Looking For Another Ann Taylor This Quarter

Monday morning, Ann Taylor (ANN) surprised the Street by increasing its 1Q08 outlook. Despite a total same-store sales decline of 4.3%, management raised its quarterly EPS forecast range from $0.35-$0.40 to $0.45-$0.47 (the previous consensus estimate was $0.36). Ann Taylor's LOFT stores, which cater to a more casual audience than the namesake brand, reported relatively strong comps of +0.7%, while Ann Taylor stores reported a comp decline of 11.5%. The announcement triggered a 26% surge in the stock, which remains in the mid-$28 range after Tuesday's close.

Honestly, we were shocked when we the saw this announcement because there have been so few reasons to invest in women's apparel retailers over the past 12 months. Though few men will admit it, the mature female consumer often represents the primary decisionmaker in a household. Confronted by a deteriorating economic situation with gas and food price inflation, housing market woes, and a tightening credit situation, she will likely be first member of the household to cut back on discretionary purchases. While some management teams attribute recent weakness to a lack of inspiring fashion trends, we believe this reason is the single biggest factor behind the sluggish traffic at Ann Taylor and its rivals over the past several quarters.

So what did Ann Taylor do differently this quarter? Sure, comparable-store sales were relatively strong at LOFT stores. However, the segment recorded a 9% decrease in the year ago period, indicating that the 1Q08 comp number was inflated a bit. In our opinion, Ann Taylor's sales figures do not really show any evidence of a meaningful inflection in customer traffic trends. Tax rebate and stimulus checks could help to reverse this in the coming periods, but we believe these funds will generally be used to purchase consumer staple products, not discretionary items.

Instead, it appears that Ann Taylor's excellent inventory management was the primary driver behind 1Q08 earnings outperformance. Total inventory levels were down 15% per square foot at the quarter, with Ann Taylor and LOFT inventories both down "significantly" according to management. Clearly, lower inventory levels are preferred when store traffic is weak, as it reduces the amount of markdowns that a company must take to clear merchandise off shelves.

We went back and checked management commentary regarding inventory on the 4Q07 conference call to determine whether there were any potential clues to signal yesterday's earnings surprise. We found that in-store inventories per square foot were down 7% and 34% at Ann Taylor and LOFT, respectively, and that management repeatedly stressed tighter inventory buys in light of economic challenges. Granted, in-transit inventories were up due to the earlier timing of Easter and Chinese New Year, but there were a few indications that lower inventory levels could protect margins during the quarter.

Given this information, we started to wonder if there could be any other potential earnings surprises among mature women's apparel retailers. It is safe to assume that sales were lackluster across much of the sector; Chico's FAS (CHS), Limited Brands (LTD), and Talbots (TLB) already reported negative comps, and our recent store checks indicated weak traffic at other chains. We do not anticipate strong earnings any of the aforementioned companies due to the de-leveraging effect of negative comps on margins (though, in fairness, Talbots did indicate modest gross margin improvement on better inventory controls).

That leaves us with Coldwater Creek (CWTR) and Christopher & Banks (CBK). Both companies had relatively clean inventories heading into the quarter (Coldwater Creek's was down 9% on a per square foot basis, while Christopher & Banks was 22% lighter on a per store basis). Both management teams reduced store growth plans for the year, thereby saving on store pre-opening costs. However, we believe any positive impact on margins will be effectively offset by negative double-digit comps and limited expense leverage opportunities. Sadly, Ann Taylor may have been an anomaly this quarter.

One other notable item from Monday's press release was the announcement that the company will not pursue a new concept targeting the "modern boomer" segment. Investors should welcome this news, as it should free up capital that can be used for higher-return projects. Despite industry claims to the contrary, we believe the modern boomer audience has too many apparel choices right now, leading to increased industry competition (and in some cases, elimination - Gap's (GPS) Forth & Towne concept being a prime example). However, we believe plans to launch a LOFT Outlet chain this summer are prudent. A reoccurring theme from last week's sales announcements was strength at outlet locations, a trend we expect to continue as long as average consumers are feeling pressured.

Investment recommendation: Unfortunately, we believe the positive news has already been priced into Ann Taylor's stock, which is now trading at 15x the midpoint of management's fiscal 2009 earnings range of $1.80-$1.90 (essentially in line with long-term earnings growth estimate).

Existing shareholders may want to use Monday's rise as a profit-taking opportunity, while prospective investors should probably wait until after the May 22nd conference call before building positions. There is still a great deal of negativity surrounding this sector among institutional shareholders, and we are curious why management did not raise its full-year guidance after reporting such a strong quarter. That being said, Ann Taylor possesses several competitive advantage over its peers and could prove to be the most promising investment opportunity in a challenging sector.

As for the rest of the space, we would avoid building positions anytime soon. This is a cyclical industry, and there will be a time when outdated wardrobes will lead to strong demand for women's apparel. However, the target audience for women's apparel is still focused on cutting back on discretionary purchases, meaning that it will probably take a at least a quarter or two before this space becomes an attractive investment opportunity. Short selling may not be the right move either, as most of the group is already trading at or near all-time low multiples and may not provide enough downside to incentivize bearish investors. Our advice: avoid the space altogether for now.

Disclosure: None.