Description

Investment Thesis

PLCE is an omnichannel children's specialty brand portfolio with an industry-leading digital-first model. In February 2024, PLCE released an extremely disappointing earnings report. The adjusted operating loss is expected to be in the range of 9.0% to 8.0% of net sales. All investors were expecting earnings to turn positive due to normalized freight and cotton costs. This report surprised the investors and spurred concerns that previous inventory cost issue is hiding problems from its ecommerce business. With the company burdened with a very high load of debt, all of sudden, it becomes clear that PLCE can’t weather through this economic cycle and hence share price tumbled to historic lows.

However, the turning point comes when Mithaq Capital SPC swooped up 54% of the shares and immediately provided $78.6 million of interest-free, unsecured and subordinated term loans to strengthen the Company’s liquidity position. Mithaq Capital publicly mentioned that their fundamental focus will be on long-term results rather than being swayed by short-term profitability considerations or reacting to – Wall Street – immediate responses.

At least with Mithaq Capital backing PLCE financially, it now has a chance to go through this economic cycle. This makes it a good investment opportunity for two reasons. First,  PLCE  historically generated healthy cash flows until recently when operating environment turned very harsh. Second, Mithaq capital’s interest is aligned with share holders and they have sound plans and financial resources to restore this business.

A brief review of the inventory cost issues at PLCE

PLCE's 2022 && early 2023 operating results were affected by a combination of unprecedented input costs, a sharp rise in cotton prices, and increased expenses related to air freight and container transportation. These factors led to higher costs for the company, which resulted in lower profits. 

Making it worse, many retailers carried excessive inventory going into FY2022Q4. Retailers had to offer discounts in order to clear through the inventory. This squeezed margins for retailers like PLCE and showed up in its financial report. In 2022Q4, the company reported a Non-GAAP EPS of -$3.87, which was a significant decline from the Non-GAAP EPS of $1.43 in 2021Q4. In 2023Q1, the company reported a $2 per share loss, which was even more of a decline from the $1.05 per share loss in 2022Q1. In 2023Q2, the company reported Non-GAAP EPS of -$2.12.

As of now, the high cost issue is over with both cotton and freight rate normalized to pre-pandemic level. However, PLCE surprised investors with a new operating issue from its ecommerce business and squeezed the margin of the business in the back of FY2023 again.

A review of the ecommerce operation issue at PLCE

In FY2023Q4, PLCE reported an adjusted gross margin of 21.7%. While this represents an improvement of 420 basis points from FY2022, it is still significantly lower than the pre-pandemic gross margins of 35%. The management team emphasized that aggressive promotions and split shipments are the main contributors to the lower profit margin. PLCE actually has gone through many heavy promotion periods in the past, but its gross margin remained firmly above 30%. For example, in 2019Q1, when Gymboree went bankrupt and triggered an inventory liquidation event, PLCE was still able to deliver a gross margin of over 35%. To put things into context, Gymboree had 800 stores, while PLCE currently has 523 stores.

So, the split shipments must be the major contributor to its abysmal gross margin issue. If one visits PLCE’s e-commerce website, they would see that the whole site was offering 80% off earlier this year, with everything available for free shipping without any minimum order size requirement. These sales were financially unsustainable and resulted in significant losses on low-value orders. 

The company has significantly increased its debt after the pandemic, relying more heavily on its credit facility and eventually become highly leveraged. This is a vicious cycle for retailers facing margin problems: they seek seasonal credits, purchase inventory that doesn't sell well, and then seek even more credit at a higher rate. For example, after the disaster FY2024Q4, PLCE secured a new $130 million term loan at the Secured Overnight Financing Rate (“SOFR”) plus 9.00% per annum, which is extremely unfavorable.

The previous management team was held responsible and left the company after Mithaq Capital took over. After Mithaq Capital SPC acquired 54% of the shares, they immediately provided $78.6 million in interest-free, unsecured, and subordinated term loans to strengthen the company’s liquidity position. Investors can now put near-term bankruptcy fears on the back burner. And this actually becomes an opportunity to purchase a fair company at a wonderful price with leadership team highly aligned with shareholders to restore the company’s value.

This is a good turnaround play

The fundamental ideas behind the turnaround is that PLCE’s core business is healthy but needs to fix its capital structure and improve operations. PLCE has a high exposure to debt, and the net interest expense was $30 million for FY2024.

Mithaq Capital has run some good statistics on key operating metrics that proves PLCE’s underlying business is healthy.

(1) Over the last 14-years, TCP has generated annual net income ranging from $53 million to $187 million with only a few years of reported losses. Over the same period, TCP generated annual free cash flows ranging from $69 million to $140 million and almost all used to buy back the shares.

