Jos. A. Bank (Nasdaq: JOSB) has reported its second-quarter numbers, and they aren’t good — they’re great!
To start with, sales were up 20.8%, and gross and operating margins improved, mainly driven by maturation of the company’s fairly new store base. But the Jos. A. Bank story is not about growth — it always had plenty of that. It is about inventories, and they were the bright, shining star of this quarter. Specifically, inventories increased only 11.7% over the second quarter last year. So why is that great news?
To answer that question, it’s necessary to understand the issues surrounding Jos. A. Bank. First, it has double the inventory days (a measure of how long it takes to convert inventory into sales) of its closest competitor, Men’s Wearhouse (NYSE: MW), and second, it had a terrible first quarter due to too much seasonal inventory. I have written two long articles on the first issue, so let me address the second issue here.
At the end of last year, Jos. A. Bank had some incredible, blockbuster same-store sales numbers. As the company prepared for future sales growth, it continued to stock up on winter inventory. However, the winter was warmer than expected, and demand did not materialize. The company launched an aggressive fire-sale campaign to move that entire seasonal inventory, and the stock was slaughtered as margins crashed and earnings estimates were missed. Wall Street was concerned that Jos. A. Bank’s “let’s have a year of inventory” strategy was falling on its face.
Last quarter, the company’s management said it had been too aggressive with price cutting — the benefit of hindsight showed that prices didn’t need to be cut so much. Management also said it will not be cutting prices for winter merchandise in the second quarter. Declined inventory on a per-store basis and improved margins suggest that management kept its word.
In fact, margins improved on an overall basis. The only cost that was rising (slightly) faster than sales was sales and marketing, which makes sense as the company has been spending more money on TV advertising.
Though inventories increased, they have grown at a much slower pace than sales — a very important nugget of information. I expect inventories will still be growing in the future, but probably slower than sales, as inventories in established stores will not be rising. This is great news on many fronts. First, the company’s free cash flows will start outpacing net income growth, and second, the management that took an unorthodox strategy will gain credibility with the Street — and the company’s stock will reflect that.
Let’s quickly take a look at three important components of any investment: quality, valuation, and growth.
Quality:
- Balance sheet: With the exception of leases, the company has almost no debt.
- Return on capital: This number has improved on a consistent basis since 2000 (despite rising inventories per store).
- Sustainable competitive advantage: JOSB is not a Wal-Mart (NYSE: WMT), but it has a product and a distinct brand that men want and it provides a better, more personal shopping experience than Men’s Wearhouse.
- Free cash flow: On average, operating cash flows have consistently grown in line with net income — a good sign in itself. As inventory growth decelerates, free cash flows will follow.
- Management: So far, it’s done everything it said it would do. It made mistakes along the way (i.e., the first-quarter mishap), but nothing that would make me doubt its unorthodox strategy.
Valuation: The stock is cheap! It is trading at 13 times next-year numbers and at 5.4 times my $5 estimates for 2009 (yes, I do look that far).
Growth: The company is set to open about 150 stores over the next three years to bring its total store count to 500 by 2009. As its fairly young store base (more than half of its stores are less than three years old) matures, its margins will increase, driving earnings growth in excess of sales growth.
Owning Jos. A. Bank requires one to think independently from the rest of the pack. Analysts don’t get fired for owning conventional stocks like IBM or Colgate, but they do get fired for owning a company that has double the inventory days of a close competitor. Investing in JOSB requires a strong stomach for high short-term volatility and a conviction that can only be achieved from one’s own in-depth research.
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