Abercrombie tries to buck the trend
Six months ago, I wrote an article highlighting the dangers of seeing a retailer running sales called, “Discounts - Good or Bad?” Little did I know that in the six months following the article, we’d see almost all consumer discretionary retailers discounting more aggressively than we’ve seen at any time in the last decade.
Just to summarize the aforementioned article, promotional mark downs are typically used in an attempt to entice a higher volume of purchases to juice declining revenues and clear inventory. The main pitfalls to such a strategy include:
- Increased volume at lower margins not translating into higher revenues. Few buyers will buy a poor product even at a discounted price.
- Reliance on discounting is often a result of structural weakness in a Company’s merchandising decisions.
- Repeated use of voluntary discounts run the risk of turning into a permanent loss of pricing power through what I call “the sale spiral.” Customers become accustomed to bargain basement prices and lower their reservation price for the Company’s products altogether.
In my previous article, I assumed discounting was the direct result of difficulty enticing customers to buy product. But, what about discounting in the face of a recession and overall tightening of wallets? If the industry as a whole begins discounting, do the same principles of loss of pricing power, profitability, and brand image apply? One company, Abercrombie and Fitch, believes so and has chosen to stay away from running promotions in addition to their annual clearance in hopes of maintaining its brand image and, more importantly, pricing power.
Throughout the last two years, Abercrombie has maintained gross margins at its historical (and astronomically high) levels of 66+% despite a significant consumer downturn. As expected, the company’s same store sales have collapsed and net income last quarter was down year over year for the first time in the last ten years.
Abercrombie is making a calculated bet in maintaining prices despite the fact that competitors have been slashing prices across the board. My assumption is that it hopes that by bucking the trend it can accomplish the following:
- Maintain its “casual luxury” image by not chasing its demographic down market.
- Magnify its brand appeal through its relatively “aspirational” pricing. The company hopes that empty handed teenagers will be walking out of the store thinking, “Someday when I have the money, I’ll buy tons of Abercrombie!”
- Capitalize on consumer surprise when competitor prices jump back up to pre-recession levels and Abercrombie’s “miraculously” stay flat.
The problem, however, is that for this strategy to work Abercrombie must prove to have a truly defensible luxury product. My contention would be that teen apparel is very subsitutable. It is, after all, difficult to establish “aspirational” status for ripped jeans and double entrendre t-shirts. In trading down or going to other similarly “aspirational” teen retailers like Urban Outfitters which are running sales, customers may find that that they don’t necessarily need to return to Abercrombie.
In addition to long term risk to the Company’s demographic appeal, the decision to maintain prices in the face of lower revenues has put some stress on the Abercombie’s balance sheet that will have to be dealt with. A quick look at Abercrombie’s inventory and cost of goods sold finds that the Company held $505 million in inventory at the end of last quarter, up from a typical $400 million-ish that are typically held through the last two quarters of the year. Assuming COGS as a proxy for inventory moved in a quarter, we find that Abercrombie typically purchases ~$300 million in inventory per quarter which would imply that the Company held almost two quarters’ worth of inventory at last check. In all likeliness, this backlog is mostly fall and winter clothing. Sooner or later the Company will have to clear this inventory, probably before summer. Knowing how quickly fashions can change, I wouldn’t imagine that it will be easy to move this build up without eventually succumbing to the so-called “promotional pied piper. “
Full disclosure: No positions held in any of the Companies mentioned in this article.
Happy New Year!
I realize this post is a bit late in coming. But, it was hard to assess whether or not it was indeed a happy new year until we finished the trading week. And, it does seem that Santa Claus has delivered once again. I wrote last year about the phenomenon that is the Santa Claus Rally between December 26 and January 2 of each end of year. It seems that it has manifested itself in full force this year with the Dow surged 7% over to close over 9,000 again in the face of continued weakening indicators - consumer confidence and the ISM indexes came in below expectation.
