Strong Retailer, but Highly Sensitive to Macro Trends

One of the strongest performing retailers over the past few years has been ANN  (NYSE: ANN  ) . While the company might still represent a good long-term investment opportunity, there are considerable risks as the U.S. consumer struggles to gain its footing.    

Recent performance 
ANN's net sales for the second quarter came in at $638.2 million, higher than the $594.9 million in the year-ago quarter. Diluted EPS also jumped 21% to $0.76 year over year. And ANN saw positive comps at both of its store brands: Ann Taylor and Loft.

A difficult retail environment, stemming from a cautious consumer, led ANN to take the promotional route. Unlike many other retailers, its promotions proved highly successful. By getting more traffic to its stores (physical or online), ANN managed to sell more items at full price. The only big negative was increased shipping costs, which affected margins.

Comps, or same-store sales comparisons, is one of the most important metrics in retail. This is because it does not include new store openings, which tend to involve higher sales and increased costs, both of which have the potential to skew overall numbers. By looking at comps, you can see if the company's strategy is successful enough to retain shoppers who have already visited its stores. 

Total company comps increased 2.8%, but this was weaker than the 4.7% bump seen in the year-ago quarter. In the Factory/Outlet stores, where it has seen weakness, ANN plans on focusing on profitability. It will look for ways to improve the bottom line, starting with conservative positioning of inventory. 

Consumer spending needs to improve 
While the above results are decent, the U.S. consumer needs to start spending again to push revenue and EPS higher. At the current time, unemployment is still relatively high at 7.3%, and the 30-year fixed mortgage continues to creep higher, now at 4.6% versus just 3.53% in January.

These trends, along with a 2% payroll tax increase and high gas prices, have put a strain on retailers. The only way to compete is to offer constant promotions, which cuts into margins and hurts the bottom line. In order to deliver EPS growth, some retailers have turned to layoffs and share buybacks. For instance, ANN's board recently approved a $250 million share repurchase program. This will reduce the share count, aiding per-share earnings. However, this doesn't indicate organic growth.

Let's take a look at the big picture and see if ANN has managed to grow the top and bottom lines despite a challenging environment.

 

2009

2010

2011

2012

2013

Revenue (in billions)

$2.20

$1.83

$1.98

$2.21

$2.38

Diluted EPS

($5.82)

($0.32)

$1.24

$1.64

$2.10

Based on those numbers, it would appear all is well. However, despite stock price appreciation north of 109% over the past three years, this doesn't mean the same type of performance is ahead. ANN has been able to bounce back from the depths of the "Great Recession" which is impressive, but the U.S. consumer has clawed its way back at best. For the company's earnings and revenue to continue to do well, and most likely its stock, the U.S. consumer needs to start spending more. 

A retail problem
Some investors might consider Aeropostale (NYSE: ARO  ) an alternative. Many retail investors used to love Aeropostale. While ANN targets women, Aeropostale mostly targets teens and pre-teens. This isn't the right place to be in the current economic environment, as teens don't have as much discretionary income for two reasons. One, it's more difficult for them to find jobs, two, their parents likely budget more than in previous years.

Another difference between these two companies is that while ANN has been consistently profitable on a quarterly basis, Aeropostale has suffered losses in its past three quarters. 

Some high-risk retail investors would look at Francesca's Holdings (NASDAQ: FRAN  ) . Like ANN, Francesca's targets fashion-conscious female consumers. However, ANN ($1.60 billion market cap) is approximately twice the size of Francesca's ($784 million market cap), which should make it at least a little more resilient to downside market corrections. Francesca's sports a net margin of 15.69%, versus 4.10% for ANN; and Francesca's ROE of 87.93%, versus 25.90% for ANN is impressive. Plus, Francesca's is consistently profitable.

The problem is that while Francesca's manages to grow its top line, its comps recently dropped 1%, indicating that top-line growth was due to new store openings (79 over the past year), not improved performance at existing stores. Therefore, Francesca's isn't likely to be a better investment option than ANN at this point.

Conclusion
ANN is a well-run company, but the current economic environment leads to downside risk outweighing upside potential. The consumer is cautious, and it doesn't look as though this will improve in the near future. If you want to own ANN, you might be better off putting it on your watch list and buying at a better price in the future.

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