Why I Like This Company's Expansion Plans

Jordan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In a world where people leave the house in pajama pants and stained t-shirts, it's a bad time to be a tailor. It's a worse time to be a suit seller.

Jos. A Bank (NASDAQ: JOSB) is fighting a decline in the suit and tie. Net earnings trends have turned negative, but a new plan may put its earnings growth back on track.

Diagnosing a financial statement disease

One big warning sign in Jos. A. Bank's financial statements is its days sales of inventory measure, which for the most recent trailing twelve months tops 294 days. Using quick math, we discover that Jos. A. Bank isn't selling its inventory as quickly as it should. The average spot on the suit rack will hold only 1.24 suits per year.

This leads to weak profits in a working capital-intensive retailer. A net margin of 7% during the period means Jos. A. Bank is earning low, low returns on its inventory.

Something has to change for Jos. A. Bank to earn its valuation. It could lever up to finance inventory with other people's money, but that only exposes it to interest rate risk should rates go higher. Besides, financial engineering isn't enough to satisfy shareholders who want top and bottom line growth.

Going long on rentals

As fewer people need a daily suit or tuxedo, Jos. A Bank is looking to tap the rental market for growth. Tuxedo rentals are wildly profitable as a cheap tuxedo can rent for $100 or more per day, several days of the year.

This model should lead to improvements in its asset utilization. Just think, if Jos. A Bank can pay $150 to create a tuxedo, and rent it out for profits of $50 per use just three times a year, it can generate 100% annual returns on all working capital in its tuxedo rental business. Even if it were to rent each tux just one time per year at a profit of $50, it would earn 33% returns on assets in the business, significantly higher than the 8.68% returns it earns on inventory for sale.

A comparable company, Men's Wearhouse (NYSE: MW), currently earns an 86% gross margin on each tuxedo rental, a fantastic gross margin for an ancillary product. Rentals take up very little sales space, require almost no additional investment (the retail locations are already in place), and are a highly-profitable business line.

Jos. A. Bank shouldn't expect similar, short-term performance from its rental expansion. Men's Wearhouse claims agreements and partnerships with David's Bridal, TheKnot.com, and other wedding-focused businesses that provide a steady stream of referrals. But there is long-term promise in a rental business seeing as the gross margins are unbelievably thick.

In 2012, the rental business added $349.88 million in gross profits to Men's Wearhouse. Given its much higher inventory turnover ratio, we can assume that Men’s Wearhouse manages to rent each tuxedo in inventory multiple times per year.

Men’s Wearhouse rents tuxedos from retail locations in which it also offers men’s clothing for sale. If Jos. A. Bank were to tap into rentals and build out the business through its existing operations, it could reach into a piggy bank worth millions of dollars per year with minimal cash outlay of its own. 

Making the case for Jos. A. Bank

Let's suppose that Jos. A. Bank can enter the rental market and make a similar amount of gross profits from tuxedo rentals as its nearest competitor. Jos. A. Bank is roughly half the size of Men's Wearhouse by store count. At 53% of the size of Men's Wearhouse, Jos. A Bank could deliver $185 million in additional gross profits with rentals each year.

This could add as much as $120 million to the bottom-line, sending net income up 150%.

Even in a worst case, where Jos. A. Bank spends heavily to promote its new rental service and devours much of its new gross margin contribution in competitive investments, Jos. A Bank could still double net earnings on a tuxedo rental expansion. Given the scale of the retailer's marketing budget, a brief blurb about rentals could be added to existing marketing spend, making marginal marketing costs negligible.

I think that makes Jos. A. Bank worth owning. At 16 times trailing earnings, a double in earnings means Jos. A. Bank trades at 8 times earnings if it fully maximizes the potential in a rental product. The existing cash on the balance sheet of $377 million (one-third of the company’s total equity valuation) is more than ample to roll out a rental service without compromising liquidity.

 

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