Net Cash Position and Positive Cash Flow Make Express a Buy
Shares of Express (EXPR) have been hammered since I last wrote about the company in December of 2018, falling almost 43% after the company posted terrible fourth quarter same-store sales and fired its CEO. Although the situation looks bleak and cheap retail stocks are often value traps, I believe there is some evidence that Express is worth a bet at its current price. Let’s take a look at why decent cash flow, a strong balance sheet, and a solid e-commerce position could lead to an Express turnaround.
Cash Flow Remains Solid
I’ll touch briefly on Q4 results and Q1 guidance, but the overall focus here will be on cash flow. Over the past three years, Express generated positive free cash flow, even when adjusting for stock-based compensation.
Operating Cash Flow
Source: SEC filings
As we can see in the above chart, Express’s worst year for free cash flow was 2018, and the company still managed to generate almost $24 million. Over the same time period, comp sales declined -9% in 2016, -3% in 2017, and -1% in 2018, with total sales falling from only 4% from $2.2 billion to $2.1 billion. Gross margin deteriorated by 150 basis points to 29.1% of sales, and SG&A climbed 200 basis points to 27.8%. SG&A includes a $5.4 million charge for CEO severance in 2018, but the equation continues to look bleak – rising labor costs, stagnant sales, and a highly promotional environment weighing on gross margin.
With all of those negative factors in-play, Express generated positive cash flow, and I think this trend will continue, even after factoring in the comp guidance of -9% to -11% for Q1’19. I actually believe the comp will improve over the balance of the year. Capex spending will be cut to $40-45 million in FY19, and I think the company will blow out some of its elevated inventory to generate some cash, even if it results in a lower gross margin.
Further, Express’s men’s business continues to perform relatively well driven by positive comp growth in shirts, casual pants, graphics, and jackets. I will attest to an improving product assortment in men’s, particularly in blazers and denim.
Women’s, on the other hand, appears to be a drag on the business. I think Express failed a few times on recent trends that have favored more ’90s-centric fashion from the likes of Urban Outfitters (URBN) rather than the more modern look of Express.
As you can see in the above picture, the graphic from Urban Outfitters looks a lot more like 1999 than 2009. Note the pastel Champion hoodie as well as the baggy, faded „Mom Jeans.“
In contrast, Express has a more modern, progressive look. While there is room for both, and Express’s sales have not gone to zero, the Urban Outfitters look is simply a lot more in-style than the Express look over the past few quarters.
Importantly, management, though an interim team, has a plan to mitigate some of this issue by implementing earlier season testing to generate data that could lead to better trend selection. This is a change in product strategy. Previously, Express would not leak much out in prior seasons, so there was no data generated to see if the style was catching on or looked likely to perform well. The new product strategy of leaking some product in should allow Express more flexibility in terms of stocking inventory for new seasons and even provide valuable feedback that a certain style may fail miserably or be poised for success, reducing capital commitments to certain products.
Admittedly, Express and Urban Outfitters have not as much historical overlap in terms of customers, but I believe the prevailing trends in women’s fashion have moved to favor the vintage ’90s look, making the Urban Outfitters look more mainstream than in past fashion cycles. Express must maintain its core customer base, so I do not believe we will see a wide product shift strategy, but the design team is likely to borrow elements from current fashion trends to capitalize on market dynamics. Express will not deviate from its product strategy within categories like „going out“ and work wear, but I see opportunity for the company to make clothes that fare better with current footwear and eyewear trends.
After reading several fashion publications, I discovered several trends for summer of 2019 in the women’s space. These include animal prints, off (off one) shoulder tops, neon green, lavender, fishnets, derby shorts, and fringe. Express is hitting on many of these key categories with its summer assortment (see below).
I’ve followed fashion and retail for a long time, and there will undoubtedly be non-consensus trends, but I like that Express has exposure to several categories that could do well in the summer of 2019.
As well, because the issue is primarily with women’s product, any trend hitting in Q2-Q4 will probably be upside versus the current plan. If Express is able to hit on trends, I anticipate a powerful combination of positive comp growth and inventory reduction.
In short, I see a clear path for Express to generate positive operating cash flow in FY19. And, if Express fails in this respect, investors are purchasing with a margin of safety.
