Description

Body Central Corp. (“Body Central” or “BODY”) is perhaps the cheapest retailer in the US relative to the size of its business.  Shares in BODY currently trade for roughly $4 per share, or approximately 0.1x EV/sales.  To us, this extreme valuation implies (i) the business is broken, (ii) the market believes the business cannot be fixed, and (iii) the company faces imminent liquidity and/or bankruptcy risk.

We have a variant view.  We believe the business is fixable.  We believe the new management team – now ten months into its turnaround – is taking the right steps to fix it.  And we believe the company has ample liquidity for management to execute its game plan.  Should the turnaround be successful, we believe the potential upside is as much as 15-20x the current share price.  Importantly, new management is credible and has successfully executed multiple turnarounds in women’s specialty retail prior to the current undertaking.

To the best of our knowledge, no one on the buy side or sell side has yet articulated the specifics of a long thesis in Body Central.  Analysts burned by the shares - which popped when new management was brought on board and have since fully reversed and then some - appear to have given up on the details.  What remains of the long thesis can be vaguely summed up as “the shares are cheap” and “maybe there is option value here" (see recent VIC comments on the thread of the BODY write-up from Sep 2012).  In stark contrast, we view this as a blocking-and-tackling turnaround with an excellent probability of success.

The Fallen Angel

Body Central is a fast-fashion specialty retailer of women’s clothing and accessories based in Jacksonville, Florida.  The brand targets a culturally diverse clientele of women in their 20’s and 30’s who seek the latest fashions and want to look good on a date or night out, but who are also budget-conscious.  In short, BODY specializes in sexy/on-trend outfits at value prices.

BODY has annual revenues in excess of $300M from its 292 stores across the eastern and southern US.  The average box is 4,300 square feet and occupies an in-line location in a “B” mall, lifestyle center, or outlet center; typical stores average about $1M in sales per year.  Body Central has a presence in 26 states with more significant store concentrations in Florida, Georgia, North Carolina, Ohio, Pennsylvania, and Texas.

The company’s origins date to the early-1970’s when Jerrold and Ronnie Rosenbaum first opened a store under the Body Shop banner in Jacksonville’s Roosevelt Mall.  As the company grew it adopted a second marque, Body Central, and eventually expanded to 170 locations in 20+ states (today, nearly all stores have been re-branded to “Body Central” from “Body Shop”).  In 2006, the Rosenbaums sold the company to a private equity firm.  Four years later, in October 2010, Body Central listed on the NASDAQ with an initial price of $13 per share.

At the time, Body Central was a high-flyer firing on all cylinders.  Comparable-store sales (“comps”) were in the mid-teens, operating margins were double-digits, and the runway for new store growth seemed almost limitless.  The strong results continued into 2011 and early-2012, with the stock peaking above $30 per share in April 2012.

At the beginning of May 2012, however, the company issued a profit warning as Q2 2012 sales were weaker than anticipated.  The stock plummeted 50% in a day.  A second profit warning came six weeks later, cutting the stock in half again to $8 per share.  Comps went negative – and then severely negative – and margins promptly collapsed.  Resignations by the Board Chairman and CEO followed in July and August.  BODY’s CFO, Tom Stoltz, was named interim chief executive, and the Board began the search for a new CEO to resuscitate the business.

A New Team

In February 2013, Body Central named Brian Woolf to the CEO role.  Brian was a 40-year industry veteran who had twice led successful retail turnarounds in the women’s apparel space, first at Cache, Inc. (2000-2008) and then at Charming Shoppes, Inc. (2008-2012) where he was President of Lane Bryant, the company’s largest division.  In both cases Brian reversed negative comps and oversaw material increases in profitability.  His efforts strongly rewarded shareholders: Cache Inc.’s share price more than quintupled during his tenure, and Charming Shoppes, Inc. was sold in 2012 for a substantial premium relative to the date of his arrival.

After taking the reins at BODY, Brian moved quickly to install a high-quality executive team.  In February, BODY overhauled its merchandising department with the hiring of senior executives to oversee merchandise, design, and e-commerce.  Eight weeks later, BODY announced additional executive hires in operations, brand presentation, and planning.  More recently, BODY on-boarded a new executive in charge of supply chain.

