Fellow Fool Alyce Lomax cast a critical eye on J. Crew Group (NYSE:JCG) in her insightful article on the retailer's recent IPO. Since then, the company has surpassed investor expectations, announcing exceptional earnings for two consecutive quarters. That performance has helped propel the shares from their initial $20 offer price to more than $40. In its recent third-quarter earnings announcement, J. Crew added more fuel to investors' enthusiasm by raising earnings guidance for the full year to a range of $0.95 to $0.97 per diluted share, up from $0.86 to $0.87. Was the initial skepticism about this stock misplaced?
In truth, J. Crew's recent success answers no questions about the company's competitive strengths, and its conventional business strategy and anemic financial condition remain sources of uncertainty. Despite the company's strong performance lately, investors should be concerned about the long-term outlook for J. Crew's overvalued stock.
It's hard to deny that J. Crew is registering impressive growth and improved operating performance on a year-over-year basis. Revenues increased 23% to $275.6 million in the third quarter, with same-store sales in the retail and factory division up a sizzling 19%. Operating income grew 51% to $33.2 million. Net income per diluted share was $0.40, compared to a loss in the previous year.
Gross margins rose to 46.4% from 43.8%. The margin improvement was due, in part, to favorable comparisons; higher prices and better sourcing also contributed to this increased profitability. The company expanded its retail store count by ten, to a total of 226 outlets.
Investors can expect these positive trends to continue. Customers respond favorably to J. Crew's accessible fashion sense, and there's no reason to expect this steady company to suddenly alienate that base. With its relatively small store base, J. Crew has room to expand before it begins to cannibalize existing stores, and to further improve gross margins as it gains scale. In addition, J. Crew has the opportunity to move further away from its roots as a catalog company and migrate more of its direct-sales customers to the efficient Internet channel, which would help improve net margins by lowering overhead expense.
Investors might want to keep an eye on CEO Millard "Mickey" Drexler's recent efforts to launch new brands. Drexler is said to be a micromanager whose brand launches during his tenure as CEO of Gap (NYSE:GPS) distracted him from the company's larger workings. Could new business units at J. Crew blur the identity of the existing J. Crew stores, mirroring the ongoing challenge of Gap stores? Gap-branded stores, caught between the budget Old Navy brand and the more stylish Banana Republic unit, struggle to define their market segment.
J. Crew's modest financial resources point to another concern for long-term investors. Proceeds from the IPO did much to reduce the company's heavy debt burden, but the company remains highly leveraged, with negative book value. Interest expense continues to consume a significant portion of the company's cash flow from operations, and even a small business downturn would limit the company's ability to generate cash. That could suspend the company's ambitious plans to expand its store base, crippling the robust growth that currently supports its rich stock multiple.
Shares of J. Crew are priced for perfection, at a multiple of nearly 50 times trailing earnings. In comparison, shares of Gap and Abercrombie & Fitch (NYSE:ANF) trade at just 18 and 17 times trailing earnings. That leaves little room for errors in J. Crew's execution. Furthermore, the IPO-related restrictions on insider stock sales will expire in December, and J. Crew's founder recently resigned her position on the company's board. While things are going well now, investors' initial skepticism might prove healthy after all.
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Fool contributor Michael Leibert welcomes your feedback. He owns shares of Gap. The Fool has a disclosure policy.
