. Similarly, a broad shouldered man with a narrow waist can match a larger suit jacket with matching narrower suit pants. Most often, off the rack suit pants are sized to whatever size most often goes with the jacket size. I myself fall into an odd-size category and have more than once had to pass on a suit at other stores because the pants could not be altered to fit me. In fact, it is so frustrating that on occasion I have switched the pants from one suit to go with another when store staff was not looking. I don't have that problem at Banks.

Banks also stocks a wide range of suites price points from a few hundred dollars to over $1000. The wide range of price points allows them to easily upsell customers who take a shine to a fancier suit while in the store or over their lifetime as a customer. They also have a range of traveler, wrinkle free and breathable products that add to their ability to meet customer needs. None of their product innovations are as revolutionary as, say, elastic in socks to hold them up over our ankles, but taken together they enhance the company's value proposition to customers and drives incremental sales.

The product, its quality, their service and the fact that their locations are typically not buried deep in a mall (which men hate; they want to get in and get out), I believe are all incremental advantage that add up to Banks taking share in menswear from department stores. A read of the 10k and a visit to a store, preferably a newer one, helps bring the picture together. A visit to Mens Wearhouse, I believe, also highlights the slightly higher quality, ambiance, and service level of Banks, though I am not putting down MW as I believe they do a good job.

Let me start with some background and information about the current problem: In fiscal year 2005 (ends Jan '06) Banks earned $1.95 per share, a 42.1% increase over 2004. They added 56 new stores (and closed one) ending the year with a total of 324 stores. Since 2002, ROA has risen from 8.9% to 13.1% and ROE has risen from 18.4% to 26.3%. For the past two years both maintenance and growth capex have been funded from cash from operations. After producing consistently strong earnings growth and margin expansion, Q1'06 saw revenue flat yoy, gross margins down 140 bps and G&A up 123 bps.

Given that inventory days have grown from 285 days in 2003 to 316 days in 2004 and 364 days at the end of 2005, one would assume that Banks imprudently loaded up on inventory and it should come as no surprise that they finally had to start marking it down in order to clear the stuff. With inventory days at the end of Q1 standing at 352 it is easy to believe that there will be more markdowns to come.

Management argues that the general increase in inventory (expressed through rising inventory days) is part of a long-term company strategy to increase inventory per store. They further argue that the miss in the quarter was not due to the general increase in inventory and, instead, was an issue specific to the quarter. Setting aside Q1, I believe and will explain why JOSB deserves credit for their explanation of the general rise in inventory. In my opinion it has contributed to earnings growth and has added value. Moreover, it has achieved this by taking an unorthodox approach to retailing; namely, increasing inventories and it has clearly been successful up to now. In short, the strategy allows JOSB to have a superior in-stock position that increases sales by taking advantage of the unique characteristics of how men shop (very infrequently) and what they buy (all the same thing) and how often the styling of what they buy changes (not often and not much change when it does).

However, I am less willing to give management credit on the problems they faced in the quarter, if only because I am unable to prove them right. Though they offer an explanation and it may turn out to be true, I admit they may have pushed a good strategy (of higher inventories) beyond its limit and needed to clean things up through lower margins.

Let me offer more information about Banks' inventory strategy and why it is effective at increasing sales. Men's business apparel consists of a narrow range of items that do not change much year to year. In addition, men only shop for business clothes (or really any clothes) once or twice a year. Thus, when they shop they all seek the same blue or grey suit and white or blue shirt. The key is not so much the fashion (because it is similar at Banks or Mens Wearhouse and stays the same from one season to the next), but in having the size and color in stock when the guy shows up. (This includes, for instance, having the range of separate suit jacket sizes and matching separate suit pants in stock to help a customer like me that at times can't buy a suit off the rack and needs to mix and match.)

If Banks fails to have the size and color in stock on that one day the shopper finally breaks down and decides to replenish his business wardrobe then the sale is lost forever. Management maintains that starting a few years back they began expanding inventory to meet this need (wider selection of sizes/colors of core items and enough of them in each size/color) and that it was successful and that in 2005 they sought to widen the selection of items and sizes of which they kept higher quantities.

