Bon-Ton Investors May Be Starry-Eyed

Investors in Bon-Ton Stores have certainly seen some good times recently. The stock, which had been administered last rites in the despondent days of March, has bolted from a low of $1.18 to a recent high of $14.00. The euphoria has stemmed from improving sales trends and the promise of cash flow robust enough to pay off some debt.

The concept of lower debt is a tantalizing one for investors. Back in March 2006, after Bon-Ton acquired the Carson chain of stores from Saks for cash, its debt ballooned to $1.2 billion. Debt stood at $1.155 billion in the most recent quarter. The stock, which was $16 when the deal was announced, ran to a high of $55 on the hopes of expense rationalization and geographic diversification of sales. Bud Bergren, who is still Bon-Ton's president and CEO, said at the time that the acquisition would "enhance shareholder value by providing an expanded and diversified geographic presence and economies of scale that will drive greater profitability."

Huge losses have followed, due to lower sales and outsized interest payments. These losses have caused book value of the shares to shrivel to $3.27 per share in the most recent October quarter, from a level of $21.00 per share in January 2007.

After the closing of the Carson acquisition, operating income per store proceeded to fall year over year for the next 11 quarters. Only in April of this year did profitability begin to improve because of dramatic cuts in selling, general and administrative expenses. SGA cost per store has declined 12% since its peak in April 2008, to roughly $3.3 million annually per store. On a square-foot basis, Bon-Ton spends only about $47 per square foot, compared with $52.48 spent by a lean operator like Kohl's.

It seems unlikely that management can cut this expense much more with the risk of alienating customers due to lackluster service. The most aggressive cost-cutting in SGA began in the January 2007 quarter. This expense line has since been whittled down 17%. Marked improvements will be difficult to realize as the company "anniversaries" two years of these savings in the January 2010 quarter.

Many investors are drawn to management's highlight of EBITDA in its quarterly press releases. However, this measure is relevant only if the expenses after earnings, i.e., interest, depreciation and taxes, are non-cash. This metric is often used as a substitute for an estimate of cash flow. However, Bon-Ton's interest payments are so significant that they typically eat up 18% to 600% of operating income each quarter. The only quarter when there is a chance of Bon-Ton generating a profit after interest payments has been the fourth quarter, which includes the sales volume of the holidays.

Bon-Ton has been paying an average annual interest rate of 8.46% on its debt. On Nov. 19, the company announced a refinancing that extended the terms of $800 million of its debt from March 2011 to mid-2013. The rates that will be charged on this new debt will be noted in a filing by the company any day. While fundamentals have improved somewhat, it will be interesting to see if there is a relevant change to the rate being paid by the company.

On the conference call discussing the October earnings, management was quite positive regarding the sales trends for the month of October. However, investors would be wise to keep in mind previous management promises before getting swept up by the glory of one month of positive comp sales. Bon-Ton has been cycling past negative comps for many quarters now, but the comparisons became much easier starting in October. Last year, October comps dropped 11%. Comparing this year's sales with such a large drop makes it easier to generate a positive number. Comparisons will remain easy for November and December, when comps dropped 16% and 5.8% respectively.

Absolute sales per store remain stagnant and below levels seen before the Carson acquisition. Management's optimism may be misplaced, as the bulk of revenue generated in the January quarter is yet to come. Encouraging comments regarding sales were made on Nov. 19, quite early in the kickoff season marked by Black Friday. December represents 50% of sales for the fourth quarter.

While management often notes how careful it has been to manage inventories, these levels appear quite high to the naked eye. Days of inventory have barely declined year over year for several quarters and closed out the third quarter at 185 days. While this is a drop of four days since last year's October quarter, it is extraordinarily high on an absolute basis. Kohl's exited the October quarter with 136 days, and Macy's had a mere 61 days. While retailers with thin levels of inventory have been able to resist accelerating markdowns, those with elevated inventory may have to resort to aggressive promotions to clear out their storerooms.

While Bon-Ton is showing signs that it can survive off life support, investors are betting the patient will be running round the track soon. With annual interest payments of $98 million to cover, Bon-Ton needs $3 billion in sales just to break even. With the average retailer trading at a P/E of 12 times, one would assume that buyers of the stock are expecting $1.16 in earnings. Even the most enthusiastic shoppers will not drive Bon-Ton's earnings to that level in the near term.