KCA wins third place in the SumZero “SMID Cap” contest: PLCE

We are thrilled to announce that KCA was awarded THIRD PLACE in a stock pitch competition hosted by SumZero. Our pitch is included below:

The Children’s Place (PLCE)

The Children’s Place (PLCE), a popular retailer of children’s apparel, is a compelling value investment under $20/share. PLCE suffered extraordinary margin pressures over the past twelve months (cotton and freight) which are turning to tailwinds. Despite a high debt load, PLCE will weather current retail challenges better than peers. I expect they can end FY23 with over $100m less net debt and relieve solvency concerns.

Background

Since 2009, PLCE has generally returned all free cash flow via stock buybacks, reducing their outstanding share count by over 50%. The company has routinely generated $100m of annual free cash flow ($101m average FY09-FY22), highlighting their ability to strategically adjust to a shifting retail environment.

From 2017-2019, PLCE began aggressively investing in their e-commerce channel, growing digital sales to 35% of revenue by the end of 2019 and over 50% today. PLCE also has a growing Amazon relationship that represents about 10% of gross sales. Their remaining storefront leases were negotiated to target 1-2 year average terms, allowing the company to retain significant flexibility – over 75% of leases are up for renewal within 2 years. PLCE has downsized from nearly 1,000 stores at the beginning of 2019 to 613 at the beginning of 2023, with another ~100 expected to close during 2023. A mere 25% of sales come from mall-based locations.

Current Headwinds

PLCE had the following headwinds in 2022/2023 that are set to reverse:

  • PLCE spent an additional $60m on freight versus 2021 due to shipping bottlenecks (~$30m air freight/$30m additional container expenses). These costs have now reversed with shipping rates plummeting to lows. (Back at 2019 levels - https://gcaptain.com/container-shipping-industry-faces-unprecedented-slump-in-long-term-rates/)

  • PLCE had $65m of COGS increases in 2022 due to the increased price of cotton. Prices tripled off COVID lows but have returned to normal levels (https://tradingeconomics.com/commodity/cotton).

  • Competitors like Target and Walmart were swimming in excess inventory during 2022 and chose to heavily discount children’s apparel to help clear products. This forced PLCE to compete on price right after the above cost pressures inflated their inventory values.

These combined pressures reduced PLCE gross margins to 28% TTM (vs. 30% FY22), driving negative earnings and ballooning short-term debt. The market punished the stock, fearing PLCE may not survive in the current environment. This fear should be dispelled in the second half of 2023 when freight and cotton headwinds cycle out of working capital. To this end, assuming a continued discounting environment without any consumer recovery, PLCE gross margins would have been above 35% TTM without the $125m of cost pressures in the P&L. Even Q4-22, traditionally a lower-margin quarter, had over $80m of cotton and freight headwinds. Absent these pressures, and despite heavy discounting, gross margins would have been above 35%.

To further illustrate this point, current inventory is over $500m compared to $350m in May 2019 when PLCE had nearly double the stores. Accounts Payable is practically flat, which means PLCE has the opportunity to reduce debt as inventory is worked down. PLCE increased inventory $50m into the end of Q1 as they prepare for back-to-school season, but cashflow from operations was positive and set to be significantly positive in the back half of the year (Q3 is seasonally their strongest due to back-to-school). This week PNC extended another $95m on the revolver for a ~1% rate increase (so ~$3-4m annual increase in interest expense) which should relieve any liquidity concerns. They emphasized on Q1 call that early June would be peak WC.

Other Considerations

When referencing 2019 as a baseline for PLCE, it is important to remember they were competing with Gymboree liquidating which required aggressive discounting. So, 35% gross margins again appear attainable even with discounting pressures. Consideration must be given to the change in sales channel mix – i.e. Amazon wholesale generates lower gross margin but higher operating margin. So aside from external pressure from cotton and freight, PLCE seems to be holding GM at a healthy 35% even with the mix shift.

Looking at 2019, PLCE spent $213m on leases versus $152m in FY22. With actions taken during 2022 and 2023, this line will approach $100-120m by FY24, before accounting for payroll and other fixed cost savings. Taking out $100m of COGS will provide another 6-7% tailwind to gross margins when compared to 2019.

Can PLCE survive in a deep recessionary environment? Fortunately, both PLCE and peer Carters (CRI) were public in 2008. Both companies held the line on margins and same-store sales in 2008 and 2009 (https://investor.childrensplace.com/news-releases/news-release-details/childrens-place-retail-stores-inc-reports-fourth-quarter-and-0). PLCE operates in a less-discretionary segment of specialty retail because kids grow out of their clothes quickly, without regard for the strength or weakness of the consumer. (https://fred.stlouisfed.org/series/DCICRC1A027NBEA)

There are convincing arguments to believe that birth rates bottomed in the US in 2020 (https://www.cdc.gov/nchs/data/nvsr/nvsr72/nvsr72-01.pdf) and will be a tailwind for PLCE going forward - https://apnews.com/article/us-births-2022-pandemic-61da497183e03b80f236fa50720b26be. Many weddings were postposed during Covid and saw a surge in 2022, which is also expected to provide a tailwind for an increased US birth rate - https://www.wsj.com/articles/weddings-postponed-covid-2022-11670605384.