Management's credibility on the general strategy of higher inventories is backed up in many ways. It has been discussed or detailed on conference calls, 10Ks, and annual reports for a number of years. If one goes to "Strategy" on page 2 of the most recent 10K, item number three of their "Four Pillars Of Success" is "inventory in-stock".

The fact that Banks sources their own clothes is actually an important key to running high inventory. It enables Banks to more easily store away this year's unsold core items (that blue suit) and bring them out next year because they are able to get a new run of the same exact item. Men's Wearhouse, which is really just a department store for men's clothing, does not sell its own brands and is less able to carry over this year's clothes to next year because they can't get a new run of the same exact item. They’re dependent on what the brands they sell are offering each season. This difference is what enabled Banks to run inventory days over the past couple years at +/- 300 with no problems, compared to MW which runs +/- 160 days.

Regarding the problem in Q1, management says that inventory levels are where they want them to be and that big markdowns are not forthcoming. I admit that statements such as "comfortable with our inventory" and "big markdowns are not forthcoming" are often management speak for "you will see this inventory at TJ Maxx in about a month with the labels ripped out". However, I think markdowns are less likely to happen or at least less likely to happen in size due to Banks' ability to carry core items from season to season.

Management's specific explanation for Q1 was that demand for winter items (e.g., coats) was higher later into the winter than usual. Men were still buying coats at a time when they are usually buying spring goods. They argue that they sold these winter goods at typical winter apparel margins (including some promotions, but no more than usual), but that margin on winter goods is substantially less then margins on spring goods resulting in a negative mix shift in the quarter. They also note that sales of entry level price point suits were below plan.

Selling more winter apparel late into the winter? I thought it was a warm winter, so much so that the country needed so much less natural gas that now we can't even find places to store it. I don't know what to make of their explanation. I'll assume there is some truth to it, but maybe it is not entire truth.

An alternate explanation is that although Banks' has a unique and successful inventory strategy enabled by their ability to source in-house, it is still an open question as to how high an in-stock position is appropriate. Is it 350 days of inventory such as they have now or is it only 325 days, a lower level at which they exhibited no gross margin problems? Maybe it is the lower number and in Q1 management had to admit they had too much and marked some of it down. If that is the case, unfortunately they did not admit it to investors on the call and they get a little testy on the call when pushed. The CFO also got testy with me when I pushed hard on the matter looking for lots of detail and for specific goals related to inventory. Leads one to believe there may be something to hide.

Even if they have too much inventory, management should still be able to carry most of it until next winter, assuming it really is core items (about 2/3 of inventory is considered core). I also suspect that part of the margin problem in Q1 was marking down and clearing fashion items that were not selling, including some entry price point suits. They claim the current inventory is "heavily concentrated in basic goods." If that is so then inventory purchases over the next year (ex inventory buy for new stores) should moderate compared to past years. Indeed during the call, management notes:

"We expect year-over-year inventory increases to be less in each of the next three quarters. Inventory increases this year will be primarily to support new stores… Given that we do not expect to build inventories at the same rate we did last year, we expect our cash position to be even stronger at the end of fiscal '06 than it was at the end of fiscal '05."

It makes me think they are carrying more fall/winter inventory then they would like and the solution is to order less to replenish it for next fall.

Two factors suggest that the situation may be improving:

1) Management claims that margins have recovered into Q2, a fact that they mentioned on the Q1 conference call. Here is the CEO's quote during the Q&A:

"…I think we need to bear in mind that what we're talking about are the first-quarter results, which primarily took place in February and March. May and June the margin normalized… So what we are talking about is an aberration that had to do with mix…"

I spoke with the CFO after the call. I asked him if when they say that Q2 margins to date have "normalized" does that mean margins simply improved over Q1, but are still lower then last year's Q2 or does it mean they are equal to or better than last year's Q2? He claims the latter, but I admit the more I pushed the more he began to back off taking a Reg FD posture claiming he did not want to give me more info then was given on the call.

2) A second positive factor is the May comp of 7.1% and a most recently reported June comp of 8.5% suggesting that Q2 earnings should once again exhibit YOY growth, particularly if margins are normalizing. (On the call management guided to double digit YOY eps growth, which if sales are growing and margins are stabilizing, they should be able to reach given the growth in stores.)