So, the question are these gains for real? Many traders were on holiday over the last week and most of the movements happened on low volume and we’ve got a calendar chock full of economic reports next week. The response to these upcoming reports as well as a return to normal volume will be the real test of the stock market recovery.
Valero: A valuation almost too good to be true
I probably should have written about this earlier as I picked up a position in Valero a few weeks ago around the $18-$19 range. The valuations presented here are a bit crude (pardon the pun). But, in my opinion, an equity investor ought to be more interested in being directionally correct than being exact when modeling. In the end, all we’re looking for is satisfactory margin of safety. On a final note, I have to give credit to Chad Brand at Peridot Capitalist for getting me interested in this one.
What is Valero?
Valero is one of the largest oil refiners in North America. It makes money processing oil and selling the resulting gasoline, distillates, and petrochemicals. While Valero operates in a commoditized industry, it operates the most technologically advanced refineries available and achieves cost advantages through the ability to process heavy sour crude. Heavy sour crude is cheaper than typical crude oil and allows Valero to extract higher margins than its competitors. For more a short primer on Valero, check out this Investopedia Article on Valero.
Valuation Study
PE Ratios
At $15-$20 per share, Valero trades between 3.5x and 4.0x TTM earnings. This is compared to an industry P/E at approximately 8.0x TTM earnings. Specific publicly traded comparable refiners including Holly Corp (7.95x), Tesoro (11.34x), and Sunoco (8.54x) all trade at significantly higher price to earnings ratios.
Even if current earnings levels prove to be the run-rate level for the next few years, Valero’s low P/E ratio ought to trend upwards as it proves the stability of its earnings. Generally speaking, no-growth P/Es range in the 6-8x range which also happens to be the industry average P/E. Valero management’s friendliness towards distribution of its cash through share buybacks and a hefty dividend (currenty 3.5%-4.0%) will only support such multiple expansion as investors become more comfortable with its baseline cash/earnings generating strength.
Balance Sheet Analysis and Liquidation Value
Multiple analysis and subjective research only serve to establish the guidelines for our “bull” case. To establish that we have some margin of safety, we must look towards establishing a more conservative valuation of the business disregarding any long term growth potential. (i.e. the “Ben Graham Valuation”)
As you can see from the above, Ben Graham might not actually agree with my assertion that Valero is a great value. The Company’s net-net working capital - the money the firm could return to investors if it shuttered its doors today - is negative. But, what we do know is that refineries and many of the properties that Valero owns are very valuable. And, if we look at net tangible assets based on Valero’s own balance sheet, we find that the firm is worth $29/share. It’s book value is an even more impressive $36/share. Basically, what we find is that the stock currently factors in a 20% haircut to its net PP&E.
Another thing we can look at is what the firm is worth based on recent asset sales and listings. The most recent listing price (based on estimates from Epiphany Investing) for Valero’s Aruba facility is less than inspiring as it implies a value for the firm around $11.50/share. The average selling price of the firms last two realized sales, on the other hand, paints a much more reassuring story and gives us confidence that current price levels probably represent a reasonable margin of safety provided we believe that gasoline demand will return in the future.
Conclusion
All in all, we find that Valero is currently trading in line with rough liquidation valuation and at a significantly discounted multiple versus its peers. There are significant headwinds for the industry over the next year, but one can be sure that these are likely transient in the two plus year time frame. My opinion is that Valero’s current pricing is very compelling.
Full Disclosure: Long shares of VLO at the time of writing.
The men who could replace Steve Jobs
In the final installment of my “What’s going on at Apple?” series (part 1 | part 2), we look forward. Can we Apple investors feel confident that the Company will be in good hands in the event that Steve Jobs decides to step down.