(2) Over the last 14-years, TCP revenue has remained relatively flat, while the number of stores decreased from 995 to 523 (a 47% reduction). E-commerce revenue as a percentage of total revenue went up from 9% in FY2011 to 48.3% (53.9% as a percentage of retail revenue) in FY2024. Despite the significant shift in revenue channel, SG&A expenses remained relatively flat.

(3) During FY1997 to FY2017 (a span of 20-years), TCP's median gross profit margin stood at approx. 40% (simple average 39%) vs. 39% of the closest listed peer in the United States. However, post FY2018, TCP’s closest peer has improved its gross profit margin by 6-7% whereas TCP lost 7%.

Mithaq Capital has already started to support PLCE with strong financial. backing. In addition to the $78.6 million of interest-free, unsecured and subordinated term loans, Mithaq capital recently stepped in to lend $90 millions on terms materially more favorable to swap out the loans from 1903P Loan Agent. These strong moves show that Mithaq capital is very serious in turning PLCE around by strengthening company’s balance sheet.

Mithaq capital also made swift actions to fix the free shipping issues. After analyzing the PLCE data, it found that after factoring in all variable costs, orders falling within the $20 - 39.99 range either result in a loss, breakeven, or yield a thin profit margin that can only be covered if we earn a sufficient gross margin. Since then, Mithaq has put a $40 minimum purchase requirement for the free shipping.

Long term-wise, Mithaq capital intend to implement an appropriate performance-based incentive system, in which business units are incentivized for the factors they can control and are not penalized for the factors they can’t control. They will also seek for PLCE to have a culture of a seamless web of deserved trust, ownership mentality and a sense of responsibility. And the top priority of the free cash flow would be used to reduce and ultimately eliminate the debt over time. 

All that being said, who is Mithaq capital. 

From their own words, “Mithaq Capital SPC, the controlling shareholder of TCP, is an independent limited-investor, private mutual fund licensed by the Cayman Islands Monetary Authority. By design, only 15 investors can subscribe to the fund and it is not open to the general public. A significant portion of Asif’s and almost all my net worth is invested in Mithaq. Being the largest shareholder translates into sharing the downside as well as the upside. That's an attitude I admire.”

From what I understand, Mithaq capital is a disciple of Warren Buffett and Charlie Munger.  They allocate capital opportunistically to a handful of high-quality public/private businesses managed by first-class management through full/partial equity stakes purchased at less than their intrinsic value as determined by our careful analysis, emphasizing concentrating on the best ideas and holding them over a long period or until fruition.

From their public letter, it seems that they are very serious about turning around PLCE and let it become a cash flow generative business where they will use the cash flow to acquire more high-quality and free-cash-flow generative businesses managed by first-class management in the future. This turnaround plan is very crucial to their long term investing journey and vision. 

Valuation

PLCE was valued at over $1 billion before 2020. If the turnaround plan succeeds, PLCE’s valuation could return to the $1 billion mark (around $90 stock price). However, it will take a couple of years for the stock to appreciate to that exciting valuation. The first target for the stock price next year is to triple from $10 to $30. There are multiple milestones the company will achieve quarter over quarter that can lead to a gradual recovery of the stock price:

1. After the split shipment issue is behind us, we firmly believe that PLCE will be operating on a cash flow positive basis each year, and the results will start to show up in the quarterly reports in the latter half of FY2024, regaining investor confidence.

2. After operations stabilize this year, the high debt load won’t be perceived as a serious issue because Mithaq Capital has already provided strong financial support to help the company through this consumer spending cycle.

3. There are signs that the Fed will start cutting interest rates, at least in FY2025. The ECB has already cut the interest rate from 4% to 3.75%. The consumer spending environment will likely become a tailwind in FY2025, accelerating the turnaround plan.

If we assume that PLCE will make $3 EPS in FY2025Q3 (they did make this much in FY2023Q3’s back-to-school season) and $0 for the rest of the year, their EPS would be $3 in FY2025. Using a P/E ratio of 10, we would get a stock price of $30.

Risk

PLCE operates in a highly competitive environment and competes with the likes of Walmart, Target, Gap/Old Navy etc. In the muted consumer spending environment, parents might choose to shop at Walmart or Target to get clothes for their kids. If the muted consumer spending environment persists, it will make it harder and longer to turn around the business.

Catalyst

The single digit stock price is because of the debt the company incurred during the pandemic, Mithaq Capital SPC swooped up 54% of the shares and immediately provided $78.6 million of interest-free, unsecured and subordinated term loans to strengthen the Company’s liquidity position, PLCE shouldn't be on the list of stocks that will go bankrupt soon. Plus, the new owner has a very solid turnaround plan for this company.

1. After the split shipment issue is behind us, we firmly believe that PLCE will be operating on a cash flow positive basis each year, and the results will start to show up in the quarterly reports in the latter half of FY2024, regaining investor confidence.

2. After operations stabilize this year, the high debt load won’t be perceived as a serious issue because Mithaq Capital has already provided strong financial support to help the company through this consumer spending cycle.