Description

Business Overview

The Children’s Place is the largest pure-play children’s specialty apparel retailer in North America with annual sales of ~$1.7 billion and a market capitalization of ~$1.2 billion.  It sells apparel, accessories and shoes under the Children’s Place brand for children ranging from newborn to ten years old.  Children’s Place is a value-priced retailer targeting low to middle income consumers via a high-low promotional model.  The company operates ~1,070 stores in mall, outlet and value center locations in the U.S. and Canada.  It generates ~10% of its sales from e-commerce.  The business has a strong balance sheet, with net cash of over $160 million, and is highly cash generative. 

The crux of our investment thesis in Children’s Place is that (a) there is substantial opportunity to improve profitability, as the company historically has been poorly managed and its 6-7% U.S. EBIT margin is well below the margins of most specialty apparel retailers in the U.S., (b) we expect margins to improve significantly as the company’s new management team implements retail best-practices across the organization, (c) we believe the market is underestimating the likelihood and magnitude of margin improvement in the business in the next two years, and (d) the business is trading at 54% of sales, 5.2x EV-to-EBIT and 10x net income based on our forecast of the earnings power of a “fixed” PLCE two years from now.

An investment in Children’s Place is extremely timely as the company has been in the midst of a turnaround for 1.5 years with significant improvements having been masked by cotton pressure and the warmest winter on record in sometime that derailed 2011 progress.  Bears point to the company’s lack of ability to improve sales productivity, however, Q212 demonstrated that going forward comparable sales will increase now that the company has lapped inventory and product mix adjustments in their Outlet and Canadian channels.  Throughout the past year Outlet which represents greater than 20% of total sales had comps decline double digits as the company moved away from a clearance model to a made for outlet strategy.  We believe Q312 will be the key turning point for the story as the enhanced earnings power of the business begins to show through as gross margins, operating margins and comparable sales increase.  After delivering many years with operating earnings of 6-8% we believe that earnings will now accelerate quickly to 10% in the next two years.  After waiting more than a year to see the fruits of management’s changes investors will now see it flow through to significant earnings improvement.

The stock currently trades at ~$55 per share.  We have a $70 price target. 

Why PLCE is an Attractive Investment

Like many turnaround stocks, Children’s Place has had a troubled operating history.  This one happens to be quite a soap opera.  We describe this history in detail below as we believe it provides important context for our belief that there is room for significant improvement in the business.

The company was founded in the 1980s by Ezra Dabah, who was the company’s CEO from 1988 to 2007 and took the company public in 1991.  While a successful entrepreneur who deserves credit for creating the concept and building it to scale, Mr. Dabah’s “growth at all costs” mindset ultimately created many problems for the organization. 

One example of this was the company’s disastrous agreement in 2004 with The Walt Disney Company  (“Disney”) pursuant to which Children’s Place licensed the right to operate the 313-store Disney retail chain in North America.  Mr. Dabah believed that combining the Disney brand with Children’s Place’s expertise in sourcing, merchandising and systems infrastructure would substantially increase Disney’s sales and margins, thereby growing earnings and strengthening Children’s Place’s leading position in the newborn to age ten category.  Mr. Dabah’s plan also envisioned doubling the size of the Disney chain through expansion into additional malls and shopping centers.

However, what was viewed initially as a new growth vehicle for PLCE quickly became an albatross for the company and for Mr. Dabah.  The Disney deal never met the company’s aggressive growth projections and the licensing deal saddled the company with substantial remodel obligations.  In 2007, Disney accused PLCE of committing numerous violations of the license agreement, including the failure to meet certain remodel obligations.  In settlement of these claims, PLCE committed to an additional $175 million in capital expenditures between 2007 and 2011 to fund the remodel of 234 existing Disney stores into a new store prototype.  This settlement increased the company’s cumulative remaining remodeling and maintenance obligation to $320 million, which was a significant obligation for a company that at the time was not generating positive free cash flow.  In 2008, with the Disney retail stores losing money and the company facing onerous capital spending obligations, the Board decided to shut the business down and to return the license to Disney.

Mr. Dabah’s growth ambitions were not limited to Disney.  Between 2003 and 2007, PLCE grew its square footage by 38%.  Many of the site locations chosen over this period were poor, causing these stores to dramatically underperform the rest of the chain.  Included in this investment program were 68 stores of an untested prototype that proved too large and costly to build.  Also in 2007, Children’s Place launched a new ”store-within-a-store” shoe concept, opening 54 new stores that were 25% larger than a typical store.  After signing long-term leases for these larger stores, the concept flopped and the company was forced to abandon the strategy and impair these assets.

