Description

Thesis

Carter’s is the largest player in the US infant apparel industry with approximately 20% market share. The business has an enviable track record with over 20 consecutive years of revenue growth, including more than a decade of annual revenue growth greater than 10% while sustaining high margins and returns on capital.

We believe the combination of sustained double digit revenue growth, substantial margin expansion and capital allocation can drive 20%-25% annual EPS growth at Carter’s for the next several years. We find the current valuation of approximately 9x forward EBITDA to be attractive given LT growth potential and the quality and stability of the business.

Market

The US market for children’s apparel (0-7) is a $22B market that should grow in the low single digits over time driven by 1-2% growth in number of births per annum and 2% inflation. We believe Carter’s derives >80% of revenue from the roughly $11B 0-2 market where CRI is 3-5x the size of its largest competitor and has a significant manufacturing scale advantage.

Private label represents 40% of the children’s apparel market (share has stabilized at 40% after growing from 20% to 40% from 2000-2010) while 24% of the market remains fragmented and controlled by brands with less than 2% share.

Carter’s market share has roughly doubled over the past decade to approximately 20%.  Specialty retailers Gymboree/Gap Kids/Children’s Place/Old Navy all have <5% market share respectively.

Revenue Drivers

Carter’s system wide sales growth (grossing up CRI sales to wholesale channel) of 13% over the past decade has significantly outpaced industry growth driven by substantial and consistent share gains. We believe Carter’s can sustain double digit revenue growth over the next several years given substantial opportunities to continue to grow in the U.S. and internationally.

Carter’s sells product via multiple channels and multiple geographies. They currently break down revenue by US wholesale (40%) / US Retail (30%) / Osh Kosh (14%) / International (9%) / E-commerce (6%).

While we expect the wholesale business to continue to grow, we expect growth to moderate to the 3-5% range vs 6-8% historically as Carter’s grows more in-line with sales growth at major big box customers given lack of incremental opportunities to grow points of distribution.

We expect annual retail revenue growth to remain robust at 12-17% versus 13% over the past 5 years as CRI continues to grow square footage at a double digit pace. We would note that CRI currently has only 300 non-outlet stores versus 1,000 stores for Gymboree and Children’s Place.

Despite challenges in recent years, we think Oshkosh should be a mid single digit revenue grower over the next few years as the company has culled unprofitable stores and wholesale accounts, and is now accelerating roll out of its dual format store concept (co-located next to Carter’s stores) which has proved successful in Canada and US test markets.

We believe the international opportunity for Carter’s is significant and under-appreciated, as the company is currently targeting countries which have a combined addressable market larger than that in the U.S. and which lack dominant local brands. We think Carter’s can leverage its manufacturing scale, brand equity and industry expertise to more than double high margin international revenue over the next several years.

Carter’s e-commerce business is currently only 6% of revenue versus 10-15% of revenue for best in class peers. We believe the basic and replenishment nature of the infant apparel industry lends itself well to online purchases. The company only launched its e-commerce initiatives in 2010 and we believe recent substantial infrastructure investments will enable Carter’s to more than double this high margin segment over the next several years.

Margins

We believe margin expansion will be a significant driver of earnings growth for CRI over the next several years. Carter’s operating margin of 12% is substantially below prior peak operating margins of 14-15% due to investments in e-commerce and international markets as well as the lingering impact of cotton inflation. Margins are lower than 2010 despite $600MM of incremental revenue (36% growth) and a larger percentage of revenue coming from higher margin business segments such as international and E-commerce.

Over the next several years we see the opportunity for 16-18% operating margins through direct sourcing, mix shift and normalized margins at Osh-Kosh.

• Direct Sourcing is a 150-200bp margin expansion opportunity

CRI expects to direct source 50% of product in the next several years (we ultimately expect this to reach 75%+). According to Gymboree call transcripts direct source savings are >5% of COGS.

• Oshkosh is a 150-200bp margin expansion opportunity

Osh Kosh is currently burning cash versus a 9% OM in 2006. Mgmt has guided to 8-10% operating margins over the next few years.

• Mix shift is a 150-200bp margin expansion opportunity

The fastest growing business segments are also significantly higher margin than corporate average. We expect higher margin e-commerce and international businesses to go from 15% of rev to 20-25% over the next few years.

Capital Allocation

Given the stability of the business, minimal capital requirements and substantial free cash flow generation, we feel Carter’s is an optimal candidate for financial leverage. The company’s ability to operate with meaningfully higher debt levels is evidenced by the fact that it was a successful leveraged buy-out twice in the past.

While the company recently announced steps to improve capital structure, we think there is a good probability further improvements will drive faster EPS growth going forward. We expect CRI to repurchase at least 10% of outstanding shares in the near term and to adopt a more Autozone like capital allocation policy going forward (keeping leverage constant by incurring additional debt as EBITDA grows). Given a pro-forma 5-6% FCF yield we believe CRI could repurchase 6-8% of FD shares per annum going forward.   

Equity Compounding

CRI should compound equity value at >20% over the medium term. The basic compounding math is as follows: Rev growth of 10% / EBIT growth of 17-19% (driven by 70-90bps/annum of OM expansion) plus a normalized 5% Free Cash Flow yield used for share repurchases gets you to 22-24% returns for equity holders (not including potential for share buybacks > FCF).

Valuation & Risk/Reward

CRI trades at about 9x 2014 EBITDA, 10x 2014 EBIT and 17x 2014 EPS. Assuming a more normal operating margin of 15% CRI is trading at 8x EBITDA, 9x EBIT and 15x EPS. P/E is optically high given a lack of financial leverage. We think risk/reward is attractive over the next 2-3 years (>3/1 upside vs downside) given upside of 50-80% vs downside of <15%.  

Risks

• Execution risk given multiple operating initiatives
• Slower than expected growth in wholesale business or increased Private Label penetration
• Potential cannibalization of wholesale sales from direct to consumer growth
• International/E-commerce growth fails to materialize
• Continued pressure on margins from investment spend
• Potential Multiple contraction

Disclaimer: will579 had long exposure to CRI at the time of publication 08/28/13.  will579 has no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation.  will579 makes no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained in this presentation.  will579 expressly disclaims all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this presentation.

Catalyst