Aside from the seeming correlation between Apple’s success as a company and Steve Jobs’ tenure as CEO, any company as dependent on customer perception as Apple needs a strong management team at the top. Management vision is the ultimate source of the Company’s competitive advantage especially when its products do not necessarily exhibit entrenchment qualities. That is, an iPod, iTunes, and MacOS are ultimately very substitutable products should the luster of brand image, ease of use, and general attractiveness dull. This could change in the future as MacOS reaches a critical mass or if Apple finds a better way to make its products more interdependent, but, as I’ve argued before, Apple is currently better compared to fashion retailer than a tech firm. Its products are basically luxury substitutes of staple consumer tech goods.
What we already know is that Apple’s board is likely to choose from the current management team. So, let’s take a look there.
Timothy Cook (1) - Apple’s COO and far and away highest paid management team member. Cook came aboard from Compaq computers in 1998 and he handles essentially all the nitty gritty for Apple and is an operations maven. He keeps costs under control and manages the balance sheet as well as anyone in the business. There’s probably no one better suited to run the Apple business than Tim Cook. And, in fact, it’s likely that he already does especially after stepping in as interim CEO when Jobs took a leave of absence in 2003. He, however, seems to prefer having Steve Jobs as Apple’s front man and has stated that he’s not quite so interested in personal visibility. It’s also hard to say how much Cook could contribute as far as continuing to fill Apple’s pipeline of innovative and creative products. Forbes’ recently did a terrific article on Cook that I think is a must read for Apple investors.
Joni Ive (2) - The Senior VP of Industrial Design at Apple, Joni Ive has been with the firm since 1996 and reports directly to the CEO. He’s responsible for leading the design of the iMac, iPod, MacBook Pro (both models) and the iPhone. Ive is a good speaker and Steve Jobs has even given him a few chances to present in his stead. That being said, Joni is intensely private. Rumor has it that Apple’s HR doesn’t even know his real birthday. It’s hard to say he would really embrace the role of CEO when he’s already an industrial design superstar. It’s possible that he’d be best suited simply taking an expanded role driving the creative side of the company should Steve Jobs’ step away.
Philip Schiller (3) - The man who will present for Apple at MacWorld Expo this year. Philip Schiller is Apple’s senior VP of marketing and has been for 17 years. He’s ostensibly responsible for greenlighting the now iconic Apple iPod silhoutte ads and the Mac vs. PC campaign. He’s a mainstay at Apple informational events and has given presentations for Apple in the past, but can sometimes lack the charisma that Jobs brings to each performance. In fact, he had a rather embarassing interview during the iPhone launch in London last year. Clearly, he’ll need a bit more practice before stepping into Jobs’ shoes as Apple’s top salesperson let alone as Apple’s top executive.
Ron Johnson (4) - Ron Johnson came to Apple in 2000 after reaching stardom in retail circles at Target. He single-handedly built Apple’s retail presence and created the “Genius Bar” that’s now synonmous with the Apple experience. Interestingly enough, anecdotal evidence claims that Ron pushed several retailing ideas that Jobs was initially resisted and has since earned the credibility to really push retail strategies on his own agenda. Ron is also a very charismatic public speaker and has all the tools to fill in for Jobs as the head of the Company should Apple begin focusing even more on its retail presence.
Tony Fadell (5) - Fadell, former senior VP of the Hardware, left Apple in November along with his wife who was VP of HR. Jobs claims that Fadell will continue to have some role in the Company, possibly as a special advisor to the CEO. The stories are that he left with his wife to focus on their children which means it’s a long shot that he’d take on the job of CEO if it were offered to him. But, prior to his departure, many thought Fadell was on the shortlist of potential CEO candidates. He is, afterall, the man who invented the iPod. The little known fact is that Apple’s former senior VP of the iPod division, Jon Rubenstein, bought Tony’s idea after he shopped his idea of a harddrive based MP3 player linked to a web-based music store throughout Silicon Valley. Fadell went on to head up the engineering team behind the iPhone as well as the iPod.
For completeness, Fadell has since been replaced by Mark Papermaster from IBM. Unlike Fadell, Papermaster was one of the main architects of the PowerPC chip at IBM. It seems that Apple has since shifted focus from just hardware design to chip design.