A final point in support of the overall strategy of higher inventory: Even though inventory has risen and turns have declined, sales per square foot, through last year, continues to rise…

Inventory Turns
Year Inventory Turns Sales/Sqft
2002 1.54 260.7
2003 1.28 269.8
2004 1.16 273.4
2005 1.00 285.5

margins have improved (until Q1 of this year)…

Year GM% OM% NM%
2002 54.88 8.04 4.45
2003 57.50 10.00 5.43
2004 60.36 11.29 6.57
2005 61.90 13.30 7.59

and return on assets continues to rise as margin growth has outpaced the decline in inventory turns and asset turns, a factor you might expect to see if management's high inventory strategy is a good one.

Year Sales/Assets ROA% ROE%
2002 1.99 8.9 18.4
2003 1.78 9.7 21.4
2004 1.72 11.3 24.4
2005 1.73 13.1 26.3

I do believe management's strategy is a good one, but also believe it is reasonable to conclude they may need to tweak it to determine the right ceiling on inventory. This may be happening now. Longer-term I believe the story shifts to the potential for profit growth and margin expansion in the store base, which I believe is significant.

As noted, Banks ended 2005 with 324 stores up from 160 at the end of 2002 and increase of 55 stores per year. This means that over half their store base is young and generates sales and margins below that of mature stores; stores take up to five years to mature. As stores mature, sales, contribution and margins from each store should improve. I am impressed with their ability to execute these store openings at such a fast pace. The fact that they will likely reach their goal of 500 by 2009 is an important factor in earings growth and adds to the story.

Management notes that operating margins on new stores are as much as 10% less then the company average of 23.2%. In keeping with these numbers, the CFO tells me that operating margins on stores opened in 2004 are just north of 13%. New store revenue is about $800K to $1.00M compared to a company average last year of $1.261M; mature store revenue is around $1.6M. If COGS are kept at the level achieved in 2005, 38.10%, and if I assume the same gross margin for new and old stores (may be reality, may not, but I’m trying to simplify) I can reverse engineer an operating margin for mature stores that is approximately 29.3%. I am arbitrarily assuming new stores (open less than 3 yrs) sell $930K and which implies mature stores (open more than 3 yrs) sell $1.608M per year, in line with quotes by management.

It is assumed that the company grows the store base by 55 stores in 2006 (per guidance), 50 a year in 2007 and 2008, and 21 in 2009; these additions get the total to 500 stores, management’s goal. From 2010 to 2012 I have them adding 5 stores per year. I am treating any store open less than three years old as new and any store older than three years as mature and applying the appropriate revenue and margin assumptions. I assume 18.2M shares in 2006 and am increasing shares by 1% per year.

These above figures, along with a few additional assumptions get me to the earnings detailed below. 2006 does not work off the model because 2006 is a bust already and I had to make special (and lower) assumptions to get an earnings number for this year. (I get about $2.11, but suspect that will change as the year plays out. I’m mainly looking for 2006 eps to be up yoy over 2005 due to at least some margin recovery from Q1 and new stores.)

Using these assumptions, the Stores segment grows as follows:

2006 2007 2008 2009 2010 2011 2012

New stores 55 50 50 21 5 5 5
Stores, <3yrs 171 161 155 121 76 31 15
Stores, >3yrs 158 208 324 379 429 479 500
Total stores: 379 429 479 500 505 510 515

Revenue 494 580 665 721 760 799 817
Op Income 109 146 172 193 211 230 237

Revenue growth% 20.8 17.7 14.5 8.5 5.3 5.1 2.4
Op margin 22.1 25.1 25.8 26.8 27.8 28.7 29.0

In addition to stores, the company runs a successful Internet and catalog business that is also growing strongly and represents about 10% of revenue but has higher operating margins. I am assuming 15% growth per year through 2009 and 10% growth thereafter. Op margin in this Direct Segment in 2005 was 35.60%. I assume some margin improvement going forward.

