Doubts about Jos. A. Bank's future growth has short-sellers in a frenzy

By Rachel Sams

Baltimore Business Journal

Published: November 14, 2004

About six weeks ago, Joseph Parnes' firm recommended that investors borrow shares of Jos. A. Bank Clothiers Inc. and sell them to others in a bet that the price would fall.

The process, called short-selling, seeks to sniff out overvalued stocks and profit as they plummet. Parnes did not believe Hampstead-based Jos. A. Bank, then trading around $30 a share, could sustain the double-digit growth in sales and earnings it has reported for recent quarters. Some of his firm's clients have Jos. A. Bank sold short in their portfolios, Parnes said, declining to provide specifics.

"This kind of industry is very volatile," Parnes, president of Baltimore-based Technomart Investment Advisers, said of the clothier. Retailing is highly competitive, and with gas prices rising, consumers will likely have less disposable income, Parnes said.

Technomart's view isn't unique. As of early October, nearly half of Jos. A. Bank's "float" -- shares available to the public -- was sold short, Nasdaq data shows. Some experts say the average level of short interest for a stock is less than 5 percent of the float.

Jos. A. Bank CEO Robert Wildrick said this week he believes the short interest level is a side effect of his company's success. When a company sees at least a 30 percent increase in profits every year, he said, "there is a short interest because people in the market always wonder, 'Can they keep it up?' " The company's 500-store growth plan will continue to drive strong results, Wildrick said. Sales growth may not be as robust once Jos. A. Bank reaches that mark, he said, but the company will then produce more cash to spend on new endeavors.

For the past year, the company's cash burn and high inventories have put it on the radar screen of firms that look for overvalued stocks. But some think the stock -- trading around $26 recently after last week's news that October same-store sales fell -- is now cheaply priced, and shorts are making a losing bet. The stock currently trades at 17.3 times earnings.

Doubts surface

To short a stock, an investor borrows shares of it from a brokerage and sells them to others. At some point, the investor has to "cover" the short -- buying shares on the open market so he can return them to the brokerage. If the stock's price falls, the investor can make a hefty profit. But if the price rises, the investor is faced with buying back shares at a loss.

In October 2003, Jos. A. Bank's stock was at historic highs near $50 a share. But the price fell as some -- including financial magazine Barron's -- publicly questioned the stock's sustainability. Those bullish on Jos. A. Bank argued that the Barron's article parroted the sentiments of short-sellers, who had a vested interest in seeing the stock's price fall.

As of early last month, 48 percent of the company's 11.8 million publicly available shares were sold short. That was actually a 3.7 percent decline in short interest from the previous month.

A high short interest level can increase a stock's volatility. If the price rises sharply, shorts scramble to buy it back and cover their losses, pushing its price even higher -- a "short squeeze." Some contrarian investors seek out companies to invest in that have a high "days-to-cover" ratio, which measures the likelihood of short squeezes. On Oct. 8, Jos. A. Bank had a "days to cover" ratio of 16.5. (The formula for the ratio is the number of shares sold short divided by average daily volume.)

Jos. A. Bank often shows big increases and decreases in stock price for no obvious reason -- which can be an indicator of short activity, though there's no way to know for sure why investors buy or sell a stock. The company's shares plummeted 14 percent on four times their normal volume the morning Jos. A. Bank announced the same-store sales decline. But on Nov. 10, shares closed up 5.4 percent, though no company news hit the market and the Nasdaq was down -- which could indicate that shorts are covering.

Experts say investors that hedge positions in a stock can drive up its short interest -- for example, protecting a stake they own from a decline in value by shorting the stock. When companies have high short interest, "there could be some option market-maker who's hedging their bets," said James Angel, professor at McDonough School of Business at Georgetown University.

Arizona-based Camelback Research Alliance provides research for institutional investors who short and own stocks. Jos. A. Bank had several of the red flags Camelback looks for to find overvalued stocks, said analyst Eric Aguirre. The company's cash flows were negative, and Jos. A. Bank's inventories were higher than recent sales levels could support.

"We just think it's too good to be true," Aguirre said of Jos. A. Bank's recent sales and earnings increases. The firm believes Jos. A. Bank has bought too much inventory and will eventually have to write down the value of the goods when they don't sell, Aguirre said.

But some analysts who have covered the company for years say the issues that raise red flags have legitimate explanations.

Brian Rafn, analyst with Morgan Dempsey Capital Management in Wisconsin, has covered Jos. A. Bank for three firms and owns the stock. The inventory levels that grab shorts' eyes please customers, who don't want to wait for a company to order basic items, Rafn said.

He also notes that Jos. A. Bank's balance sheet is relatively uncomplicated, and the company runs mainly on cash: "It's just a simple, blocking and tackling, nuts and bolts business, without a lot of places to hide."

The tug-of-war between believers and naysayers can be heard clearly on the company's conference calls with analysts. Many companies do not take questions from analysts who are bearish or short on their stock. Jos. A. Bank does not block them, meaning Wildrick sometimes gets hammered by critical questions. Supporters fire back, saying they're proud to own the stock.

Poised for change?

Jos. A. Bank has long encountered investor doubts about the way it reports same-store sales, a key measure of performance for retailers. Throughout the industry, same-store sales figures describe performance at stores open at least a year. Jos. A. Bank does not include stores until their second fiscal year of operations, and leaves out for at least a year stores that open within 10 miles of an existing store.

Many investors have complained about the practice. Wildrick said Jos. A. Bank measures same-store sales that way partly because of its fast growth -- it may open several stores in a market within a year, which would affect older stores' sales there. But the company recognizes that detractors have latched onto the issue, Wildrick said, and the board is considering changing the way same-store sales are reported.

Earlier this fall, the company paid $425,000 to settle an investigation by New York Attorney General Eliot Spitzer, who claimed the clothier misled customers about its sale prices.

Jos. A. Bank's inventory increases have slowed. Inventories on July 31 rose 9 percent from a year ago to $121.6 million. The company produced $3.5 million in cash flow from operations in the six months ended July 31, while a year ago it spent $23 million in cash on operations. Long-term debt dropped to $29.4 million from $32.6 million a year ago.

But inventories could rise again. Same-store inventories fell this year from last, Wildrick said, which may have played a role in last month's same-store sales decline. The company may bulk up inventories further, Wildrick said, but no final decision has been made.

StockDiagnostics.com issued a warning on Jos. A. Bank stock last year, noting its negative operating cash flow per share. StockDiagnostics lifted the warning in September, saying the firm's cash burn has slowed and profit margins are at their highest level in five years -- good indications the stock has probably bottomed, said firm analyst Michael Markowski.

Jos. A. Bank's high short interest level puzzles Markowski. The logical time to short the stock, he said, would have been when it was at record highs last year.

Of the current short-sellers, he said: "It looks like they're a day late and a dollar short."