Management’s capital allocation can be called into question, given they repurchased $1.7B of stock since 2009 and trade below a $250m market cap. However, I would argue the average price paid of ~$90 per share represented fair value for the business before they were blindsided by a pandemic. The Company’s $180m of repurchases in FY21-22 combined showed more discipline and trailed their historic averages, though they would obviously like a redo. They avoided over-extending their repurchases during a record 2021 and made one meaningful acquisition – Gymboree in 2019 for $76m, which now represents ~$250m of sales.

Leverage is the main overhang on the PLCE story and given their history of collaborations with Kim Kardashian, I wouldn’t be surprised to see her new PE fund consider a buyout of the brand. There are no major operational issues and the cash generation should be very attractive to a PE buyer.

Valuation

PLCE has 12.4m shares outstanding, $18m cash, and $350m of debt. At $18.77/share, this is a $564m EV. Through the end of FY23, I believe PLCE can work the debt down by over $100m even if sales remain depressed and they miss their guidance. My approach is below:

$0 EPS (vs $1-1.50 guide)

+ $47m D&A (Q1-23 annualized)

+ $100m working capital (Inventory is elevated over $150m despite store base only ~50% of 2019)

- $25m Capex guide (should remain comfortably below D&A given shrinking base and digital investments made pre-covid)

+ $29m stock-based compensation (FY22 value)

Net $151m cash benefit at breakeven EPS.

Therefore, even below their current guidance, PLCE should be able to exit 2023 around a $400m EV at the current share price. Is that a fair valuation for a business with their flexibility, digital penetration, and history of solid FCF generation? I don’t think so. Their worst year of cash flow from 2008-2019 was +$69m in 2019, when they were competing with Gymboree on price and made over $70m of capital investments to expand their digital fulfillment abilities.

If we assume only $1.5B sales for 2024 ($100m below street estimates and ~5% below 2023 guide) and only the depressed 35% GM from 2019, with $460m of SG&A (current trend), they will still have $65m to cover CapEx (<$50m) and interest expense ($15m), remaining cash flow positive.

In the more likely event they can maintain $1.6B of sales or even recover to $1.7B from FY22/FY19, the business could once again generate about $100m of cash flow in 2024 without any upside to the 35% GM. Remember FY22 would have been over 35% even with all their discounting, if you just removed the freight and cotton spikes that have normalized. I don’t think they will attain 41.5% from FY21 again soon, but management has maintained their digital shift should allow them to hit double digit operating margins and they managed to do so in Q3-22 despite all the cotton and freight headwinds.

Given this, I believe $100m of normalized FCF remains a very reasonable expectation for PLCE in 2024 and beyond, and a 15% leveraged FCF yield would grant them a $650-700m EV vs ~$400m expected at the end of 2023, almost double today’s equity value. At a 10% yield, the stock should trade near $60 (+220%), before accounting for any future repurchases or debt paydown. The business generated consistent 20%+ returns on capital for the decade prior to Covid and should continue to do so as the consumer environment normalizes.

Currently, Carters is guiding to $6 of EPS for FY23, and PLCE is guiding to $1-1.50. Carters trades at $67.42 and PLCE at $18.77, suggesting 10-12x EPS may be the market valuation for these businesses. With only $1.6B of sales and 35% GM, PLCE should earn about $3-4 per share in 2024, suggesting a $30-48 share price.

Risks

PLCE’s leverage is the biggest concern, but they own a 700k sq ft distribution center in Ft Payne, Alabama that could probably be monetized for $50m if they need additional capital. This would probably cost them $4-5m a year in a lease-back, but if long-term cash flow is around $100m this shouldn’t be a major headwind compared to the liquidity relief it provides. They were able to get an extra $95m of liquidity from PNC this week, without tapping this DC for liquidity.

PLCE competes with many other children’s retailers, especially Carters. Their sales trends have been almost identical (TTM Carters and PLCE are both –11% vs FY19, Q1-23 CRI & PLCE were –11% versus Q1-22), suggesting no meaningful change in market share. But if PLCE were to begin to cede customers to other retailers, their cash generation ability will be called into doubt. 2019 PLCE sales didn’t include Gymboree, or their new internally launched PJ Place and Sugar & Jade brands, providing some avenues for growth as the business environment normalizes.

Executives paid themselves about $30m during 2021’s record results and only own about 5% of shares. No executive bonuses were paid after FY22’s poor results, however. The lack of recent insider buys isn’t encouraging, but their history of steady capital returns does suggest they are well-aligned with shareholders.

Given how significantly cotton and freight have hammered margins, future spikes in these costs could again cause working capital and margin pressures. With these costs back to normal levels and most items contracted out ~9 months, this won’t be a risk until 2H-24 at the earliest.

ZUMZ and TLYS have both cited wage inflation as a headwind for FY23, but a glance at PLCE’s last two proxies’ show their median employee went from $14.34 to $15.05/hr from FY21 to FY22. Meanwhile – this is more than offset by their total employees dropping from 17,300 in Jan-20 to 11,300 in Jan-23 as they reduced their store base, of which a flat 1,900 were warehouse and corporate employees. With 500 stores and 2-3 FTEs per store, I estimate payroll runs around 5% of gross sales.

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