Description

Thesis

SELL.  BKE is a broken growth story trading at $54, or almost 16x FYE Jan. 2014 P/E and 8.2x FY’14 EV/EBITDA.  Declining comparable store sales and sales per square ft., lack of store growth opportunities, increasing competition, peak margins and a declining macro environment for mall based apparel retailers lend this stock to be worth closer to 12x FY2014 $3.47 (essentially flat eps growth) or about $41 (24% downside).  There are a number of issues facing BKE that are unlikely to be resolved in the next few quarters including continued margin deterioration as the ability to raise AUR declines, increased competition, and  weakening macro environment which is further hurting sales.  Like its other mall-based teen peers, BKE will in the long term see a permanent decline in its OPM as current margins are just not sustainable.  Assuming a decline in OPM to 18% (which I believe is generous) and still significantly above its peer group including URBN (now at 13% but once at 20%), EPS drops to $2.82. A weaker margin profile would lower the multiple, putting BKE more inline w/ peers such as AEO and ANF. At 12x that new EPS, BKE would be a $33 stock, almost 40% downside from today’s levels.

Investment Highlights

Maturing Domestic Retail Business:

• BKE has few opportunities to grow its store base given that it has almost 500 locations
• While management claims to have not studied its store productivity, it appears that the newer locations in the NE area have not gained traction forcing them to depend on their core Midwest business
• In the last five years, store base has gone from 387 to 440. Within the last two years, BKE has only had square footage growth of 2%.
• No new concepts in the works – and any new concepts would clearly come with risk

Extremely Weak Social Media Presence and Ecommerce Channel:

• For most retailers, ecommerce is a huge driver (at least double digit growth), especially as most are growing off a low base but BKE is seeing very weak ecommerce sales. Growth of only 6% in Q1 on top of a meager 15%.
• Ecommerce growth peaked in FY10 at 45% and has then been in the low 20s and now single digits
• Ecommerce is the highest margin business in retail and BKE is unable to capitalize on it versus peers such as URBN where ecommerce is a huge sales and margin driver
• The next generation is all about mobile and e-commerce and in the long run without a strong e-commerce presence, this does not bode well for the company’s future
• Google trends for Buckle store peaked in December 2010 and is going nowhere to down versus up and over for strong growth brand such as kate spade or Michael Kors
• Only 356k likes on Facebook vs. 9.1M for AEO, 7.7m for ANF, 1.8M for URBN
• Target demographic is 18-25 y.o. – yet internet/social media presence is extremely weak 

Deteriorating Comparable Store Sales and Margins:

• Comparable Store Sales
  • Comparable Store Sales (SSS) have been very inconsistent the last 12-18 months essentially peaking in February 2012 (at the high single digits) to a low single digits ever since with even a few negative months.  Should this trend continue which we think it will, it will eventually hit GM as BKE needs at least a msd sss to leverage buying and occupancy costs.

• Margins
• BKE is at peak OPM in the low 20s vs. most peers in the mid-teens or even hsd
• About 1/3 of the business is private label, helping to drive margin improvement but also increasing fashion, design and manufacturing risk; however when compared to other mall-based peers (ANF, AEO, ARO, CHS, ANN – etc. are all 100% private label and have lower operating margins)
• BKE has managed to maintain GM through increases in merchandise margins and by reductions in incentive compensation.  Most of the increase in merchandise margins has come from increasing AUR, with msd to even low dd increases at the end of CY2011 and into CY12.  Now going CY13, we are seeing that trend decrease AUR’s flat to even down in the last couple of months. 
• Margins also benefited in the fall of 2012 from the steep reduction in cotton costs on a year over year basis from 2011. Since denim is 45% of BKE’s sales, they were one of the greatest beneficiaries of this product cost decrease. However, going into fall of 2013, the cost benefit will anniversary and we are starting to see a slow rise in cotton prices again.
• A quick analysis of BKE’s margin profile indicates that if its OPM falls to even 18% (significantly higher than well run operator URBN (13.4% FYE Jan 2013) and almost double other specialty retailers such as ANF (8.3% FYE Jan 2013), EPS would drop $2.82 to for FYE Jan 2014 vs. $3.47, an almost 20% drop   

Other Warning Signs:

• Management does not give guidance and provides very little information on its conference call.
• Management’s answers to questions, particularly about store productivity are vague and dismissive. What management team in the retail business hasn’t studied it store productivity, product costs or has really tried to figure out why its ecommerce business is lagging? If management hasn’t taken the time to study it, it’s likely they won’t be able to fix it either.
  
• On Nov. 2012 Q3’12 earnings conference call, analyst Paul Alexander asked a question about productivity of retail stores separate from online and again management answered, “I can’t say that I’ve studied that well enough to be able to give a good comment on that.”
  
• On March 2013 Q4’12 earnings conference call, again sell-side analyst Paul Alexander asked how much of the 20bps improvement in merchandise margin was from lower product costs.  Management’s answer was “I don’t know that I’ve studied it well enough to say…”
• Insiders continue to sell the stock in droves – obviously this does not show confidence

Competition is growing:

• BKE is facing an increasing competitive environment.
• Other Specialty Retailers:  
• Specialty retailers like AEO, ANF and URBN are actively marketing and competing w/ the BKE for market share and share of wallet. This often includes steep discounting and markdowns.  The mall “being on sale” makes it difficult for any one player, especially in the key 18-22 y.o. demographic to continue to play without offering competitive pricing.
• Fast Fashion:
• New fast fashion players like H&M, Zara, Forever 21, and Uniqlo are continuing to build out their store bases and able to offer trend-right fashion at entry-level opening price points that specialty retailers such as BKE cannot match.  This teen demographic is extremely fickle and trying to get the most bang for its buck. 
• Ecommerce
• As mentioned above, ecommerce is the future of retail and seemingly all retail players are working on building out there ecommerce/Omni channel platforms. Even the worst players are seeing strong growth in ecommerce except for BKE.  Competitors such as URBN have made ecommerce a keen focus on their future growth and believe it will eventually be larger than its brick and mortar store business.
• Outlets
• Outlets used to be located far away from the cities – maybe 45-60 miles away.  Increasingly outlets are moving closer to cities and regional malls, placing increased competition on typical mall-based retailers who are competing with themselves at the outlet channel as well as high end retailers with stronger brands and steeper discounts to full price.

Why now?

• Continued weak comparable store sales, slow store growth, increased competition and weak ecommerce sales
• Valuation
• Almost 16x FYE Jan 14 EPS of $3.47 is too expensive for company with slowing growth/(actually no growth), potentially weakening margins and the headwind of weaker mall traffic.  BKE’s cash balance and one-time special dividends are not enough to justify a premium valuation to the group as peers such as AEO and ARO are also sitting on almost half their market caps in cash and are trading at 12x.   BKE should get a multiple more in line with its current growth rate or 13x FYE 13 or about $41 per share.  The downside could be considerably more in the longer run as we believe operating margins will normalize at much lower levels.

Risks

• Large cash balance – could do special dividend, increase regular dividend or a share repurchase; although they had done a larger than unusual special div last year ahead of changes to tax law
• Heavily shorted name (20% of float); could result in short squeeze in spite of poor financial performance

Catalyst

Catalysts

• Report Q2 earnings Friday August 16, 2013
• Start a new concept/buy a concept – would require heavy investment/use of cash and very hard to execute. Retail landscape is littered with failed acquisitions, new concepts including acq of J.Jill by Talbots, concepts such as JimmyZ’s by ARO, Martin + Oso by AEO, Ruehl by ANF and Forth &Towne from GPS