Does ANN Have a Split Personality?

This review of ANN Inc.'s (NYSE: ANN  ) earnings quality is the first in a series of commentaries about specialty retailers listed in the S&P 400 index -- specifically, retailers that have income statement and revenue issues. This group of retailers will include ANN, American Eagle Outfitters (NYSE: AEO  ) , Aeropostale (NYSE: ARO  ) , and Foot Locker (NYSE: FL  ) .

Earnings quality is reflected in the financial statements
The Motley Fool offers two databases -- EQ Scan and EQ Score -- that are used to uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important for investors to understand before hard-earned money is lost.

The EQ Score database assigns an index rank to the company from one (lowest quality) to five (highest quality). As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward.

Earnings quality trends for specialty retailers with revenue recognition issues

Retailer

EQ Score January 2012

EQ Score February 2012

EQ Score March 2012

Trend

Likely Issue

ANN 3 4 2 Down Revenue
American Eagle Outfitters 2 2 1 Down Revenue
Aeropostale Not ranked Not ranked Not ranked Flat Revenue
Foot Locker Not ranked Not ranked Not ranked Flat Revenue

Source: Fool EQ Score, week ending March 16, 2012.

Both ANN's and American Eagle's EQ scores have trended down, and Aeropostale and Foot Locker have shown no trend. All exhibit income statement and revenue recognition issues. I'll discuss American Eagle, Aeropostale, and Foot Locker in future commentaries, but here is a brief look. American Eagle shows increasing revenue YOY -- up 14% -- but its gross margin is down 14%, and its cost of goods sold, or COGS, is up 24%. This translates to decreasing gross profit levels, which have been negative six of the last eight quarters, and net income that is down 41% YOY. Aeropostale's revenue was down 4% YOY, while its COGS was up 51% and its gross margin down 51% YOY. Gross profit was down 53% from the same period a year earlier, and net income and earnings per share were down 69% and 66%, respectively. Foot Locker saw its revenues rise 8% YOY, but its COGS increased markedly to 68% from 22% a year earlier, and it gross margin dropped from 78% to 32% YOY.

ANN's earnings quality: not so "lofty"
ANN, together with its subsidiaries, operates as a retailer of women's apparel, shoes, and accessories in the U.S. It offers a range of career and casual separates, dresses, tops, weekend wear, shoes, and accessories under the Ann Taylor and LOFT brands. As of Jan. 28, 2012, the company operated 953 retail stores, which consist of 280 Ann Taylor stores, 500 LOFT stores, 99 Ann Taylor Factory stores, and 74 LOFT Outlet stores in 46 states, the District of Columbia, and Puerto Rico. According to a recent Fool blog post:

Essentially Ann has 2 lines of business. One is the high end Ann Taylor stores focused on those woman age 47 to 65 who are primarily professionals. The other is the lower end Loft targeted at younger women, who shop for both work and fun outfits. ... According to Apparel Strategist, Ann Taylor stores account for only 25% of sales, down from 40% in 2006.

ANN's revenue and gross profit margin for the last two years are charted below:

ANN's revenues have increased YOY almost 10%, but the company's COGS has increased 16%, and despite the quarterly fluctuations shown in the chart above, the gross margin has decreased 5% YOY. Inventory levels have increased from $169.14 million in FY 2010 to $213.45 million, or 26%. Days in inventory on a four-quarter average basis are at 85 days, and the company's cash conversion cycle on a four-quarter average basis increased from 51 to 53 days. In short, revenue is not keeping pace with increases in the COGS, and inventory remains in stock longer, while the inventory stock levels are also increasing. Price reductions at the register will further depress margins and net income.

This second chart illustrates some correlation between ANN's stock price and net income and the effect the reduction in shares outstanding may have had on the net income. Note that from October 2010 to January 2011 the stock price rose prior to the company's reporting net income, but it fell just before the issuance of the report. The most recently reported net income, announced Jan. 28, fell sharply from $7.97 million to $2.18 million YOY, and we have not yet experienced a drop in stock price similar to what occurred last year. Note the severe dropoff in net income from $32 million last quarter to the current level of $2.18 million. The "shares outstanding" line shows a reduction in shares from year-ago levels of about 7 million, which had the temporary effect of boosting net income and earnings per share (not shown) until the latest quarter.

Since the beginning of 2012, ANN shares have traded between $24.78 and $29.38. Analysts anticipate EPS will be $0.50 for the coming quarter, which translates to about $26.18 million in net income. Ann Taylor stores represent a declining percentage of sales, based on demographic trends -- like baby boomers retiring in increasing numbers. Combine this with the data that show rising input costs and inventory levels, and I for one would not bet the ranch on this retailer.

Fool contributor John Del Vecchio is co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF. You may follow him on Twitter @johnfdelvecchio. He does not own any shares of the companies mentioned in this article. The Motley Fool owns shares of Aeropostale. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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