Net Cash is a Wonderful Asset
Several retailers, including Francesca’s (FRAN) and Toys ‚R Us, are victims of poor capital structure rather than necessarily a failing business. Keep in mind that Express still generates over $2 billion in sales at a positive operating margin, so the business is not a complete disaster. More importantly, Express avoided the sins of many a retailer by limiting the amount of debt on its balance sheet.
Like all retailers, Express has considerable lease obligations, though Express will see a considerable reduction in 2020 and 2021, and though profitability is declining in aggregate, I suspect several stores remain profitable. It is impossible for an outsider to know individual unit economics, but based on my knowledge of retail, a company of Express’s size is likely to have plenty of profitable stores. Unfortunately, I cannot quantify how many.
Source: EXPR 2018 10-K
Other than lease obligations, long-term liabilities are minimal.
On the plus side, Express has $172 million in net cash, translating to roughly $2.52 per share in cash. As a result, investors are getting the cash flows of the Express business for about $0.90 per share or ~$60 million. This would equate to a multiple of about 2.5x recent free cash flow, though I add back stock-based compensation as a cost, making the valuation around 5.5x free cash flow. I normally wouldn’t be enamored with the valuation, but it is important to note that Express has done a solid job in e-commerce.
Express Retains a Solid E-Commerce Position
Like all legacy retailers, Express continues to operate a wide base of stores, with 631 stores in the United States and 16 franchised stores in Latin America, primarily in Mexico. Express last disclosed the composition of its retail footprint in 2011, and at the time, 82% of its stores were in malls. I suspect the composition is relatively similar today, with the exception being that Express is converting a lot of its less premium mall locations into outlet stores in order to preserve sales rather than simply absorb lease expenses from closing stores.
Express has reduced its store count since its high watermark in 2016 when the company operated 656 stores. This number slightly understates closures because, while net store count fell by only 25 units over the past three years, the company impressively closed 125 full-priced locations over the same time period.
New Retail Stores
New Outlet Stores
Retail Stores Converted
Retail Stores Closed
Net Ending Stores
Source: EXPR 10-K
Although I am not privy to the economics of the outlet stores, I trust management is only opening outlets because they are at least marginally accretive. However, I anticipate that a new CEO will review the store footprint and could have a different view on how to manage the store base.
Express has quickly adapted to its millennial customers, creating a relatively good online experience that has driven online penetration to 30% of sales, with a growth of 20% y/y; thus, total sales declined only 2% y/y on a consolidated basis to $2.1 billion. There is a wide variance in terms of e-commerce penetration. On aggregate, it’s about 15-16%. However, Express does a great job of running compelling sales and entering into partnerships with more prominent influencers (1m+ followers) and NBA players to help drive brand awareness. Below is the online penetration rate of a few retailers that I follow closely. Note that many retailers do not disclose online sales, likely because either they are not that good, or it would signal how well they are doing online to competitors.
Foot Locker (FL)
Urban Outfitters (URBN)
Finish Line (owned by JD Sports (OTC:JDSPY))
Dick’s Sporting Goods (DKS)
Source: SEC and Other Regulatory Filings
With a solid position in e-commerce and the ability to grow this penetration over time, Express will undoubtedly need to improve logistics and lower shipping and fulfillment costs. However, this strong e-commerce position will likely prevent a rapid decline in the business, even as sales shift away from physical locations. Express, in my limited experience, has consistent fit, which also reduces the risk of buying online. The strong level of e-commerce penetration provides some durability relative to other retailers and is the primary reason why I feel confident the company over the long term.
As you move through the financial statements, one can see how even the base-case scenario for Express (which, in my version, includes a sales decline of more than 5% for FY19 before stabilizing in 2020) can lead to significant cash generation and leave the company in a strong position.
Inventories currently sit at an incredibly elevated level, but Express likely worked hard throughout Q1 to move the inventory; albeit at a heavily discounted price. The company frequently ran aggressive e-commerce sales campaigns that, while helpful for my monthly personal P&L, are likely to hurt the performance of my investment accounts. Still, as you can see in my forecast below, I am not expecting 2019 to be a fantastic year. However, I anticipate a 5.3% drop in sales will produce just a modest loss. More importantly, and I cover this later, the company has substantial D&A charges that hide cash earnings.