As a result of these missteps and others, PLCE’s earnings declined substantially.  Operating income for PLCE’s U.S. stores declined by 65% in fiscal 2007, and the Disney Stores lost money.  Earnings per share declined from $2.84 in fiscal 2006 to $1.53 in fiscal 2007.

Beyond the many strategic and tactical errors, Mr. Dabah also exhibited questionable judgment on multiple occasions that raised doubts about his ethics.  In late 2006, the Board opened an investigation into the company’s dating of stock option grants.  While no intentional wrongdoing was uncovered, the investigation forced the company to restate its financial statements for 2003 through 2007.  In response to the results of this investigation, the Board added two independent directors and replaced Mr. Dabah as Chairman.

In September 2007, the company discovered that Mr. Dabah had violated its Code of Conduct.  Specifically, Mr. Dabah had failed to comply with internal policies regarding securities trades when he pledged shares to a margin account during a blackout period.  Around this time, Deloitte resigned as the company’s auditor, citing its unwillingness to rely on Mr. Dabah’s representations in connection with its audits. 

Finally in 2007, the Board of Directors decided it had enough and it fired Mr. Dabah.  Unfortunately, he did not go quietly.  As the company’s largest shareholder and still a Director, his presence continued to destabilize the business over the next several years.  Soon after his firing, he filed a lawsuit against the company and forced PLCE to hire an investment bank to conduct a review of strategic alternatives for the business.  In the midst of the strategic review process, in February 2008, Mr. Dabah sent a letter to the Board indicating his interest in making an offer to purchase the company.  The purported bid of $24 per share never materialized, and the strategic review was completed in February 2009 without receiving any credible offers. 

Mr. Dabah was not finished.  In May 2009, he notified the company that he intended to nominate three new directors to the Board.  If successful, this would have given him control of the company, as he and his father-in-law already served as directors of a nine-person Board.  In July 2009, just days ahead of the scheduled shareholders meeting, the company reached a settlement agreement with Mr. Dabah.  Under the terms of the settlement, PLCE agreed to buy back half his shares at a 5% discount to the then-prevailing stock price and to register his remaining shares for a secondary offering.  Mr. Dabah and his father-in-law resigned from the Board, withdrew their proposed slate of directors and agreed not to vote at the shareholders meeting.  The repurchase, at ~$29 per share, was 7-10% accretive to earnings.  Mr. Dabah subsequently sold his remaining shares and today holds no shares in the company.

Not surprisingly, the distractions caused by Mr. Dabah in the years following his departure as CEO, including forcing a formal sales process, made it impossible for PLCE to attract a permanent CEO.  With the settlement behind them, the Company accelerated its search.  Five months later, the company announced the appointment of Jane Elfers as CEO.  Ms. Elfers joined PLCE in January 2010 from Lord & Taylor, where she had been CEO for eight years and was credited with leading a turnaround of the business.  She is known as a top-notch merchant and a tough, disciplined leader.

Investment Thesis

Our investment thesis is predicated on our belief that there is substantial room for Children’s Place to expand its margins and that the new management team, led by Ms. Elfers, is a huge upgrade to its predecessors and will serve as the change agent to drive this improvement. 

The greatest room for improvement is in PLCE’s U.S. operations where operating margins of 6-7% significantly lag those of its specialty apparel peers.  While few companies in the industry separate Canada from the U.S. as PLCE does (making direct U.S. to U.S. comparisons difficult), even looking at it on a North American basis illustrates that PLCE’s 8% margins are below the apparel-retailer average of 11%.  Management has set forth a long-term objective of double digit operating margins and we believe that, with better management and execution, PLCE can achieve this.

Source:   FactSet

While Ms. Elfers has laid out a detailed list of initiatives to grow the company and improve its profitability, we believe this is, at its core, a margin improvement story.  There are two main drivers of margin improvement: one is more conservative inventory management, and the other is addressing the company’s troubled outlet channel.  Below, we describe the company’s initiatives in these two areas in detail.

1)      Better buying.  Prior to Ms. Elfers’ arrival, Children’s Place was an undisciplined company that was run for volume rather than profit.  Too often, the company developed overly optimistic sales forecasts, which led to over-buying and heavy discounting of excess product.  The old retail motto “pile it high and let it fly” applied to PLCE.  Further, the company applied the same buying strategies for each of its four channels (U.S. full line stores, Canada, outlet and internet).  Little thought was given to whether the products and volumes purchased for a particular channel were appropriate for that selling channel.  Moreover, because they bought so much product up-front, PLCE’s buyers were not given “open-to buy” flexibility to purchase more of those items that were selling well.  The result of these poor purchasing decisions was that historically only 20% of PLCE’s product was sold at full price versus 40% for the industry.  Naturally, this lack of planning and discipline negatively impacted margins. 

