Rule Maker Portfolio
Is Ann Taylor a Rule Maker?

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (September 22, 1999) -- Like many of my fellow TMFers, the first investment book I ever read was Peter Lynch's Beating the Street. Although the book is geared toward the beginner, it holds many truths -- referred to as "Peter's Principles" -- that are valuable for investors of all experience levels. Here are a few of my favorites:

Peter's Principle #3 -- Never invest in any idea you can't illustrate with a crayon.

Peter's Principle #4 -- You can't see the future through a rearview mirror.

Peter's Principle #14 -- If you like the store, chances are you'll love the stock.

It's this last principle that I want to discuss today. One of Lynch's favorite sources of investment ideas was none other than his local mall. He tells the story of how some of his biggest winners, such as the Limited and the Gap, came from paying attention to which stores his wife and kids liked best.

The same rationale recently led me to an interest in AnnTaylor Stores (NYSE: ANN). If you're a career woman, you probably know all about Ann Taylor. The upscale retailer's 387 stores offer a classic but fashionable look that might be simply described as "sharp." Not plain, but not flashy. Rather, just well-cut clothing of high quality materials, such as cashmere and wool, as well as some more fashionable stretch fabrics for this year.

The company says it targets fashion-conscious women age 25-55. That sounds about right to me. My 23 year-old girlfriend (Melissa) and 49 year-old mom both claim Ann Taylor as their favorite store. Thanks to Melissa, I've had the opportunity to do extensive on-site research of the company's operations. I've found the stores to be consistently elegant, with an atmosphere of luxury and success -- exactly what an affluent professional woman seeks.

According to Melissa, Ann Taylor always uses the same shade of navy, gray, and black from one season to the next so that it's easy to mix and match new Ann Taylor items with your existing Ann Taylor wardrobe. Classic styling and consistent colors promote the idea that a purchase from Ann Taylor is more than just a purchase -- it's an investment.

Okay, so Ann Taylor gets an A+ for wowing its customers, but what about its shareholders. The stock does not have strong historical performance. For the past five years, shares have dramatically underperformed the S&P 500. However, the performance has been somewhat better recently, with a year-to-date return of approximately 12%.

One click over to Ann Taylor's financial snapshot, available at quote.fool.com, shows strong business performance of late. "For the three months ended 5/1/99, sales increased 26% to $249.4 million. Net income totaled $14.8 million, up from $6.4 million. Revenues benefited from the opening of new stores and the expansion of existing stores. Net income also reflects higher profit margins and lower S/G/A expenses as a percentage of sales."

Judging by that description, the income statement is in solid shape. Let's quickly put Ann Taylor through the paces of the Rule Maker Criteria to see if this company deserves a closer look. The first five criteria are qualitative aspects of the business that either get a "yes" or a "no." Let's hop to it.

1) Dominant Brand -- Is the company the standout category king within its industry?

No, I'm afraid not. Ann Taylor is a very strong brand, but it's not the dominant retail apparel brand. Gap wins on this one.

2) Repeat Purchases -- Do consumers return for purchase at least once a month?

Once again, no. Some avid customers might return every month. But, Ann Taylor is not a repeat-purchase business the way Coca-Cola is.

3) Convenience -- Within its industry, is the company's product/service accessibility and convenience the best?

No, with less than 400 stores, other retail giants like Gap and Limited are far more available, and thus more convenient.

4) Expanding Possibilities -- Can you answer "yes" to the following two questions?

a) Do your friends know about and use the product/service?
b) Is worldwide expansion believable for their stuff?

Finally, a yes!

5) Your Familiarity & Interest -- Are you a user of the company's products or at least very familiar with them?

Another yes. This one is subjective, but for me, it's a resounding yes.

Okay, let's pause for a moment. So far, the score is 3 no's and 2 yes's, so it's not looking good for Ann Taylor's possibilities of being a Rule Maker. But we still need to evaluate the financials, which actually tell us more important details than the first five qualitative questions.

If you haven't downloaded our Rule Maker Essentials spreadsheet, scroll down to the end of this article, and you'll see the download link. That tool makes evaluating the 10 RM criteria a snap. Watch, and I'll show ya.

The first step is to gather the financial data from the most recent quarterly report. From the SEC filings at quote.fool.com, I pull up the latest 10-Q which was filed on 9/14/99. Then, I click into the financial statements portion of the document, available at this link:

Ann Taylor Financial Statements -- for the period ended July 1999

Okay, now we just need a few pieces of raw data. From the income statement for the six-month period, we gather the following four pieces of data ($ thousands):

Sales               $515,147 
Prior Year Sales     421,563
Cost of Goods Sold   257,905
Net Income            27,166
Then, from the balance sheet, we grab the following five numbers:
Cash & Equivs.       $90,603
Current Assets       317,486  
Current Liabilities  110,751
Short-term Debt        1,256
Long-term Debt       113,661
That's it. Now, we can assess the last five of our criteria.

6) Sales Growth -- Ann Taylor's year-over-year sales grew by 22.2%, which is well ahead of our 10% benchmark.

7) Gross Margins -- At 49.9%, the company just misses our standard of 50%. Close but no cigar. However, Ann Taylor does score quite a bit better than our own Gap's 41% gross margins.

8) Net Margins -- Here, the retailer rings in at only 5.3%. That means only a little more than a nickel of each $1 of sales goes to the bottom line. We like to see at least 7% net margins, and most Rule Makers do far better than that. Nevertheless, Ann Taylor has been showing improvement here as the company gains scale, and thereby reduces the relative portion of administrative and overhead expenses.

9) Cash-to-Debt Ratio -- A ratio of only 0.8 falls shy of our standard of at least 1.5 times more cash than debt.

10) Flow Ratio -- Uh oh. It gets ugly here for Ann Taylor -- 2.07. And, that number is not an aberration. The company's flowie has hovered around 2.0 for every quarter of the past year. Not good.

There's the final whistle. The score is only 3 out of 10, so Ann Taylor is clearly not making any rules in the retail industry, even if its customers are in love with the "Ann Taylor look." That all goes to show that maybe Peter's Principle #14 isn't always right. Just because you like a company's products doesn't necessarily mean it'll be a great investment. It's just too easy to look at the numbers, as we just did, and thereby get a more thorough picture of a company before laying your money on the line.

Fool on.