Transforming a company is difficult in the best of circumstances; it requires not only a clear vision but also the right people to help make that vision a reality.  As a result, when evaluating turnarounds we spend considerable effort getting to know the people involved.  We specifically try to answer two questions: (i) whether management has successfully worked together in the past, and (ii) whether management has experience overseeing other large/successful organizations.  A turnaround should be no one’s first rodeo.

In late-November, we traveled to BODY’s headquarters in Jacksonville to meet senior management.  In addition to sitting down with Brian and Tom, we also toured stores with Michael Millonzi (the head of store operations) and visited BODY’s old and new distribution centers with Tom Moran (the head of supply chain).

Both Michael and Tom (Moran) were impressive – neither would be learning on-the-job.  Michael was a 20-year industry veteran who had overseen store operations for LensCrafters, a 1,000-unit chain owned by Luxottica Group S.p.A.  Prior to LensCrafters, Michael held a similar role at Lane Bryant.  Tom had joined BODY only three weeks prior to our visit, but his qualifications were equally clear: he had managed the supply chain for 4,000 stores at Ascena Retail Group.  And, like Michael, Tom had previously worked for Brian at Lane Bryant.

Michael and Tom were not only qualified, they were overqualified.  Each had served in similar capacities at much larger chains than BODY, and each had previously worked for Brian with good results.  In a turnaround, however, that’s exactly what is required – leaders who know what success looks like and can be trusted to execute because they’ve done it before.  In our view, Michael and Tom (and the rest of the new leadership team) fit the bill.

The Turnaround

People are one part of the equation.  The other part is the business itself.

In the case of BODY, we believe the underlying business is fixable – and that management is taking the right steps to fix it.  Specifically, we believe there are four elements to the turnaround: (i) merchandise, (ii) infrastructure, (iii) presentation, and (iv) brand.

The proximate cause for BODY’s mid-2012 collapse was merchandise.  Body Central’s product strategy at the time was referred to as “test and reorder” – BODY’s merchandisers would select styles they liked from a few key suppliers and roll out the merchandise in a limited run.  If the product worked, BODY would order more.  If not, the merchandise would be discounted and BODY would move on to the next style.

“Test and reorder” is a bare-bones approach that works well so long as the product is hitting at least some of the trends.  The strategy runs into issues, however, when the product completely whiffs, as there is then no feedback mechanism to instruct the merchandiser on what to do next.  In such a scenario, it is critical for the merchandiser to have a range of tools at his/her disposal including detailed customer data, on-the-ground intelligence from fashion centers like Los Angeles and New York City (“NYC”), and a keen independent sense for current trends.

In 2012, BODY had none of these.  The company relied almost exclusively on suppliers to identify trends, spent little money gathering or analyzing customer data, and had no on-the-ground presence in the major fashion centers.  The company was flying blind – so the merchandise team started guessing.

For Body Central to resonate with customers, its product must strike a balance between “sexy” (more revealing/risqué going-out clothes) and “core” (outfits that are flattering but more wearable/less risqué).  In 2012 and into 2013, BODY’s product mix swung wildly between the two as the merchandise team grasped for the next trend.  The product strategy was inconsistent, lacked a basis in data, and – in short – was a disaster.

Walking into stores today, our sense is the problem has largely been fixed.  BODY’s new merchandisers are more sophisticated: the team has adopted a data-driven model incorporating customer surveys, established an on-the-ground presence in NYC, and upgraded the product mix with a balanced assortment.  In addition, where the previous strategy relied on separate buyers by category (tops vs. dresses vs. footwear), the new team has placed greater emphasis on outfits – in-line with BODY customers’ shopping habits.  We also note BODY appears to be on top of recent trends such as sexy stretch, the flip from silver to gold, and the current “it” handbag.

The second leg to the turnaround is infrastructure.  Modern retail is an omni-channel world: brands must interact with customers in a range of mediums (in-store, online, mobile, social media, etc.) and provide a fully-integrated experience.  This is especially true for younger consumers such as those in BODY’s core demographic.

To-date, BODY has come up short at being an omni-channel retailer.  BODY’s internal systems do not speak to each other: if a customer orders an item online and wants to return it to a store, the store can’t accept it; if a store is out of the desired size in an item, in-store systems do not allow the customer to order digitally from the store.  In online reviews, customers appear to love the clothes – but to hate the shipping and returns process.

