Rue21, Inc. (RUE) was one of the stocks ranked tier 1 in a recent stock screen. The screen attempted to identify stocks that would exhibit predictable growth and that carry little to no debt. Rue21 satisfied all of the identified criteria and now we are tasked with investigating the company further in an attempt to identify any red flags that would preclude our inclusion of this company in a value investment portfolio. These are all steps of the value investing workflow we developed in an earlier article.
Rue21, Inc. is a clothing retailer targeted at teens, with stores across most of the United States. Stores are located primarily in small towns where there is less competition, yet the company offers very fashionable clothing items and changes themes frequently to keep “fresh”. We will now examine the company in detail and seek to determine an intrinsic value, margin of safety, and target entry price range.
The company currently operates approximately 850 stores and is expanding at a rate of more than 100 stores per year. Rue21 sees the potential to have over 1,500 stores in operation over the next few years. The company is also remodeling many of its existing stores to a new format that features a bigger emphasis on high margin items such as accessories, footwear, and fragrances. Following are some highlights I gleaned from the most recent annual report:
- Rue21 does not manufacture any of its own products, instead choosing to source from independent importers and clothing manufacturers.
- The company is a heavy user of social media in promoting its brand, which is a good fit for their target customer base.
- Distribution is handled via a single, central distribution center with the majority of product arriving pre-ticketed from the manufacturer to reduce turnaround time.
- Primary competitors are large discount retailers such as Walmart, Target, and Kohl’s.
- Business is seasonal, with highest sales in the 4th quarter for back to school and holiday shopping.
- Rue21 does not own any real property, instead choosing to lease all real estate, including its main office and distribution center.
- Dividends are not anticipated in the foreseeable future, as the company instead intends to focus on growth.
- Typical new store investment is $170,000 and new stores generate $900,000 to $1.1m in revenue during their first 12 months of operation
Rue21 has exhibited extremely predictable, high growth over the past four years. EPS has grown at 34% compounded annually, with sales growing at a compounded rate of 27%. The company has a current market capitalization of $693m based on a recent share price of $29.14. Third quarter earnings were reported in November. Overall 2012 earnings guidance was provided at $1.83 to $1.86, compared to $1.55 is 2011. Rue21 has zero long term debt, for a debt/equity ratio of 0. Rue21’s growth strategy can be summarized to three main ideas:
- Increased square footage – through new store openings and conversion of existing stores to a larger layout.
- Increased comparable store sales – primarily through the conversion of stores to the new “etc.” format with a higher emphasis on accessories that bring in higher margins.
- Increased profit margins – expected as the company grows and economy of scale plays a bigger role in obtaining supplier discounts and other efficiencies.
Based on my review, I believe that rue21 is an excellent company, and exhibits the predictability and quality we sought out in our screening criteria. Rue21 will be added to the stockodo watch list.
Determining the Intrinsic Value
We will use the EPS Growth Capitalization method to determine a present day intrinsic value for rue21. Be sure to check out the complete guide to this technique.
Analyst consensus is that rue21 will grow at a rate of 17% per year over the next five years. Does this make sense? EPS grew at a compounded rate of 34% over the past four years and grew 28% last year. While excellent, EPS growth appears to be slowing as the company becomes larger. Sales and equity grew at compounded rates of 27% and 119% respectively over the past several years. Based on the above numbers, 17% seems to be too conservative, considering there are no indications of growth slowing that significantly based on the information available. I am going to estimate an EPS growth rate of 19% over the next five years for the intrinsic value calculation.
As rue21 only began to be publicly traded a few years ago, historical PE data is minimal. In 2010 the average PE ratio for the year was 28.6 but has dropped significantly to an average of 18.1 in 2012. As of today’s trading, PE is 17.55. Based on rue21’s high and consistent growth rate, I believe a future PE of 20 is sustainable, and will be used in the intrinsic value calculation.
Summary of all inputs to the calculation:
- Future EPS growth: 19% (estimated)
- Future PE ratio: 20 (estimated)
- Current EPS (ttm): $1.67
- MARR: 15%
- Prediction timeframe: 5 years
Based on a growth rate of 19%, a future value calculation results in a predicted EPS of $3.99 in five years time. If rue21 were to trade at a PE ratio of 20, this would equate to a share price of $79.70 in the future. To achieve our minimum acceptable rate of return of 15% the present value of the stock, and hence our intrinsic value equates to $39.63 per share.
A margin of safety must be applied to the intrinsic value to account for any errors in our estimation, and should be based on the confidence level we have in the predictions. A future PE of 15 is possible, particularly if growth begins to slow as the analysts are predicting. Let’s also assume that EPS growth slows to the 17% predicted by the analysts. Running the numbers again results in a lower intrinsic value of $27.31 per share. $27.31 represents a 31% discount to the original intrinsic value of $39.63. Therefore, a 35% margin of safety should protect us from the uncertainty in our calculations, which results in a target entry price of $25.76.
Rue21, Inc. will be added to the stockodo watch list with a target entry price of $25.76 based on an intrinsic value of $39.63 and 35% margin of safety.