Source: Detroit Bear
Regardless, under my base case that calls for a decline in gross margin and a decline in sales, I believe the company can generate over $100 million in free cash flow. How is this possible? It’s simple – Express has high depreciation charges from its retail footprint dominant days. However, the company doesn’t need to invest all of the deprecation currently booked back into stores, as the company is on balance reducing its footprint. Thus, I think the company will book about $80-90 million in depreciation and amortization that will be offset by only $40-45 million in capex that the company will spend in 2019. The reduction in inventory and hidden earnings power should allow the company to generate plenty of cash even as sales fall.
Source: Detroit Bear
In fact, my range of potential cash generation outcomes are all in the neighborhood of $80-120 million in part due to the hidden earnings power, coupled with the belief that inventory should be reduced regardless of what happens to revenue. The severity of the revenue decline will, however, determine how much the company is able to generate in net income.
Longer term, the story becomes a bit more precarious. I do not believe the current model supports a robust comp growth rate. However, I believe if the company hits on trends for the next few years, I can see 1-2% on average, with some quarterly volatility. Assuming the company is able to improve on shipping costs by increased distribution investment, operating margin could hit 2-3%, though I forecast just 1% operating margin in my base case, with less than 1% in 2020. Additionally, other than $40-50 million a year in capex, I model no value creative uses of cash or returns of capital.
Here’s a detailed view of my Base Case model:
This is not a great business, but it continues to generate a solid amount of cash, given these assumptions, which thus supports a fair value of $10 per share. It’s not a great business, but it’s worth more than it is today.
The below table summarizes my Bear, Base, and Bull case assumptions and price targets:
+1% to 1.5%/yr
Annual Capex Spend
Perp Growth Rate
Source: Detroit Bear Estimates
Under my bear case scenario, comps are -1% as the company enters a terminal decline. Still, the company is able to generate enough cash to support a fair value of more than $7 per share.
An upside scenario seems rather unlikely, and in my view, the upside is unlikely to be on sales but rather on operating margin. Assuming the company achieves an operating margin of 2% annually with similar low-single digit comp assumptions, I believe shares could be worth as much as $12.
Ultimately, the range of outcomes in the scenario is relatively wide, but such is the case with a distressed asset in a changing marketplace like retail. Additionally, the company remains without a full-time CEO. Without knowing who the CEO is, we simply cannot know how capital allocation will work. Could Express make a bad acquisition with its cash hoard? Will it commit to a dividend that is unsustainably high? Will management buy back too much stock? Sadly, we cannot know at this time, and this should be factored into any investment consideration.
Margin of Safety and E-Commerce Upside
Overall, I think Express looks poised to generate positive cash flow, and even if it doesn’t, the company has enough cash to make it through a challenging FY19. Although there is no full-time CEO at the moment, the search remains ongoing, and I believe the strong capital position could attract a talented manager. While I do not believe Express will return to mid-single digit comps, even a flattish comp and the right cost structure would make this a winning investment. Unfortunately, the company faces an ongoing headwind from its malls located in less premium malls that experience large declines in traffic that will limit most growth to e-commerce, A-malls, and outlet stores.
Nevertheless, I think shares could double over the next 18 months, particularly if Express hits on fashion. The company will generate cash this year even under the worst-case scenario, leaving the new CEO with a strong balance sheet position. Although the business may be declining, there is a lot of cash in Express’s coffers. I am interested to see how the new CEO decides to allocate capital. It will be the difference between the business languishing or creating a massive windfall for shareholders.
From a private equity perspective, I believe Express would be an interesting asset to acquire and run for cash for the next few years, though I think adding leverage to the balance sheet would shorten the asset’s lifespan, potentially making it less valuable to private equity. Still, there is an outside opportunity that private equity takes a swing, given the relatively strong balance sheet and large sales base. I have not contemplated this scenario in my valuation, but it is possible.
The best part of an investment in Express is that the business doesn’t have to perform that well for shareholders to do well. Express only needs to be moderately profitable for the investment to be successful, and because the company has not burned too much cash on buybacks or acquisitions, there is plenty of time for management to discover the right size of the organization and optimize the cost structure.
By my calculations, a 1% operating margin would produce $0.24 in earnings, while a 2% operating margin would get the company to $0.48. Add in another $40 million in excess depreciation/amortization charges, and Express could earn a whopping $0.83-1.07 in cash earnings. Not bad for a retailer trading for $0.90 net of cash.
Disclosure: I am/we are long EXPR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.