It’s hard to say that there’s any singular candidate who could perform all of Jobs’ tasks as a salesperson, creative guide, and executive. But, it’s clear that Jobs has assembled a terrific management team at Apple and that there is more than enough talent to continue to guide the Company going forward. While the Company needed a transformative thinker in the late 1990s to revive it from irrelevance, Apple’s three key products - Mac, iPhone, and iPod - have set a solid foundation for this talented team to build upon and manage for continued success.
The Company trades at a 16 P/E today which implies a growth rate in the mid-teens if you assume PEG trends towards 1. Apple’s international sales are just 42% of revenues. It’s anyone’s guess how much marketshare MacOS can take and the Company is leading the charge in the development of a mobile computing industry. Clearly the Company is well positioned, has a highly talented management team, and its products - outside of the iPod - are far from mature, even without Steve Jobs, one could say the Company is at least fairly valued and possibly trading at a modest discount. Let’s not forget it also has nearly $30/share on its balance sheet. To date, we know that Steve Jobs is highly reluctant to spend Apple’s cash. New management could be more willing to distribute at least some of this cash in the form of a buy back or dividend to shareholders.
Full Disclosure: Long shares of AAPL at the time of writing.
The End of Steve Jobs ™
In part II of my “What’s going on at Apple?” mini-series, I’m wondering what the move to end the decade long tradition of the Stevenote speech at Macworld means to Apple and its ongoing strategy. While Apple always has its own developers conference and events for the iPhone and iPod product lines as well as its so-called “Special Events“, there is no gathering quite like the MacWorld Expo. And, while I argued in my previous post that pulling out of MacWorld is just the next logical step in a decision to minimize investment in tradeshows, it is undeniable that the MacWorld Expo is at least a little bit more important than the rest. Only at MacWorld, did average consumers, fanatics, and general press willingly gather to listen to Steve Jobs (and, hopefully, to Phil Schiller this year) set the tone for the coming year’s consumer tech products. It was, in many respects, a state of the union address both for Apple and for consumer tech.
MacWorld Expo is where Steve Jobs ™ was born. Not, Steve Jobs, the Apple co-founder or CEO, but Steve Jobs ™, the visionary and deliverer of salvation from bland tech products. No company, not even Microsoft with Bill Gates or Google with Sergei and Larry has a CEO that more embodies the term keyman as Apple does with Steve Jobs. Whether true or not, we all know that the Company was an uncompetitive also ran in the personal computing industry before Steve Jobs returned from exile and transformed the Apple into a consumer tech juggernaut. It was his passion for typography and design which inspired MacOS and eventually the beautifully designed and easy to use product hit parade that techies and non-techies alike have enjoyed for the last decade and particularly in the last five years.
More importantly, the emergence of Steve Jobs ™ created a powerful competitive advantage for Apple in that Jobs himself has become a trend setter for the entire industry. His adoring fans hang on every last word and fall in love with any new gadget he holds up in the air. Marginal products - internet enabled phones, MP3 players, solid state memory - become legitimate industries all with a few slides in a Keynote presentation.
Whether healthy or not, the decision to pull out of MacWorld will, in some ways, mark the end of Steve Jobs ™. Afterall, there is no longer a ready made pulpit for Steve Jobs to espouse on what’s hot in tech and what’s new in Apple-land. New product announcements and other PR will be handled through the Apple website and Apple retail stores. It seems that Apple consumers and investors are finally being weaned off Steve Jobs ™ and being faced with the fear of losing Steve Jobs all together.
I wish Apple could have chosen a better way to do this. A surprise withdrawal from MacWorld Expo is not necessarily the best way to inspire confidence especially when there is already concern over the CEO’s health. But, in the long run, this could be a good move for Apple. Steve is 53, and hopefully has many good years left. But, everyone gets tired and everyone ages. Bill Gates is 53 as well and has already stepped away from operations at Microsoft.
