Description

Source for idea: I picked up on Jo-ann stores while perusing Olstein's holdings…

Jo-ann stores (from the YE-05 10-K) is the nation’s largest specialty retailer of fabrics and one of the largest specialty retailers of crafts, serving customers in their pursuit of apparel and craft sewing, crafting, home decorating and other creative endeavors.

Here are some relevant statistics on the industry;

According to a 2002 research study conducted by the Hobby Industry Association,
Approximately 60 percent of all U.S. households participated in crafts and hobbies in 2002.
Although expenditures for such projects are generally discretionary in nature, average sales per ticket during fiscal 2005 were relatively low; $17 - $23.
Industry sales, according to the Hobby Industry Association’s research study, were approximately $29 billion of which Jo-ann has 1.879B YE Jan-05.

Jo-ann has largely completed a turn-around plan started back in 2000 – the aim was to increase profitability by eliminating underperforming traditional stores (about 14,500 square feet) and replacing them with new Superstores (about 35,000 square feet), in the process bringing sales up from about 110 per sq foot, to 140 per sq foot.
In parallel, a company wide ERP system (SAP retail) was implemented and despite some considerable difficulties, is now up and running successfully, with Inventory Turns up from 1.8 at YE-Jan-01 to 2.3 at YE-Jan-05. In addition, I estimate Return on Invested Capital (ROIC: Average Shareholder's Equity + Average Debt less cash) to have improved from 8.2% at YE-Jan-00 to 12.3% by YE-Jan-05.

[As an aside, there is still significant room for improvement, Michaels, their largest competitor has sales of about 200 per square foot and (roughly calculated), ROIC of nearly 22%.]

All in all the results for YE-Jan-05 were excellent:

Net sales for fiscal 2005 increased 4.5
Same-store sales increased 3.2%
Fiscal 2005 earnings of $2.02 per diluted share an increase 15.2%
And the share hit a 52 week high of 30.69

At this point in time the turnaround plan is largely complete - most underperforming traditional stores have been closed and replaced with new Superstores (from the YE-05-CC "Store square footage increased .5 percent for the year to 15,452,000 square feet. Because of the number of performance related closings associated with our turnaround plan, this was the first year in the last 4 years that the Company posted positive store square footage growth for the full year.")

So with these positive results, the company focused on driving growth by building out the new Superstores, but as you might have guessed, things are not working out to plan, with the current share price cut in half from the 52 week high – the M Cap is currently a little below book value.

So what has gone wrong? I'll let the CEO explain; here are some extracts from a conference call the company held after announcing the Sep SSS results (which by the way is available in transcript form on the company's website, including the full Q+A session):

Alan Rosskamm - Jo-Ann Stores, Inc. - President and CEO

Same-store sales during the 3rd Qtr 9 week period (up to the end of Sep) declined 0.9% which did not meet our goal of a 3 to 4% increase.

Weak customer traffic continues to impact our top line performance

Craft business continues to be strong, [but] our sewing business, particularly home decor textiles, and our finished seasonal and home decor businesses (finished product categories, which is seasonal and home accents, and the fabric business, particularly home decor textiles -- textiles that go into draperies, bedspreads and those categories) continue to struggle (down 9.2% in the 9 weeks of the 3rd quarter)

Not only did we fail to deliver the comp store sales increases we had planned, but we have also seen an acceleration of the gross margin deterioration that we saw in the first two quarters of the year.
Gross margins impacted by a substantial increase in coupon usage by our customers.

But also, with sales below plan clearance markdowns are necessary

We consider our current performance trends to be wholly unacceptable

We believe it is prudent to slow our expansion plans while we focus on improving execution

Fiscal 2006 has been a major disappointment

A portion of the gross margin issue was self-inflicted through some promotional experimentation (i.e too many promotional coupons providing customers with large discounts, which customers are simply waiting for, instead of buying at the regular price).

Based on where sales are likely to come in relative to what we planned, we were just -- more aggressive than we wish we had been based on the external environment, which from everything we can see continues to scare us and continues to deteriorate somewhat.