Conversely, Ms. Elfers believes that inventory management is the key to profitability and has quickly brought this discipline to the PLCE culture.  Under her leadership, initial buys are smaller, replenishments more frequent and assortments narrower – all of which should lead to less frequent and shallower mark-downs.  At the beginning of her tenure, Ms. Elfers’ “value over volume” strategy worked as gross margins expanded from Q410 to Q311.  This improvement in gross margin occurred even in the face of declining comparable store sales and significant promotional activity from its competitors, as PLCE was willing to sacrifice revenue for profitability.  Unfortunately, management’s gross margin improvement paused for a few quarters as record cotton prices across the industry pressured gross margin.  Entering Q312 cost inflation pressures have disappeared as input costs have stabilized allowing management to return their energy to improving gross margins and sales.  Another sign of the effectiveness of PLCE’s new “pull versus push” strategy is lower levels of “carryover inventory”, which represents inventory from the prior season that was not sold and therefore was “carried over” into the current season.  PLCE’s carryover inventory declined by 39% in Q4 2010, 15% year-over-year in Q1 2011 and 29% year-over-year in Q2 2011.  We expect to see further gross margin improvement as the quarter’s progress, particularly as the company laps the impact of this year’s high cotton prices in the upcoming 2H 2012.

2)      Outlets.  Under previous management, merchandise managers at PLCE’s full line stores were not held accountable for overbuying.  Rather, they utilized the company's outlet stores as a dumping ground for product that could not be sold in the full-line stores.  Outlets did not have their own buyers or their own separate product; instead, their role in the company was to serve as a trash-receptacle for poor decisions made by the full-line stores.  As a result, PLCE’s outlet stores were barely profitable under prior management.  In comparison, for most apparel retailers, outlet is the most profitable channel other than e-commerce.  This is meaningful to our investment in PLCE because outlet represents greater than 20% of PLCE’s overall sales.

Under Ms. Elfers’ leadership, the company has appointed separate leadership for each channel, including outlet, and assigned these leaders full P&L responsibility.  The company now plans its inventory buys by channel and budgets for the clearance of most product within the same channel for which it was originally purchased.  This latter change fundamentally alters the role of the outlet channel within the company.  PLCE is now designing outlet-exclusive product, which is common practice in the industry.  In 2010, only 3% of PLCE’s outlet sales came from made-for-outlet product.  In 2H 2012, the number is expected to be 65%.  Thus, rather than the outlets selling product that consumers did not want, at steep discounts, they will be selling made-for-outlet product with fewer and shallower discounts. 

We expect these changes to be a critical driver of margin improvement, as historically gross merchandise margins at PLCE’s outlets have lagged those of the full-line stores by ~1,000 basis points.  In comparison, most apparel retailers enjoy higher merchandise margins in the outlet channel than in their full-line stores.  While the full line stores will lose some margin themselves from having to clear their own merchandise, we estimate that closing the gross merchandise margin gap between outlets and full-line stores will drive 125 basis points of consolidated margin improvement, equivalent to $0.50 per share or 16% on PLCE’s 2011 earnings.

There is much more to Ms. Elfers’ turnaround plan than what we have described in this letter.  Based on the totality of her plan, our knowledge of how poorly the company was run before she arrived, our familiarity with how PLCE stacks up relative to the rest of the industry from a best practices standpoint and our confidence in her and her management team to execute, we believe that the company will be able to achieve double digit margins on a consolidated basis within two years.  In addition to the benefits of the initiatives described above, we believe that PLCE’s earnings this year are depressed due to headwinds from cotton price inflation.  In order to achieve management’s double digit operating margin goal we do acknowledge that sales productivity must be improved.  This is why we believe an investment in PLCE in Q312 is very timely as management has finally lapped the two large overhangs that have been holding back the company from producing positive comparable sales – Outlet and Canadian sales.  As management made significant changes to inventory levels, assortment mix and began to implement the made for outlet product both channels pressured PLCE overall comparable store sales.  For instance, until Q212 outlet was running at double digit declines.  Q312 will be the first full quarter that both outlet and Canadian comparable sales should approach flat levels which will allow the improvements at the US full line PCLE stores to drive the performance.