A visit to BODY’s distribution centers makes clear why this is so: the old distribution center is antiquated.  Space is limited.  Paper labels are still used on many items.  Employees use a single-order picking process instead of batch-picking.  The contrast with BODY’s new state-of-the-art distribution facility, set to go live in 2014, is stark: it can hold much more inventory, move the inventory faster/more cost-effectively, and will be a game-changer for gross margins.  BODY’s internal systems will be integrated in tandem with the new facility’s launch.

The third leg is BODY’s customer-facing presentation.  BODY’s website is well-designed but under-inventoried, with hundreds of SKU’s vs. 4,000+ at Charlotte Russe, BODY’s closest competitor (BODY’s new distribution center allows for 10,000+ online SKU’s).  Store design, as outlined below, also leaves room for improvement.

In other areas of presentation, BODY has made strides.  In the past, items featured in BODY’s catalogue differed from those on its website and in-store – almost unbelievably, stores at times didn’t carry outfits highlighted on in-store signage.  Since Brian’s arrival the messaging has been made consistent across platforms.

Another positive shift has occurred in the culture of stores.  Newly-installed systems allow district managers (“DM’s”) to track sales hourly by category in every store.  With detailed data on foot traffic and conversions, BODY has re-emphasized the customer experience with its staff: our conversations with salespeople and store managers indicate a shift in focus from “task-based” work to “conversion-based” work and to helping customers with entire outfits.  This has created a boutique feel in-store, a clear differentiator relative to the competition.

The final leg to the turnaround is brand.  BODY needs to distinguish itself from competitors – Charlotte Russe, Forever21, Wet Seal, rue21 – who skew slightly younger (more teens than 20’s/30’s) and less sexy/trendy.  As Body Central is not well-known, management has a blank canvas on which to create a compelling brand identity.

The New Prototype

We have visited numerous BODY locations.  Our observation: BODY’s stores are straight from the 1970’s.

The signature feature on a Body Central store is a blue tile overlay on the front entrance best described as “tacky”.  Neon signage lights the “Body Central” banner on storefronts and behind the check-out counter.  Stores feel dark, with merchandise on black hangers resting on black fixtures that absorb light.  Locations tend to be hit or miss, with some near old dying retail anchors like Sears and JC Penney.  The experience generally feels cheap.

During our Jacksonville trip, we visited BODY’s new prototype store in the Orange Park Mall (a typical “B” mall) two hours before it first opened.  In our opinion, the company nailed it.  The tacky blue tile was gone, replaced by vibrant pastel colors inside and out.  White fixtures with clear hangers made the store brighter.  Wall pop-outs gave the store structure, and additional mannequins allowed BODY to highlight looks/outfits.  The experience felt high-end – like walking into a Victoria’s Secret – even with identical inventory to other BODY locations.

The Jacksonville Business Journal reported after our visit that the prototype store has been the #1 location in BODY’s 292-store network since launch.  BODY needs to get the cost structure right – but we think the new design can quickly be rolled out system-wide.  In our conversations with DM’s and store managers, it is clear that BODY personnel have heard about the new design and can’t wait to have their stores updated.

Investment Thesis

Retail turnarounds take time.  Once a new management team arrives, it must (i) assess the problem, (ii) come up with a game plan to get the concept back on track, (iii) hire the right people, (iv) implement the new strategy, and (v) eventually get people to notice that things are different.  Turnarounds simply don’t happen overnight.

In this case, we believe the Body Central story is on the cusp of reaching an inflection point.  Brian has been on the job for ten months.  Most of his senior team has been in place more than half-a-year.  Customers are only now beginning to notice the step-change improvement in BODY’s merchandise and customer experience.  With the new distribution center coming online in less than twelve months – and store retrofits rolling out in early-2014 – we think there could be a compounding effect on positive sentiment around the brand.

From a stock perspective, we consider the set-up particularly attractive.  In Q3 2013, BODY used back-to-back box sales over the July 4 and Labor Day weekends (plus a mid-quarter buy-one-get-one-free sale) to unload old merchandise.  The “clear the decks” quarter was necessary from an operational standpoint: the strategy re-set inventory levels and allowed BODY to shift its focus to fresh product selected by the new merchandise team.  The blow-out sales, however, resulted in poor Q3 2013 numbers – gross margins below 20%, comps down high-teens – and investors panicked.  BODY’s share price fell 40% following Q3 2013 earnings to sub-$4 per share.

