Description

Yes, I know everyone hates retail and so do we. Yet we believe PLCE is an interesting situation and an interesting risk reward at this price. PLCE is the leading specialty apparel retailer focused on the children’s market. When evaluating a specialty retailer, we like to think whether the customer would miss the concept if the stores were to go away and we believe that this is the case for PLCE, especially as a number of other providers of children’s apparel either close or are less focused on the category. In March 2018 during its Q4 2018 earnings call, the Company correctly identified digital transformation as its biggest opportunity for growth and significantly stepped up its digital investments. The company also gave a 3-year outlook and a target of $12 EPS by 2020 based on 12% operating margin, a significant increase to the margins at that time. The key levers of this operating margin increase were based on a business transformation through technology and fleet optimization. Shortly after putting this target out, Gymboree ran in trouble and started its liquidation. PLCE decided to sacrifice margin in the near-term in order to strengthen its long-term position. In other words, PLCE became more competitive and went after the Gymboree customer.  This extended the timeline for this 12% operating margin and $12 EPS target. And then Covid happened … yet we believe the company has the balance sheet to survive this crisis and the building blocks to eventually return to high single digit operating margins with a very significant e-commerce business. We believe the stock could be worth between $60 and $96 per share in 18 months when investors start focusing on calendar 2022 results.

Why do we like it?

Growing market share and strong competitive position

PLCE is competing against a group of poorly positioned retailers and has steadily taken market share over the last few years. This further accelerated with the acquisition of Gymboree’s intellectual property in early 2019 for $76 million.

Here is a comment from the Q4 2019 call which summarizes the situation.

"Moving on to additional market share opportunities. We don't think of the recent bankruptcies as isolated events that will shift to the rearview mirror rather we consider these events to be part of a longer term and significant shift in the competitive children's landscape. We see market share gains as an annuity that is anticipated to live long beyond any single troubled competitor. As we indicated on our Q3 call, we estimate the market share opportunity from a collective group of ill-positioned retailers is meaningfully larger than any single player like Gymboree or Sears. We anticipate this group of capital constrained, poorly positioned and/or over-stored retailers will continue to be forced to consolidate and shutter doors and if we continue to successfully execute on our long-term strategy, the current market presents the Children's Place with significant and ongoing market share opportunities"

We expect more competitors to close their stores over the next few years continuing to provide market share opportunities for PLCE. This is particularly interesting because PLCE has a significant digital presence and is therefore well situated to gain market from these competitors through e-commerce.

Strong digital presence

For the last few years, PLCE has spend a lot of money on its inventory management and digital transformation. The numbers speak for themselves. During its Q4 2019 earnings call in March 2019, the company forecasted achieving a mid-30s digital penetration by 2020. This will prove conservative as the Company is already here. On its Q3 2020 call in December 2019, the Company stated that its E-commerce business was up 23% and represented a record 35% of total sales, a 650 basis point increase versus last year. On May 18, 2020, the Company provided a business update where the Company stated that through May 16, its Q2 digital demand was up more than 400% compared to prior year.

Real estate flexibility and fleet optimization program

One of the attractive aspects of this situation is PLCE’s real estate flexibility. While the Company is often described as a mall-based retailer, less than 40% of its sales come from malls and it is declining as e-commerce is growing. Over the last few years, PLCE has closed and renegotiated many leases with the majority of the lease renewals being 1 or 2 year deals. The Company has hundreds of lease events every year which allow them to negotiate rent reductions or simply exit stores. The current average lease term is just above 2 years.

Quality management team

Having followed the Company for many years, we believe that CEO Jane Elfers is a very strong merchant as evidenced by years of positive comps and market share gains focused on product differentiation. COO and CFO Mike Scarpa is focused on the more mundane things like inventory management and fleet optimization and is a good partner for the CEO

Shareholder-friendly board

The board has prioritized share buybacks and dividends over M&A. Over the last few years, the Company has repurchased hundreds of millions (in dollars) of shares and shrunk the shares outstanding by more than 50% over the last 10 years. There was also some nice insider buying over the last couple of months although at prices that are well below current price given the rapid price increase over the last few weeks.

Fiscal 2020 – what will it look like and how much cash will the company lose?

On its May 18, 2020 business update, PLCE shared that its Q1 net sales for the first quarter ending May 2, 2020 was $254 million, a decrease of 38% compared to the prior year. As things normalize (hopefully) and e-commerce sales surge, we assume things will improve. In 2019, gross margins were 35% and SG&A (ex depreciation) were 25% of sales respectively. We don’t consider this to be a normal year given the liquidation of Gymboree but it is a good starting point. E-commerce sales carry lower gross margins but end up having a similar operating margin contribution as retail sales since there are no rents associated with those sales.  We assume gross margins at 30% of 2020 sales given the change in mix. We assume that SG&A goes from 25% to 20% of 2019 sales as a result of the Company’s cost cutting efforts.

Our base case implies EBITDA of negative $10 million. Capex will be around $30 million. There will be around $10 million of interest payment. We therefore expect the Company to lose around $50 million of cash in 2020. The situation will be better if the Company doesn’t pay rent or is able to defer rents for stores that are closed. The company has $70 million of cash and has significant liquidity from its revolver. It has the liquidity to make it through the other side of this crisis. Net debt at Q4 2020 was $100 million and we expect net debt at the end of 2020 (Q4 2021) to be around $150 million. The Company will then switch to a positive free cash flow situation in 2021 and pay down this debt rapidly.

Valuation

We assume that in calendar 2022 (this would be their fiscal 2023 ending in Jan 31, 2023), PLCE generates $1.8 billion. This would be below their 2018 revenue of $1,938 million and 2019 revenue of $1,870 million. We believe this is conservative as PLCE should have higher market share in the children’s market, especially as they start generating Gymboree revenue. We have assumed EBIT margin between 7% and 9% which leads to EPS between $6 and $8. We assume EPS multiple between 10 and 12x, leading to a stock price between $60 and $96 per share, a significant gain from today’s price. At the midpoint of the range, this is a double. As a further check, we also looked at the FCF generation of the business. The company has historically generated $125 to $150 million of FCF. Using the lower end of that range and assuming an 8x multiple would yield a market cap of $1,000 million and a stock price of $70 per share.  We believe these multiples are conservative for a retailer which by then may be close to 50% e-commerce.

Catalyst

Normalization of Covid situation

Execution