A Company is not built on the back of one man. In our closest example, Microsoft doesn’t seem to have missed a beat after Bill Gates stepped down. Granted, some may argue the company was already mature and no longer needed a visionary leader so much as a manager for the business. Apple is still a company very much focused on growth and diversification of its product base. Furthermore, its success is not built on entrenched, mission critical software as much as it is on hot products and a desirable brand. In this sense it will always need a management team that shares a Steve Jobs-like mentality focus on design, innovation, and user friendliness.
The question for investors is whether or not there is someone or several someones that can fill Steve Jobs’ shoes and continue to execute and evolve its very solid business strategy in the event that Jobs does eventually decide to take a lesser role in the business. The problem for investors is that Apple refuses to be forthright about either Jobs’ health, his intentions going forward, or any succession plan at all. While this isn’t something we ask of most companies, who would succeed Eric Schmidt if he became technology czar or 64-year old Larry Ellison? It is an issue for a Company which has willfully decided to turn its CEO into its greatest salesperson and the symbolic source of its intangible competitive advantages. For now, all we can do is speculate.
Tune in tomorrow for the final part in this series, detailing Apple’s current management team and potential Steve Jobs’ replacements.
Full Disclosure: Long shares of AAPL and GOOG at the time of writing.
What’s going on at Apple? (Part I)
As everyone knows by now, Apple is pulling out of MacWorld Expo after this year. More importantly, Steve Jobs won’t be delivering his annual keynote speech. Instead, Philip Schiller, Apple’s senior vice president of Worldwide Product Marketing, will deliver the keynote address. Following a year of rampant speculation on Steve Jobs’ health, it is quite worrisome to note that Philip Schiller also presented in Steve Jobs’ stead at Macworld Expo when Jobs had pancreatic cancer in 2004.
Health and continued presence of Steve Jobs’ aside, this is the first time that Apple’s shift away from trade show marketing has manifested itself to the general public. While unexpected to most, the decision to leave MacWorld Expo is not entirely out of character. Apple has been slowly pulling out of trade shows all year. Apple pulled out of the National Association of Broadcasters Conference in February. And, it also pulled its appearance at Apple Expo this September.
Is this necessarily a poor decision? Apple’s brand cache has been created and propped up in both its darkest and now brightest times by an enclave of true Mac enthusiasts. Tradeshows like MacWorld have been the corner stone of this community for the last decade. Leaving MacWorld and taking away its yearly showcase risks alienating these fans. Could Apple be giving up a tremendous opportunity to create continued buy-in amongst its fans? Is Apple giving up on a key differentiator by declining to support the culture and community which has its products?
Truth be told, I’m not so sure. Apple is a global brand now. The company doesn’t just reach towards a niche and disparate group of enthusiasts anymore. The company also now has its own set of retail locations around the nation and has the PR clout to run its own events for product releases. Blogs, news outlets, trade magazines, chronic Apple.com visitors. They all fawn over new Apple releases. Apple enthusiasts no longer have to make their annual pilgramage to MacWorld. The community is alive and well and more decentralized than ever. If anything, Apple has more reach through other channels. Tradeshows are very expensive and Apple, being the headliner of any tradeshow it attends, likely spends much more than even the average tradeshow attendee which can pay upwards of $20,000 for three days just to have a booth not to mention the cost of designing and constructing its display. In an economy like this one, tradeshows are a prudent and effective way to quickly cut costs.
All-in-all, I see the move away from trade shows as a neutral to positive move for Apple. It shows fiscal responsibility, prudent planning, and a commitment to their long-standing strategy of doing everything they can to control the “Apple experience” from announcement to delivery. The real question is, “Where is Apple going from here?” And, as a corollary, can they get there without Steve Jobs? Tune in tomorrow for more.
Full Disclosure: Long shares of AAPL at the time of writing.
