J. Crew Group (NYSE:JCG) is a hot stock right now, but it's like a fast car with poor brakes and no air bags: Any bump in the road could produce an ugly crash.
So far, investors have enjoyed an exhilarating ride with the apparel retailer's stock. Those who bought shares in the company's IPO have seen their investment almost double in less than six months. That market enthusiasm has been stoked by the company's dazzling double-digit growth rates in sales and earnings.
While J. Crew's current growth rates are not sustainable over the long run, the company can probably extend its strong performance for the foreseeable future. J. Crew has good customer service, a steady fashion sense that resonates with customers, and a small store base that provides the opportunity for further expansion. Nevertheless, J. Crew has a considerable problem in its limited ability to manage a potentially unstable competitive landscape.
J. Crew's business strategy is fairly conventional, which makes the company vulnerable to competition. J. Crew distinguishes itself with a pleasant retail experience in its stores, catalogs, and website, and by stocking attractive merchandise of a high standard of style and quality on its shelves. The elements of that retail formula, however, could be easily copied by rivals like the Banana Republic unit of Gap (NYSE:GPS) or Abercrombie & Fitch (NYSE:ANF), which already operate in the same malls, recruit sales staff and managers from comparable talent pools, and merchandise similar fashions.
An increase in the intensity of competition would put J. Crew at a unique disadvantage relative to its retailing peers. The company used the proceeds of its recent IPO to pay down substantial debt, but J. Crew still finds itself in a financial condition without much flexibility.
The company has a deficit of shareholders' equity, and its capital structure is therefore entirely supported by long-term debt. Interest expense consumes a significant portion of J. Crew's cash flow from operations and would limit the company's ability to generate cash in the event of a business downturn. J. Crew's rival Gap has been notoriously clumsy in executing an effective marketing and merchandising strategy, but Gap's stronger balance sheet still makes it much better prepared to endure either a slowdown in consumer spending or a period of tighter profit margins resulting from increased competition.
For now, investors seem willing to suspend their skepticism about J. Crew's long-term competitiveness, focusing instead on the firm's dynamic growth. The company grew revenues by 23% last quarter, including an impressive 19% increase in comparable-store sales. But a rapidly expanding store base -- J. Crew increased its store count by nearly 5% in each of the two quarters since it went public -- is probably a big component of the market's enthusiasm for the company's stock. Future store openings, however, would have to be cancelled or postponed if an unfavorable business climate were to impact the firm's cash flows from operations, since the company's debt burden is still heavy.
J. Crew's stock now trades at multiples that don't reflect any recognition of such risks. For example, J. Crew's shares trade at an EV/EBITDA multiple of 18, while Gap and Abercrombie & Fitch trade at multiples of just more than 7. The rich valuation leaves little room for a misstep and a lot of room for the share price to fall on any disappointing news.
J. Crew's weaker financial condition and overheated stock price should be immediate concerns for investors in this stock. Perhaps less worrisome, but still potentially troubling, are CEO Mickey Drexler's plans to launch new retailing brands. Drexler appears to be reading from the same script he followed when he was CEO of Gap. That script contributed to Drexler's undoing as Gap's CEO. New brands that he conceived and launched helped cannibalize sales at the flagship Gap stores. Gap's managers still wrestle with the legacy problem of trying to identify a distinct market segment for the brand.
With shares of J. Crew trading at $40, the market seems willing to overlook the company's substantial competitive and financial weaknesses and bet instead that the good times will roll on. Risk-averse investors should be thinking about ending their ride with J. Crew's shares.
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Fool contributor Michael Leibert welcomes your feedback. He owns shares of Gap. The Fool has a disclosure policy.