The negativity around the Q3 2013 results was made worse by a technical trading phenomenon: tax loss selling.  Most investment vehicles are structured as pass-through entities for tax purposes; underlying investors pay tax on gains realized during the year.  In a year of strong equity returns such as 2013, portfolios tend to have substantial realized gains to pass on to investors.  To manage this liability, investment firms “sell their losers” to crystallize investment losses that can offset gains realized elsewhere in the portfolio.  We believe BODY has been a prime candidate for heavy year-end tax loss selling, which we think is in the process of abating.

From a valuation perspective, BODY shares trade at an extreme level relative to the size of the business.  BODY is currently valued at 0.1x enterprise-value-to-sales (“EV/sales”), ranking the company as perhaps the cheapest retailer in the US on an EV/sales basis.  As the store refresh rolls out and the new distribution center ramps, we believe operating margins can return to double-digits.  Should the company revert to 10% operating margins on $300M+ in sales, the stock would trade today at barely above 1x EV/EBIT.  For reference, “healthy” mall-based retailers tend to trade at 5x to 10x EV/EBIT depending on the specific retailer’s brand quality and growth profile.

Should the new store design be a success, we think there is runway to 750+ stores (in our home city, for example, we think BODY can more than double its store count from a dozen to 25+) – implying nearly $1B in system-wide sales.  Assuming a 10% EBIT margin on $1B in sales, BODY’s shares trade at a small fraction of potential future “blue sky” EBIT.  The upside in such a scenario is as much as 15-20x the current share price.

We are not counting on everything to go perfectly.  Again – there is no such thing as an easy turnaround.  But we do think Body Central is moving in the right direction.  Given the extreme pessimism built into the shares, not much has to go in BODY’s favor for the stock to re-price meaningfully higher.

Risks

We note three important risks to the thesis:

• Timing.  Both back-to-school and the holidays have been difficult for US retailers, with recent trading marked by aggressive and widespread promotional activity.  Body Central is not immune to this dynamic.  We anticipate Q4 2013 will be another difficult quarter for the company with gross margins barely above 20% and comps down high-teens or perhaps even low-twenties.  With the possibility of another bad result ahead, our investment could be a quarter early.  Our sense is the market may look past Q4 2013 results and focus instead on BODY’s go-forward prospects as the store refresh gets underway.  This judgment on timing, however, could prove incorrect.

• Liquidity.  We believe the market is concerned Body Central may lack the liquidity to successfully execute its turnaround.  Our view is that BODY’s balance sheet is stronger than many perceive.  As of Q3 2013, BODY had $20M in cash with no debt.  The company has access to a $5M revolver that is expandable to $20M via an accordion feature.  BODY has also commented publicly that it is working to secure financing collateralized by its new distribution center, which we estimate could total as much as $10M.  Finally, BODY has a tax asset of $9M (a tax refund) which we anticipate the company will receive in early-2014.  Putting it all together, we think BODY has nearly $60M of liquidity to absorb near-term business losses, the build-out of the new distribution center ($5-10M), and the store refresh (we estimate $100K per store, or just shy of $30M to complete).  Should BODY prove unable to secure access to capital as outlined herein, our thesis may prove incorrect.

• Retail.  The biggest risk to this investment is if we are wrong on the turnaround.  Retail, when it’s working, is an amazing model – cash-on-cash returns are excellent and free cash flow is large.  Should the turnaround not work, however, the company can go bust as it burns cash trying to get it to take hold.  Retail is highly competitive and there is no guarantee the new management team will be successful in its efforts to re-foot the business.  If it is not, our thesis is likely to be wrong.

A Concept Reborn

When we investigate a prospective investment, it’s often the little things that resonate with us most.

During our BODY store visits, we were told by store managers how much things had changed over the last year – better merchandise, better systems, better people, greater discipline and structure and professionalism in the organization.  But what stood out was the level of energy.  Store managers were excited.  DM’s told us they were fielding waves of inbound calls from industry contacts looking for jobs, which wasn’t the case six or twelve months ago.  People see something is happening and want to be a part of it.  The ship is beginning to turn.

The trade is starting to take notice.  It won’t be long, we think, before the investment community does as well.

Disclaimer

The author of this posting and related persons or entities (“Author”) currently holds a long position in this security.  Author may buy additional shares, or sell some or all of Author’s shares, at any time.  Author has no obligation to inform anyone of any changes to Author’s view of BODY US.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  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 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 BODY US.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

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