We're looking at all our merchandise categories with the obvious intention of boosting space and investment in those that are trending well, and cutting back perhaps more aggressively than we have in the past in those that are not performing as well

[In answer to question about buying back shares] "we're going to be expeditious in the steps we need to take to right the ship here [but our focus is first to protect the + strengthen the balance sheet]. But it's not going to be an overnight fix. We're going to let things settle out a little bit and then certainly evaluate all of the appropriate options [meaning , once they get things stabalized they will look at a buy-back]"

All in all, they are struggling and don't have all the answers yet as to how things will be fixed, but I think the current price easily discounts all of this. In the numbers that follow I tried to extract the underlying profitability of the business by removing all expansion related costs, just focusing on the existing business by making a few, I believe conservative assumptions about maintenance capital expenditure and margins.

Based on the current sales to date, I have estimated that full year sales should be about:

1,879 (which is 3.68% up on YE-05). I did this by calculating the seasonal percentage of overall sales for each quarter – this may seem high, but it is consistent with Q1 increase of 3.9% and a Q2 increase of 3.45% and a 4.1% increase for the first nine weeks of the third quarter.

I then looked at Gross Profit based on the following gross margins:

46% - 864.4M (optimistic, but as you will see, I think it shows the potential of the business + once things stabilize I think this is a reasonable target – the last three years have all exceeded this).

45% - 845.6M (reasonable, going back to 1991, there have only been 6 years with Gross Margin lower than 45%)

43.15% - 810.8M (pessimistic, going back to 1991, there has only been one year with Gross Margin less than 43%)

And then Operating Profit

For this I assumed that SG+A (without store pre opening and closing costs) can be kept at YE-05 levels (i.e. 38.67% or revs). I am assuming that SG+A is in theory more controllable than sales and therefore can be brought into line (eventually) with whatever level of sales are achieved.

The other components of SG+A are ongoing closing costs and ongoing pre-opening costs. Assuming no net growth, management expect to close 8-10 underperforming stores a year (CC notes).

Closing costs are 100 to 200K. I assumed 150K times 10 for an ongoing 1.5M.

I then assume that to maintain a steady state, 10 new stores need to be opened to replace the 10 closed. Pre-opening costs are about 380K per store, for a total of 3.8M.

So 38.67% of 1,879 plus 1.5M + 3.8M gives SG+A of 732M.

Next we need to subtract Maint Cap Exp, which is 15-20M (CC notes), so I take 20M. In addition, I add Cap Exp for the 10 replacement stores noted above (my feeling is that this amount is not included in ongoing maint cap exp mentioned on the CC).

Total store opening costs are about $2M ("Our average net investment in a superstore is $2.0 million, which includes leasehold improvements, furniture, fixtures and equipment, inventory (net of payable support) and pre-opening expenses. ")

As the above includes inventory, (about 700K per store) and pre-opening costs of 380K and they move (when possible) Fixtures from the closed to the new store, my guess is net Cap Exp is about 800K per new store. For 10 stores, that's 8M, for total ongoing Cap Exp of 28M.

Bottom line:

With Gross Margin of 47%, Op Profit is 104.4M (864.4M, less SG+A of 732, less Maint Cap Exp of 28M)
With Gross Margin of 45%, Op Profit is 85.6M (845.6M, less SG+A of 732, less Maint Cap Exp of 28M)
With Gross Margin of 43.15%, Op Profit is 50.8M (810.8M, less SG+A of 732, less Maint Cap Exp of 28M)

Putting a ten times multiple on each of the above results in the following valuations:
1. 1,044B
2. 856M
3. 508M

At today's close (15-Oct-5) of 15.31, I calculate an enterprise value (EV) of 509M, which is equal (surprise, surprise) to my worst case scenario (so I don't see much downside from here). But I think my other two scenarios are very plausible, providing a potential upside from today's price of 60 to 100% (without taking into account the resumption of growth).

Note: To calculate EV I include all outstanding options ((2.29M) not just those currently exercisable). This is why, in case anyone noticed, I didn't subtract stock based compensation expenses from my operating profit calculations.

I also like the following:

Significant insider stakes: 23%.
CEO very open (results are unacceptable + no excuses / did not blame the weather) – see CC extracts above.
Very good disclosure CC transcripts are published on their web-site.
Business is reasonably easy to understand and long term potential for growing market share due to their size would also seem to be reasonable.

Catalyst

Hopefully results of focusing on execution will result in the exposure of the underlying value of the business and receipt of an appropriate valuation.
Resumption of growth once conditions permit – which is not factored into the above valuation calculations.