SUMMARY:  CRI - LONG

Carter's is a franchise apparel retailer and wholesaler with a dominant and growing market share, strong brands, solid operating history, and decent growth prospects selling at an attractive 9x 2013 EPS (7x 2013 EPS less net cash) with a few call options and a potential catalyst.

BUSINESS OVERVIEW:

• Carter's is a U.S. based children's apparel retailer/wholesaler operating under the highly recognizable Carter's and OshKosh brands. CRI generates ~94% of its EBIT from the Carter's brand. Carter's focuses on basics for the 0-2 year-old baby market and the brand is known for "quality, comfort and value".

INVESTMENT THESIS:

CRI is a LONG because:

• Carter's is a franchise apparel business trading at 9x 2013 EPS (7x 2013 EPS less net cash)
  • Carter's dominates its core baby (0-2 year old) apparel market with a ~30% market share
  • Carter's focuses on basics, which is resistant to fashion risk and economic cycles
  • Carter's has a strong operating history: Revenues and EPS CAGR of 13% and 20%, respectively, and ROICs averaging over 30% over the past 13 years.
  • Carter's has a solid balance sheet ($13M in net cash) and stock buybacks could add up to ~7% of float
• The stock is cheap because 140-year high cotton prices will negatively impact margins in the short-term. However, the margin impact is likely to be less than consensus fears because management is raising prices and controlling costs to offset some of the impact, and customers are willing to accept price increases.
• Call Options:
  • Berkshire Partners has taken up a 13.5% position in the company and filed a 13D with the intention to advise management on strategic initiatives which could include a "going private" transaction.
  • Turnaround at OshKosh based on improved products and new concept stores
  • Continued growth in higher margin eCommerce sales launched in Mar10.
  • Carter's branded retail store expansion runway (opportunity to increase store count by 2-3x).
• Probability-weighted upside of 67% (PT $48/shr) by 2012 at 15x 2013 EPS (13x 2013 EPS less net cash)

THESIS POINTS:

CRI designs and sells apparel for 0 to 7 year-old kids under the Carter's and OshKosh brands

• The Carter's and OshKosh brands are highly recognizable worldwide and date back to 1865 and 1895, respectively.
• The Carter's brand is positioned with a focus on basics for the 0 - 2 year old market. (no fashion risk)
• The OshKosh brand is positioned with a focus on the 2 - 7 year old market. (some fashion risk)

CRI generates over 80% of its revenues and 94% of its EBIT from the Carter's brand

• CRI generates 54% of its revenues and 57% of its EBIT from the wholesale (e.g. Macy's) and mass channel (e.g. Target and Walmart) segments. The remaining revenues and earnings are generated through the retail and eCommerce channels.
• CRI has been expanding its own branded retail stores (51 Carter's stores and 1 OshKosh store in 2011) giving it more control over its brand and customer experience, and a direct connection with its core consumers.
• CRI currently operates a total of 495 retail stores including 316 Carter's stores and 179 OshKosh stores.
• CRI launched its eCommerce offering in Mar10A. Based on the current run-rate, eCommerce sales will generate ~6% of retail revenues in 2011. Website traffic and on-site times are trending upwards.

Carter's dominates its core baby (0-2 year old) apparel market

• Carter's has steadily grown its market share due to its superior brand value, quality products and value-based pricing through increasing the size and productivity of its distribution network.
• Carter's brand baby products and sleepwear products have a market share of ~30% and its playclothes have a market share of ~12% in the wholesale channel. Carter's brand products in Target and Walmart have a market share of ~8%.
• The Carter's brand primarily competes with private label in the wholesale and mass channels. Carter's prices its products 20-25% or about $1 to $2 above private label competitors. Given its positioning, consumers tend to trade up to purchase Carter's products in the wholesale and mass channels due to its superior brand value vs. private labels.
• The Carter's brand primarily competes with Gymboree, Children's Place, Baby GAP and Old Navy in the retail channel. Children's Place competes with Carter's at comparable price points but is more focused on fashionable attire (not basics); while Baby GAP, Old Navy and Gymboree tend to offer higher priced items and their branded stores are generally located in malls and lifestyle centers that target higher income demographic households. Carter's branded stores, on the other hand, are located in strip malls in lower income geographies with limited or no direct competition. Given its positioning, consumers choose Carter's in the retail channel due to its value-based pricing i.e. strong brand value and great product quality at a compelling price. As such, Carter's can be characterized as "affordable value".

