Summary

Citi Trends (the "Company") is an off-price retailer in the midst of turnaround. The key corrective actions of the turnaround - bringing back the old CEO who presided over the Company's successful growth years and replacing the chief merchandising officer with a mandate to return to off-price roots - are showing signs of progress including posting the first positive same-store-sale comp in 10 quarters last quarter. These improvements are not recognized in the current share price and have set up an attractive risk-reward situation. I estimate fair value to be c 2x current levels with limited risk of permanent capital loss given the strong balance sheet (estimate around $6/share of cash at the end of the current quarter; no debt), conservative lease position, and strong cash generative profile of the business.

 

Background

Citi Trends (the "Company") is an off-price retailer focusing on urban fashions. It has c 500 stores that are mostly located in poor areas targeting a 18-25 year-old customer with household income of c $30k. The majority of the Company's customers are African American and Hispanics. It sells a mix of branded and non-branded product and offers best prices through late-season inventory purchases and carry-over of inventory into the proceeding season.

 

From 2001 to 2009 the Company grew stores from 123 to c 400 and comparable store sales averaged in the high single digits. Following the retirement of longtime CEO Ed Anderson, the business suddenly deteriorated in 2010 and 2011. The main reason for the decline was a flawed change in merchandising strategy led by the new team that moved away from close-out buying toward full priced on-trend buying. The change in strategy was aimed at increasing profits through a higher-end assortment, but it backfired because the diminished value proposition could not stand up to the weak economy, which disproportionately impacted the Company's target customers. The strategy was also unsuccessful because at the same time the Company had pre-committed to buy, on long lead times, various urban fashions, the fashion trends themselves shifted away from what the Company was buying.

 

Performance worsened throughout 2011. Responding to the weak results, the Company fired the CEO and brought back Ed Anderson, who had become the Company's chairman after retiring. It also replaced its Chief Merchandising Officer with Jason Mazzola (previously with AJ Wright division of TJX). The Company also announced a reduction in force to cut costs and scaled back its expansion plans for 2012 and beyond.

 

Messrs Anderson and Mazzola have now been with Citi Trends for almost one year. In that time they have been most focused on returning the business to its historical mix of close-out buying. Such close-out buying trades predictability and consistency of merchandise for great bargain prices that it can pass on to its customer, which were core to the Company's historical success. These changes could not be implemented immediately because of buying commitments undertaken by the prior team, which have been rolling off. Same store sales and gross margins have been improving and last quarter (ending October 2012) the company reported its first positive comp in ten quarters.

 

Valuation

The Company has a market capitalization of c $190m and enterprise value of c $135m ($55m of cash and no debt; c $4/share of net cash). I estimate that cash on the balance sheet will be c $6/share at the end of this quarter. At its peak the business generated c $50m of EBITDA and c $1.4 of EPS on a base of c 20% fewer stores.

 

On currently depressed results, the Company trades at 3-4x EBITDA and is generating high teens free cash flow yield to EV. During the worst of its problems it generated positive EBITDA and cash flow.

 

I estimate fair value of CTRN in the low-mid 20s per share based on 5-6x next year EBITDA of $40-45m, which assumes continued modest improvement of the business into next year.

 

Risk Reward

Citi Trends represents a very attractive risk reward.  As discussed above, I estimate fair value at twice the current price.  In a rather bleak downside scenario where the Company's challenges are more structural and long-term than I appreciate, the company has c $7/share of cash and does trough EBITDA of $14m (4 quarters ended April 2012).  Using a conservative 2.5x trough EBITDA, downside value is about $9.50/share.

 

Key Risks

(1) Execution risk around turnaround. Company needs to change its product assortment, offer lower price points, and potentially change its format to compete successfully in this environment. This is a challenging task for any team.

Mitigant: New CEO has strong track record. CMO has experience from TJX that is highly relevant.

Mitigant: Results over the last few quarters demonstrate that the changes being implemented are working.

 

(2) Niche could be structurally challenged. Lack of product innovation within the "urban" category may have shifted customers toward more traditional product/fashion lines.

Mitigant: Company objective is not to dictate fashions, but respond to customer demand, and it refreshes its "urban" look via merchandise choices.

 

(3) Target Customers could be challenged for a while. Difficult economy may not abate and the customers core customers could remain challenged for the next several years. Is this really the right time to invest in a consumer turnaround with customer headwinds?

Mitigant: There is no need to  underwrite heroic growth assumptions. Company  will generate a lot of cash flow without a strengthening economy.

CTRN still trades like a broken business notwithstanding the incremental improvements that have occurred over the last year. Improved operating performance and strong free-cash flow generation should fuel re-rating of the stock. Company also has substantial cash on hand to fund buybacks. Management seems open to repurchasing shares but has been hesitant to do so until further progress is made on the merchandising front. I expect this posture to change in the near future because the cash balance is becoming very large but the valuation continues to languish.