Our Projections:

We estimate that in two years time (fiscal 2014, which ends in January 2015), PLCE will generate a 9.5% operating margin and earn ~$5.10 per share.  This is 22% higher than the current consensus of $4.18.  Beyond our EBIT margin estimate, our forecasts assume that PLCE is able to stabilize same-store sales trends starting in Q312 as it has fully re-based its inventory levels; specifically, we assume 2% annual growth in same-store sales.  Further, our model assumes that PLCE uses all of its excess domestic free cash flow to repurchase stock at 15x earnings, consistent with the company’s practice since Mr. Dabah’s departure. 

Price Target / Valuation

After reporting strong earnings last week with strong positive comparable sales for the first time in many quarters, the stock current trades ~$55 per share.  At this recent price, it has a market capitalization of ~$1.35 billion and an enterprise value of ~$1.2 billion.  In fiscal 2012, we believe consensus estimates are too low for the 2H of the year as we think management has taken a strategy of under promising and over delivering.  Consensus expects PLCE to generate sales of $1.8 billion, operating profit of $121 million and EPS of $3.28.  We think the business trades at full multiples based on current consensus estimates, however, with the turnaround gaining speed in Q312 we think this presents a unique buying opportunity as consensus operating margins remain at the low end of PLCE’s historical range at 6.7%.  We think in a bear case scenario the business will continue to earn 2012 levels of EBIT (~6-7%) and thus you are underwriting the downside case at a valuation of ~74% of sales, 9x EBIT, 15x earnings and 14x cash-adjusted earnings.   

Two years from now based on our earnings forecasts and our assumption that the company will use its free cash flow to repurchase stock, the company would be trading at 54% of sales, 5.2x EV-to-EBIT and 10x earnings.  These multiples are not only well-below PLCE’s current trading multiples but they are equally far below the average multiples that PLCE received over the 2005-10 period (71% of sales, 8.4x EBIT and 15.4x P/E).  Thus, we believe that we are getting the earnings improvement that we expect for free.

Our price target range for Children’s Place is $70 per share, which represents a 26% premium to the current share price.  At our price target, PLCE would trade at 72% of sales, 7.1x EBIT and 13.4x earnings, which is still below the company’s historic and current trading multiples. 

Our assessment of this investment includes a downside case and an upside case.  Our downside case assumes that management is not able to improve the margin profile of the business.  In this scenario, we estimate 2013 earnings of $3.00 per share based on a 6.5% operating margin.  In our upside case, we assume the company can reach a 12.5% operating margin and generate $6.90 in earnings per share. 

As with all investments, there are risks involved.  Below we describe some of the greatest risks:

1)      Weak consumer.  One obvious risk to our investment is macroeconomic risk.  High unemployment and inflation continue to pressure PLCE’s core lower-to-middle income consumer and it is not hard to envision an economic scenario where these pressures increase.  Fortunately, while apparel is by-and-large a discretionary purchase, we take some comfort in the fact that the children’s category has substantially outperformed the rest of the apparel industry over the last five years as parents have chosen to trim their own discretionary spending before cutting back spending on their children.

2)      Fashion misses.  Without question, the PLCE turnaround hinges in part on consumer reception of its merchandise, ~60% of which is considered “fashion” rather than basics.  While we are hopeful that Ms. Elfers’ track record of success as a merchant is a driver of upside for our investment thesis, we recognize that there is an element of fashion risk for any apparel business, even in children’s apparel.  Like investors, all merchants make mistakes from time to time, which adds volatility to earnings.

3)      Competition.  It is no secret that the children’s apparel environment is extremely competitive.  Parents have numerous alternatives when shopping for children’s apparel, including department stores, mass merchants and specialty retailers.  Within specialty retail, the children’s space has many offerings, including long-standing concepts such as GapKids, Old Navy, Gymboree and Carter’s, and new concepts such as Crazy 8 and 77Kids.  Over time, product differentiation has declined, causing price and promotions to play a bigger role in determining where consumers purchase their apparel.  If industry inventory levels were to rise significantly due to a further slowdown in consumer sentiment, this could offset some of the margin improvements we expect to see over time.

4)      Canada.  Historically, Canada has been by far the company’s most profitable channel.  Over the last five years, margins have averaged over 17% versus under 6% for the company’s U.S. operations.  This huge margin gap stems from the fact that the children’s apparel marketplace historically has been underserved.  However, in recent years, strong children’s apparel retailers such as Target and Carter’s have expanded in Canada and we expect margin pressure to accelerate as a result.  Since peaking in 2007 at ~20%, PLCE’s Canadian margins have declined to 13%.  Our models assume further deterioration in the near future before stabilization at 13% in fiscal 2014. 

Catalyst