Strong operating history:  Trusted brand, focus on basics and strong management

• Carter's focuses on basics i.e. tops, bottoms and body suits for every day use. Basics in baby apparel are less susceptible to fashion risk and economic cycles. Babies grow out of their clothes quickly so parents need to replenish them frequently. Moreover, styles do not change from season to season thus limiting inventory risk.
• Moms want to provide the best for their child and therefore, are brand, quality and comfort conscious. Moms prefer Carter's because they trust that the brand delivers both quality and comfort at a compelling price. With prices per piece ranging from ~$7 in the retail and mass channels and ~$12 to $20 in the wholesale channel before discounts, moms can purchase ~4-6 articles of quality clothing for ~$40 (the average transaction value) at Carter's.
• CRI has been acquired on three occasions through LBOs since 1993 indicating that private buyers on multiple occasions have recognized the "moat" around Carter's business. The most recent private equity owner, Berkshire Partners acquired the company in 2001 and continues to be represented on their board. Berkshire recently reacquired 13.2% of the company in the public market and is now its largest shareholder.
• CRI has a strong management team that is straightforward, long-term focused and conservative. Mike Casey, the CEO has been with CRI since 1993. Top management is incentivized to beat net sales, EBIT and EPS targets weighted at 25%, 25% and 50%, respectively. Management along with the board of directors own 3.9% of the CRI's outstanding shares.
• CRI under-performed in 2007 due to poor performance of the OshKosh brand, which Carter's acquired in 2005. The poor performance resulted in a goodwill write-down causing the EPS drop. However, the strength of the brands and the quality of management is illustrated by the strong recovery and stellar performance through the recession.

CRI has a solid balance sheet and stock buybacks could add up to ~7% of shares outstanding

• CRI has $13 in Net Cash as of Mar11A and is likely to generate over $90M in free cash flow in 2011E (base case).
• CRI bought back $50M in stock in FY10 and is authorized to purchase another $58.9M. Combined this would represent ~7% of shares outstanding.
• Including the remaining authorization, CRI would have bought back $182M in stock net of issuances since 2007.

The stock is cheap because cotton price inflation will hurt margins in the short-term; however, the margin impact is likely to be less than consensus fears

• Retail store visits indicate that Carter's is raising average prices by 10-15% to offset some of the product cost inflation. Customer conversations indicate that consumers will continue to spend on children's apparel even if the economic environment deteriorates. Customer conversations also indicate that consumers are willing to accept price increases at Carter's given its strong brand value, but are less willing to accept price increases on competing private label brands.
• All industry participants including private label will be forced to raise prices in the 2H11 and 1H12 given the industry-wide cost pressures. As such, Carter's is likely to capture market share from private label over the short-to-medium term. However, over the long-term, there continues to be a secular shift towards private label products in the wholesale and mass channels (discussed in the Investment Risks section).
• Carter's management has been maintaining a tighter control over other product costs and SG&A spend. This is likely to generate ~100 bps of cost savings in 2011 and 2012.
• Continued growth in higher margin eCommerce sales will likely add 20-30 bps to margins in 2011 and onwards.
• New direct sourcing initiatives could lower costs and add to margins as well; however, the impact of this initiative will largely be realized in 2012 and 2013.
• All things considered, my base case estimates expect operating margins to decline from 13.9% in 2010 to 11.5% in 2011; and to improve to 13% in FY12 and 14.2% in FY13.

Potential Catalyst and Some Call Options

Potential Catalyst:

• 2001 to 2006 - Berkshire Partners' owned Carter's.
• May10A - Bradley Bloom, Managing Director at Berkshire Partners resigns from Carter's Board. Thomas Widdon, an advisory director at Berkshire continues to serve on Carter's board.
• Nov10A - Berkshire Partners becomes the largest public shareholder of Carter's through open market purchases. Their average price appears to be around $29.
• May11A - Berkshire raises its stake in Carter's to 13.2%.
• May11A - Berkshire files a 13D and declares its intention to engage with Carter's to review its strategic activities, assess its organization, manage its balance sheet and pursue other corporate transactions (including new financings or a "going-private" transaction).
• Jun11A - Berkshire raises its stake in Carter's to 13.5%

Call Options:

• Going Private - CRI should at least be worth $35-40 per share (~14x Normalized 2011 EPS) before any call options.
• Sale or Spin-Off of OshKosh - OshKosh should at least be worth ~$330M (1x 2011 EV/Sales) or ~$6 per share.
• OshKosh Turnaround - For illustrative purposes only, if OshKosh could generate margins similar to Carter's at current sales-levels it would add 50 cents to EPS.
• Growth in eCommerce Sales - CRI launched its eCommerce offering in March 2010 with the expectation that sales through ecommerce could grow to become 10% of retail revenues over the short-to-medium term. For illustrative purposes, if this goal is realized, which seems doable given that CRI is currently generating a run-rate of ~6% in retail sales through its website, it could add 15 to 20 cents to EPS.
• Branded Retail Store Expansion - The Carter's brand has 306 stores compared to 1,005 stores for The Children's Place and 1,048 stores for Gymboree. As such, and with new stores delivering ROICs of 20-30%, Carter's has the opportunity to grow its branded retail store base by 2-3x. See Appendix III for additional information.

CRI offers a probability-weighted upside of 67% with a price target of $48 per share

Investment Risks Discussion - Cotton, Private Label and Macro

Product Cost Inflation:

• Product cost inflation, as discussed before, has caused margins to deteriorate. Cotton costs now represent close to 20% of product costs up from ~11%. CRI has begun increasing its prices to offset some of this cost inflation. Although, it is uncertain how consumers will react, store visits and customer conversations indicate that Carter's should be able to pass through some of the cost increases to consumers given its strong brand value and value-based pricing.

Secular shift towards private label products will continue

• There is a secular shift at retailers in the wholesale and mass channels towards private label products and this shift is expected to continue. As it has gotten easier to know and compare the value between products, consumers are now in total control of what to buy and where to buy it. Large retailers in the wholesale and mass channel segment are in direct contact with the consumer and therefore, have the knowledge and ability to localize their in-store offerings and build their own brands. In this environment, private label products have thrived at the expense of branded products and currently account for 43% of the total children's apparel market. JC Penny, for example, carries Carter's brand products, but presents Carter's right next to "okie dokie", its own private label offering, which is priced at a 20-25% discount. Moreover, large retailers earn higher margins on private label products - 40-45% on private label vs. 35-40% on Carter's; and therefore, are incented to push private label product sales.
• While this secular shift is expected to continue, branded apparel makers like Carter's who used to sell primarily at the wholesale level are opening their own specialty retail stores in order to directly interact with their core customers and control their brand and customer experience. Done right, it strengthens the brand in the minds of the consumer and enables Carter's to continue to command a price premium over private label competitors. Furthermore, wholesale and mass channel retailers need brands like Carter's to draw consumers to their stores and therefore, increasing the brand value in the minds of consumers through a retail expansion could stem some of the likely loss in long-term store space in the wholesale and mass channels.

Will consumers continue to spend in a $4 gas environment?

• Carter's is a value brand: Carter's products are priced around ~$7 per piece in the retail channel and ~$12 to $20 per piece in the wholesale channel. Carter's prices its products 20-25% or ~$1 to $2 above private label competitors. Historically, consumers have been willing to trade up to the Carter's brand at those price points. However, if private label competitors implement more aggressive pricing tactics, it could draw customers away from Carter's which would negatively impact Carter's margins.
• Babies grow out of their clothes quickly requiring parents to replenish them frequently. For all the mothers I spoke with across the North East, not one indicated that they would hold back on buying clothes for their child. I heard sentiments like "Carter's is a brand you can trust" and "You can never go wrong with Carter's", repeatedly. More importantly, historical trends suggest that consumers revert to the brands they trust in times of economic hardship. As such, in tough economic times, Carter's will likely benefit from customers who trade down from more expensive brands.

APPENDIX:

Retail Expansion: Carter's could grow its branded retail store base by 2-3x

• Retail stores enable Carter's to interact directly with its core customers and control its brand and product experience with a proven store and merchandizing concept.
• The direct connection with the consumer also enhances the brand value which carries over to the wholesale and mass channels.
• Carter's has ~130 branded retail stores and ~176 outlet stores. As such, CRI has a significant opportunity to expand its branded retail store presence in the U.S.
• Current branded retail stores are generally located in strip malls with limited or no direct competition from other children's apparel retailers like The Children's Place, Gymboree, and GAP etc. There are ~1,000 such locations available in the U.S.
• Retail store EBIT margins of ~17-18% have been increasing steadily due to increasing store productivity and are likely to be higher than wholesale margins (18%) in the long-term through operating leverage.
• Returns on new stores average between 20-30% with a pay-back of about 3 years
• CRI plans to open net 51 branded Carter's stores and 1 branded OshKosh store in 2011.

Carter's Store Economics (estimates):

Quarterly Comps:

Opportunity for Retail Store Expansion: