Description

Investment Overview:

Citi Trends is the rare retailer for which we think COVID is going to be a meaningful tailwind. Demand is soaring with the US government stimulus supercharging the spending power of the company’s core urban customer. A supply glut from department store liquidations has allowed them to build up inventory at bargain-basement prices.

But these are just some accelerating factors in a business which was already undergoing structural improvements. They have a newly revamped management team that is focused on improving operational efficiencies and have already seen some success in expanding gross margins. Another major growth lever is the company’s long-term plan to remodel stores and increase focus on their highly profitable and fast-growing non-apparel and home goods segment. 

They’ve expanded slowly, adding about 10-15 stores each year, and have a remarkably strong balance sheet with $64M in leftover net cash (~$6/share). The business has generated $16-21M in FCF every year since FY16, which implies an EV/FCF of around 5x at today’s current price given the $105M EV and $169M market cap.  

We think the business is way too cheap at the current $16/share price. Based on our projections and guidance by management, we believe the company will return to its previous levels of profitability and generate close to $2 in EPS in FY21. At a fairly conservative 15x multiple, we get to a $30 price target which offers 85% upside. We think this is a very favorable risk/reward given the downside protection provided by the stable earnings power and $6 cash/share. With margins expanding, accelerating store expansion, and a sizable addressable market, CTRN should start trading closer to a TJX/ROST/DG multiple of around 20x, which would lead to 146% upside. Off-price retailers are the highest quality retailers given their resilience in the face of e-commerce. If CTRN is successful with its growth strategy, the company should generate north of $3/share in EPS in ~3 years. We believe the stock would trade between 15-20x earnings leading to a share price of $45-$60 vs $16 today.  

Company Background & Discussion:

CTRN is a discount retailer with 574 stores in 33 states, with a concentration in the south-eastern United States.  Their small-footprint stores are predominantly located in underserved urban neighborhoods, where larger off-price retailers (with larger store footprints) are unwilling to compete.

 Around 70% of their customers are African-American, and 90% are female; they do an exceptionally good job of following this core customer and her tastes. As a result, they have a reputation for stocking the latest styles for their customer demographic, which differentiates them from similarly-priced chain competitors like CATO or DG. 

Let’s start by digging in on what’s going on in the short-term on the demand side. 

First, some context: It is important to understand CTRN’s customer demographics - CTRN and other retailers with a heavy concentration in urban areas (eg. FL, HIBB), often do more sales in Q1 than in Q4, largely because Q1 includes the yearly “tax rebate season” during which eligible individuals receive their earned income tax credit (EITC) checks. This period is a bonanza for CTRN and others because the extra spending power tends to be used up quickly; promotions go down to zero given the strength of demand. 

We had not one but two senior former executives at CTRN describe the CARES stimulus to us as basically “tax season every week”. The stimulus provided a one-time payment of $1200 per adult and $500 per child (so $3400 for a family of four). It increased weekly unemployment by $600 (from an initial average payment of $385), lasting through July. In our conversations with executives and store managers, we heard across the board that the stimulus didn’t just make up for the demand shortfall; in fact, the average CTRN customer probably has more spending power now than they usually do. As a former executive put it: “When all of your customers are suddenly bringing in $900 a week versus $400 a week and they aren’t big savers, there’s no way you don’t absolutely kill it.”

CTRN’s product mix is also well-suited for the current moment. Their apparel selections are heavy on casualwear and athleisure, which have been top performers in the stay-at-home world. Additionally, they have a small but steadily growing home goods business (7% of sales in FY’20) which is poised to benefit from the massive increase in demand for home items.  

This makes it unsurprising that as stores have started to reopen (they are currently at 500+ of the 570 store base) demand has been exploding. Our conversations with two former executives (both of whom are now with private companies targeting the same demographic) suggest that open store comps are very likely 20%+. While some of that might be pent up demand, the stimulus effects are strong enough to ensure demand side strength through 2Q at the very least, and that isn’t even considering the real possibility of supplemental stimulus. And in case we do see a longer downturn over these next few years, it’s worth noting that the business performed particularly well through the Great Recession, with customers flocking to its fashion-forward bargains, and sales showing continuous y/y growth through the period. 

Beyond COVID-related factors, this business is not a dying retailer; CTRN comped positively for 20 of the last 29 quarters and they came into FY20 with strong momentum from two preceding quarters of comps increases. 

There are also opportunities COVID generated on the supply side. CTRN was lucky to enter the crisis with a very healthy balance sheet. Many bigger retailers like DG canceled orders in the early stages of the pandemic, and CTRN cannily decided to swoop in and purchase with the intention of putting them in stores for Q2 at attractive initial mark-up’s (IMUs) – a gamble that has paid off as stores reopened around May. Then, in a second gamble reflecting their understanding of their market and consumer, they decided to not mark down any of their Spring product when they reopened given the expectation of strong demand. Management told us they’re selling through it which has been a big windfall. As a result, they not only had enough inventory to meet the strongly elevated demand after May reopenings but also meaningfully expanded margins. 

Increasing bankruptcies, especially on the small business side, will give CTRN a real opportunity to take market share. CTRN stores are mostly located in underserved areas where their competition is in a weak financial position, therefore many competitors are likely to go out of business after COVID.

We think COVID related supply-side opportunities should have strong impacts for the business well into 2021. We’re going to see a tidal wave of retail bankruptcies in the near term from JCP and SSI all the way to thousands of mom-and-pop stores across the country. That should allow CTRN to bargain much more favorably with their suppliers, and acquire things at favorable prices in liquidation sales given their own strong cash reserves. 

We heard from a former executive who was able to get in touch with vendors that CTRN had pulled a lot of orders forward given strong demand and were accumulating inventory for the back half of the year with anticipation of strong demand. A home goods vendor for CTRN told him that the company had taken all of their orders early and shipped everything else the vendor had. This continued opportunistic buying should set the company up for attractive margins throughout FY20 and into FY21. 

CTRN has a significant long term margin expansion opportunity. Historically, CTRN has maintained remarkably steady gross margins around 38% with occasional variations but no evidence of a sustained improvement. Q4 2019 was notable with a significant increase to 39.7% gross margins. Management also implied that they were on track to maintain those Q4 levels in Q1’20 before the coronavirus struck. 

The first factor driving margin expansion is the opportunistic buying strategy which they’ve deployed to great effect through COVID. The board chairman, Peter Sachse, former Chief Growth Officer and 37-year veteran of Macy’s, has been leading the merchandising teams’ effort to renegotiate aggressively with vendors and capture higher IMUs. That allows the company more flexibility to mark down items earlier if they’re not selling without sacrificing net markups. 

The second factor has been improved operations and logistics. They’ve had recent success in lowering inbound shipping costs by renegotiating contracts, and they recently brought in a new hard-charging supply chain SVP (formerly at BURL) who is on a single-minded mission to reduce outbound shipping costs. While we’re on the topic of the supply chain, it’s worth noting that CTRN owns its distribution centers instead of relying on a sale-leaseback model; we’ve seen several other retail stories where that’s been significantly accretive over time. 

From our sense in talking to management, the business was positioned to start trending closer to a 40% gross margin, and COVID-related catalysts are only helping accelerate that movement after the initial Q1 hit. 

The other big long-term growth opportunity for the company is expanding the home goods and non-apparel business, which has been a key driver of growth in recent years; the home segment registered a +10% comp in FY19. With that in mind, they’re redoing 50 of their stores (~9% of their store base) over 2020-21 to have more of a focus on the home segment. Just one more ongoing trend which COVID should accelerate and CTRN is well-positioned to capture.  

Beyond improving and reshaping the business, the company also has a real opportunity in terms of expanding its presence. The company’s pre-COVID plan charted an acceleration in store openings going into FY20, upping the pace from the existing 10-15 openings/year to 30 new stores per year.

While the most recent earnings update indicated that store openings would continue at the normal rate (~14 new stores for 2020), there’s no reason for the more aggressive expansion strategy to not resume going into 2021. CTRN articulated a 3-year plan which is laid out below:

If CTRN is successful with its growth strategy, the company should generate north of $3/share in EPS in ~3 years. We believe the stock would trade between 15-20x earnings leading to a share price of $45-$60 vs $16 today.  

Our talks with former executives suggested that the addressable market for this model is indeed quite sizable. The stores are very community-centric, with 73% of customers living within a 15-minute drive. And with other community-oriented small businesses and competitors weakened by COVID, CTRN is well-placed to expand into new locations and build on its loyal customer base. CTRN has very strong ROI’s for new stores. The average new store investment is $377k, and average cash flow is $180k leading to a 48% ROI for new store investments.

CTRN has a niche, knows it, and serves it well. Its fashionable and frequently updated assortments keep its customer base coming back for more. As a former executive we spoke to put it…”They have things like Michelle Obama on handbags – you just don’t see that at other off-price”. The company’s focus on small communities in which it can be the big fish in a small pond has insulated it from bigger competition and helped it acquire pools of captive customers.

The market can’t help but see CTRN as another irrelevant retailer inevitably rushing towards certain doom. The truth is that CTRN has next to no competition in offering its core customer base the product they want at affordable prices. And even as e-commerce bites into retail everywhere, CTRN’s target demographic is probably going to be the last to make that jump, especially given that a lot of their business is cash-based. 

Conclusion:

CTRN is a healthy, cash-flow positive business with a great balance sheet, serious growth opportunities, ongoing margin expansion, and major tailwinds coming out of the COVID crisis which will leave much of its competition battered and bruised. CTRN has low downside given the cash on the balance sheet and low multiple of earnings, and significant upside of $45-$60 if they reach their 3-year targets. 

Catalyst

• The recognition of the strong growth the company is seeing in stores that have reopened post lockdowns from the CARES Act stimulus.
• The margin expansion the company is beginning to see.
• An acceleration of new store openings.
• Signs of success in achieving their 3-year growth plan.