We believe that the stock of 1-800-Flowers.com, Inc (FLWS) represents a compelling investment opportunity. We believe that FLWS core profitability and cash generation potential are misunderstood, and optically the valuation appears far more expensive than it actually is. We believe that FLWS has ~30-50% upside in our base case, and the potential to appreciate nearly 75% from current levels in our upside case.

Why we like FLWS

We became interested in the consumer floral space in August, after Wolverine’s write-up of United Online, Inc (UNTD). For those of you who missed that write-up, Wolverine outlines a compelling case to own UNTD, which is in the process of spinning of its consumer floral business, FTD. After reading the write-up, we began doing work on UNTD. In our work, we naturally started at looking at FLWS, which is a very close comparable to FTD. What we found is what we believe to be a compelling investment opportunity in FLWS.

In August, FLWS reported their fourth quarter and full year earnings for fiscal 2013 (FLWS fiscal year ends in June). In that earnings release they gave some seemingly uninspiring guidance for free cash flow. They guided to free cash flow of “approximately $20mm” for FY2014 (YE June 2014). On a market capitalization of ~$340mm, this $20mm of free cash flow equates to a pedestrian yield of sub 6%. However, in diving in more deeply on FLWS, we believe that this FCF guidance dramatically understates the cash flow generation of this business. We believe on a normalized basis, the FCF for FLWS is ~50% higher than this guidance, and instead of trading at a ~6% yield, we believe it is trading closer to a ~9% yield, which we believe is far too cheap for this business.

Quick Overview of FLWS

FLWS operates three business segments; Consumer Floral, BloomNet Wire Service, and Gourmet Food & Gift Baskets. We will give a very brief overview of the business segments, however for those readers who desire more context, we would suggest reading Wolverine’s UNTD write-up, which does a good job of detailing FTD’s business, which is highly comparable to the Consumer Floral and BloomNet segments for FLWS.

Consumer Floral is FLWS’ largest segment, representing ~56% of FY 2013 revenues, and ~51% of EBITDA. As the name suggests, this business is delivering flowers to consumers, primarily through the 1-800-flowers.com website. Revenue in this segment is a function of the number of orders placed through the website, and the average order value.

BloomNet Wire Services represented ~11% of FY 2013 revenues and ~28% of EBITDA. This business provides products and services to florists, who are members of the BloomNet network. FLWS earns revenues in this segment through both fees charged to members, as well as volume-based fees on the amount of orders sent through the network.

Gourmet Food & Gift Baskets (GFGB) represented ~33% of FY 2013 revenues and ~22% of EBITDA. In this segment, FLWS manufactures and sells various food products (chocolate, cookies, popcorn) and gift baskets, through various brand names, both directly to the consumer and to retailers on a wholesale basis.

Free Cash Flow Bridge

Below we attempt to bridge reported profitability from FLWS’ recently reported fiscal year, to our estimate of “normalized” profitability, excluding one-time items.

In FY 2013, FLWS reported Cash Flow from Operations of $34.6mm. However, on the Q4 call, management calls out two one-time items causing a $5.3mm negative impact on CFO. Adjusting for these items, CFO for FLWS was ~$40mm in FY’13. 

However, in addition to the one-time items that management called out in their Q4 call, there were also significant one-time costs in the GFGB segment related to operational issues at FLWS Fannie May chocolate factory. We estimate that those costs depressed CFO by another ~$6mm. Therefore, we believe that the true baseline CFO for FLWS was ~$46mm in FY’13.

Management gave guidance of mid-single-digit revenue growth for FY’14. If we assume that our baseline CFO grows in line with this revenue growth, this takes our CFO estimate up to ~$48mm.

In terms of Capex, management’s guidance for FCF includes $23mm of capex, versus ~$17-18mm of what management considers to be “normal” capex (Q4 call). The incremental $5mm in capex in the guidance is to build out capacity at the company’s cookie factory in Ohio. With this investment, the capacity in this plant will be doubled, and further investment in other GFGB plants appear to be limited for the foreseeable future (other plants are operating with significant excess capacity).

Therefore, using ~$48mm for CFO, and ~$18mm for capex, we arrive at ~$30mm in normalized free cash flow, or ~50% higher than managements stated guidance of ~$20mm.

To be clear, the numbers above represent what we believe would be FY’14E free cash flow, adjusting for operational issues experienced in FY’13 and normalizing capex based on management’s guidance. We believe actual FY’14E FCF will be closer to ~$25mm (operational issues should be reversed, however capex will be elevated).

However, In FY15E, we believe FCF could be ~$33mm, as capex normalizes, and CFO grows at a high-single-digit rate. If our assumptions prove accurate, we estimate this would equate to ~$67mm of FY’15E EBITDA, v consensus at ~$58mm, and ~$0.49 in FY’15E EPS v consensus of $0.34… FLWS is trading at only ~10.5x this EPS estimate.

Valuation Detail

Wolverine, in the FTD write-up, argues for a “market” FCF yield of ~6% for FTD’s business (same as S&P 500), but uses a ~7% yield to be conservative. We agree that a market multiple for these businesses is logical, but even using a ~7% yield would equate to a price for FLWS that is ~30% higher than where it is currently trading. Using the “market” yield of 6% provides upside of ~50%.  This valuation is also supported by our EPS estimates, as a 15x multiple on our FY’15E EPS yields a price of $7.50, or upside of ~50%.

Additionally, FLWS has no financial leverage on its balance sheet. This is in contrast to FTD, which we estimate is being spun out with debt at ~2.3x EBITDA. FLWS recently entered into a $200mm credit with an interest rate of LIBOR plus a range of 150 to 225 basis points. FLWS is not averse to buying back stock. It repurchased $10mm of stock in FY2013 (~65% of free cash flow), and currently has a $20mm buyback authorization. If the company were to increase the authorization, or announce a tender offering, massive accretion would result.

Theoretically, assuming ~$125mm draw on the credit line (to basically bring the capital structure in line w/ FTD), to fund a tender at $6.00 per share (~15% higher than current price), the company would be able to buy in over 30% of the shares outstanding, for an estimated after-tax interest cost of a mere ~$2.5mm. We calculate the FCF yield would increase to over 12% in such a scenario, and if the stock were to trade at a 7% yield, FLWS could be a $9.00 stock, up over 75% from current levels.

Obviously, this is a theoretical example. We have no idea whether FLWS will take on any capital structure altering transaction. The purpose of this is more to highlight the fact that we believe that FLWS gets little credit for its net cash balance. This is also clear in looking at FLWS v FTD on unleveraged metrics. On an EV/Revenue basis, FLWS is trading at ~0.5x trailing revs, v ~1.2x for FTD. On an EBITDA basis, FLWS trades at ~6.0x our NTM estimate, v ~9-10x for FTD.

It is worth noting that on an EBITDA less Capex basis, the valuations of FTD and FLWS look more comparable (the $17-18mm of “normal” capex for FLWS compares to $6.4mm for FTD in 2012)  However, in addition to the one-time items we discussed impacting capex for FLWS, we also believe that FLWS is currently experiencing higher capex from technology spending relating to shared services (moving all consumer brands onto one platform), and building out capabilities in its BloomNet business. However, in a steady state, we would not imagine the capex of FLWS and FTD to be too far apart.

Other Items to Note

In our view, there are a few other items which are incremental to the thesis, and we believe should be noted.

First, given the FTD spin-off (and looking at the share price of FLWS since August), we would not be surprised if there is a contingent of investors who are actively short this name as a “hedge” to a long investment in UNTD/FTD. To the extent these investors are just focusing on the headline valuation multiples, the tactical setup in this name could be quite positive. More generally, it is our view that with the entrance of FTD as a standalone publicly-traded company, FLWS should benefit from increased attention to the space from the analyst and investment community, and the positive characteristics of these businesses will become better understood.

Additionally, management should be highly incentivized to increase the share price and act as responsible stewards of capital (and has been to date, in our view). The founder, Jim McCann, still runs FLWS and owns over 50% of the company. Jim is an entrepreneur who grew this business from a single flower shop in Queens, and evolved it into what it is today. We like to see this dynamic generally in the investments that we target.

Finally, there is a lot of potential upside to the business model in an economy with improving consumer sentiment. Currently, FLWS is still ~$80mm in sales and ~$15mm EBITDA below the peak levels of 2007. We calculate a ~90% incremental margin from Gross Profit to EBITDA in Consumer Floral in FY 2013.  Using this math, each $10mm in sales could =~$3.5-4.0mm in EBIT, or ~4c in EPS. Therefore, any increase in consumer sentiment could provide material upside to earnings. Importantly, this does not include the benefit to BloomNet from increased fees from order volumes sent from 1800flowers.com to member florists (FLWS Consumer Floral is the largest customer of BloomNet)

Summary

In summary, we believe that FLWS represents a very attractive investment opportunity, as it appears to us that the market is taking on face value the uninspiring forward guidance provided by management. However, we believe this masks the true profitability of the business. We believe that over time, once investors “wake up and smell the roses”, the earnings power of FLWS will be revealed and shareholders should be rewarded.

Catalysts

*Better understanding in investment community on FCF dynamics, potentially achieved through better than expected earnings

*Increased investor awareness and analyst coverage in space due to FTD becoming a stand-alone publicly-traded company

*Better macro environment supportive of higher volumes in Consumer Floral

*Potential for continued share repurchase/capital structure transaction

Disclaimer

The author of this posting and related persons or entities ("Author") currently holds a long position in this security. The Author makes no representation that it will continue to hold positions in the securities of the issuer. The Author is likely to buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform Value Investors Club, the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note. The views expressed in this note are the only the opinion of the Author.  The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note.