2006 2007 2008 2009 2010 2011 2012

Revenue 49.0 56.2 64.7 74.4 81.8 90.0 99.0
Op Income 17.5 20.3 23.5 27.4 30.3 33.5 37.1

Rev growth% 10 15 15 15 10 10 10
Op margin 36.0 36.2 36.5 36.2 36.7 37.0 37.5

The company’s "other" classification includes revenue from a few legacy franchise stores, factory outlets and tailoring. I am growing income in this segment by 3% per year. Distribution and G&A are in this segment and I am growing these in line with increases in stores. The company claims its current DC is set to handle 500 stores.

I assume interest on the revolving line of credit for working capital to be 1% of COGS, a number consistent with historical numbers, but a little arbitrary. Tax rate is at 42%

Rather then continue to type out numbers for all the particulars, I'll assume those with real interest will build their own model. Instead I'll offer consolidated numbers:

2006 2007 2008 2009 2010 2011 2012

Revenue 554 649 743 810 856 903 932

Op Inc 68.4 99.2 119.5 141.4 161.6 182.1 193.0

Net income 38.4 56.8 68.6 81.3 93.2 105.2 111.7

EPS 2.11 3.09 3.69 4.34 4.92 5.50 5.78

Shares 18.2 18.4 18.6 18.8 19.0 19.1 19.3

The 10K provides detail on capex and inventory needs per new store. In addition, as stores mature their inventory needs grow (from about $300K to $550K per store.). Though I have accounted for these costs in my own FCF calculations, I've not dealt with them in this write up. It is worth noting that they are funding growth from cash flow. However, cash flow will not begin to approximate earnings until the out years when growth capex declines dramatically (2010 and beyond).

Keep in mind I have not provided every tiny assumption I've made, my numbers shown are rounded, and that 2006 does not work off the assumptions I detailed above because of the problems the company has already encountered. Finally each year’s model is built top down based on the economics of new and old stores using 2005 as a template. It doesn’t feed off the prior year’s model and thus may be one source of error. I’m sure there are others. I most want to show the potential of the company as it grows and matures.

G&A was also up in Q1. Banks claims much of the problem was that the company mostly self insures for medical and that Q1 had outsized claims, driven by multiple organ transplants. The quarter had other minor problems that caused margin deterioration, including testing a new compensation scheme for sales staff.

In addition, the current inventory build occurred prior to the 2005 holiday season. I can make an argument that carrying all that inventory in late 2005 (and the in-stock position it created) was a factor that enabled them to have a blow-out Q4, but was also the seeds of the problems in Q1 and now will cause them not to carry so much inventory in the future. If that is the case and they can't fix their other supposedly one-time cost issues, it could mean 2005's margin assumptions may not be achieved again any time soon. With that in mind if I change my model to bring store segment operating margins back to 2004 levels, or 20.6% versus the 23.2% achieved in 2005, I get the following earnings:

2006 2007 2008 2009 2010 2011 2012

EPS 1.84 2.70 3.26 3.87 4.43 4.99 5.25

This would mean further negative surprises in 2006. If you think this is likely to be the case then you may want to wait to purchase, but at least you can better judge your entry point. However, upon recovery, 15 times these revised 2008 earnings of $3.23 still yields a $40.20 stock; 15 x 2010 earnings of $4.43 yields a $66.45 stock. While I don't know if this scenario will play out it at least offers some insight into the downside if things go wrong or perhaps if the consumer dies, which would be beyond their control.

Note: A couple years back Banks had a misleading method of calculating same store sales. If they opened a new store near an existing store they excluded the existing store from the same store sales calculation for a year. The Street called them on it and management changed the calculation to include the stores. Historical same store sales declined slightly, typically +/- 1%.

Finally, I once again urge those who see value in the concept and its long-term prospects, but who can't get comfortable with the near-term company specific or macro issues to keep the stock on their radar screen as I have conviction that the chain's long-term potential will be met.


More markdowns to come. A consumer slowdown. Q1 representing a fundamental deterioration in JOSB’s biz model and store economics do not return to 2005 levels.


Second quarter margins and earnings back on track or at least trending in right direction. Company realizing full potential as it rolls out the store base and operating margins expand. At some point I think they may get more and better sell-side coverage.
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