CTRN (16.3), 11/5/07

Citi Trends has most of the ingredients needed to be a 5 bagger in 5 years:

 

Low valuation (4.9 EV/EBITDA, 6.8 EV/EBIT)

Depressed but fixable operating margins (normal is 6% - 7% range)

6+ more years of rapid square feet growth to under-served market (20%/year)

Positive comps (annualized 9% over past 5 years, >3% annually likely for next 5)

Good unit economics (100% cash-on-cash 4-wall returns for last 3 years)

Good cash flow (positive FCF despite >30% annualized sales growth)

Strong B/S ($57m cash)

Minimal competition (will get tougher, but probably not too bad)

Experienced top management

Macro resilience

 

The big missing ingredient is the management and infrastructure needed to handle rapid growth, as evidenced by recent problems with inventory control, shrinkage, and payroll management.  The management/infrastructure should be in place within a year, though the obvious big risk to this story is management taking far too long to address the operational issues—perhaps the margins could drop even more, the financial impacts could last far longer than a year, and/or management could be forced to slow down growth for a time.  While this risk is real, and there are generic retailer risks as well, I explain below why the risk/reward for CTRN stands out from the morass of beaten down retailers.

 

 

Citi Trends is a fast growing off-price clothing retailer that has served the low-income, urban-fashioned African American niche since 1999.  ROST and TJX, the best large chain operators in the off-price retail business, have increased EPS at an annualized rate exceeding 15% during the past two decades, while also proving themselves more resistant to recession and fashion shifts than the average clothing retailer.  Nevertheless, the stock prices of TJX and ROST have been substantially more volatile than the underlying businesses, offering opportunities on occasion to earn annualized returns much higher than 15% with appropriate timing (i.e. ROST’s stock price quadrupled in 3 years from 2000 through 2003, and ROST and TJX were both nearly 10 baggers between 1995 and 1998).

 

There are some substantial differences between Citi Trends and the TJ Maxx/Ross stores:

 

1)      CTRN caters to the African American subgroup of the low to mid income demographic with urban-styled clothing.  The only concepts that come close to CTRN are the DD Discounts (ROST) and AJ Wright (TJX) concepts, neither of which has ever been profitable – even though AJ has similar total square footage.  The TJ Maxx and Ross concepts are aimed at a higher income demographic in mostly white neighborhoods.

2)      30% to 50% of CTRN’s products are nationally recognized brands (Phat Farm, Rocawear, etc.) that rotate in and out of the store according to the latest fashion trends (also 10% private label, and the remainder is brands that are less well known).  Management likes to say that getting the right look is more important than getting the right brand – but the brand matters too.  This greater fashion and brand emphasis than TJ Maxx, Ross, DD’s, and AJ (along with appropriate store ambiance) gives CTRN a stronger identity, but also means there is greater variability in comps due to fashion trends/hits/misses.  For example, the percentage of branded sales changed from just above 30% Q105 to almost 50% by Q406 which quickly drove up sales (average ticket is higher on branded items).  That has dropped to 42% by Q207, and comps have correspondingly adjusted (from double digits down to low single digits).

3)      Units are 9,000 to 11,000 square feet of selling space, less than half the size of typical ROST/TJX stores.  New stores are about 11,000 selling square feet.

4)      Home Décor is 2% of CTRN sales, but over 15% of ROST and TJX sales.

5)      The TJ Maxx and Ross concepts are approaching saturation, while CTRN is in the early stage of its national rollout, with 300 locations out of a possible 800+.  DD and AJ are also in the early stages of their national rollout, so it is entirely possible that head to head competition will eventually prove challenging to the company – but this is at least a couple years away from being significant as the locations have little overlap so far.

 

With 70% of its sales to African Americans, CTRN clearly has a narrower target market than TJX and ROST.  But this target market is drastically underserved.  Reporter Kimbriell Kelly found in Chicago (2005) that white neighborhoods had eight times as many apparel stores per capita than African American neighborhoods.  For a variety of reasons, many national retailers do not open stores in neighborhoods with heavy African American demographics, and the result is that most such neighborhoods are under-stored, forcing residents to shop elsewhere.

 

But how can a retailer do well when the demographics have low and often dropping income, combined with high and oftentimes rising unemployment?  The 2001 recession had a much stronger and longer impact on low-earning African American incomes, which led to a 4 year income drop of over 10% (see http://www.census.gov/hhes/www/income/histinc/h03b.html), and  higher unemployment rates during that period, yet CTRN had 2001 through 2005 comps of 6.5%, 14.6%, 5.7%, 3.0%, and 16.7%, respectively.  The only explanation I can offer for this kind of sales performance in such an environment is that the sales were shifting from other stores – perhaps from far away neighborhoods back to the neighborhoods where African Americans reside—perhaps from higher priced stores to lower-priced Citi Trends stores—perhaps from stores with less appealing fashions/brands to more African American fashion focused Citi Trends.  Regardless of the explanation, the statistics make clear that CTRN’s business is recession resistant.

 

Also, the African American population is growing a bit faster than the overall U.S. population, and African Americans spend approximately 45% more per capita on clothing than the average U.S. consumer—$22 billion on apparel products/services in 2004, according to Target Market News.  And, given how important clothing is to African Americans, it is not necessarily the first discretionary item this group targets for cutbacks when economic difficulties occur.  With these kinds of stats, it is somewhat amazing that this is the first national chain to focus on the low income African American demographic, though they are no longer alone thanks to DD and AJ Wright.

 

The prior paragraphs present the dry statistics, but if you visit a DD or Citi Trends you will see for yourself how these shoppers are really different then shoppers at other discount stores like Ross or TJ Maxx.  It is a social atmosphere, with shoppers delighting in various finds together.  I don’t know if I have ever seen two large, muscular, middle aged men excitedly chattering about a pair of pants – but that is exactly what I saw in a DD when two men were ooing and ahhing over a $94 pair of Akademiks jeans marked down to “only” $35.  They were far more interested in these pants than the $9.99 jeans from no-name brands that dominated the offerings at this DD store.  How often do you see $35 pants at Ross?  (Hint:  Not often).

 

CTRN’s track record and unit economics (which you’ll find in 10Ks, the S-1, and the Q406 CC transcript) makes it obvious that the concept has the right economics to follow a similar growth path as ROST and TJX, if not slightly better.  I say slightly better because the direct competition in their niche is minimal at this point, and the unit economics look to be a slight bit better: lower per square foot rents and opening costs thanks to taking over vacant stores in less desirable neighborhoods (total rent as % of sales is 4% at CTRN vs. 5% at ROST).  There is still much potential for higher comps and higher sales per square foot as CTRN’s sales per square foot is half that of ROST – and this would of course further improve the unit economics.

 

With $57 million of cash on the B/S, CTRN has plenty of time to fix its problems.  So it really boils down to two questions that need to be answered:

 

Are the recent operational problems temporary?

 

Does the current valuation offer a good risk/reward?

 

I believe the answers to both of these questions are yes, as I explain below.

 

 

Inventory buildup – There are several reasons for the inventory build.  Obviously inventory must increase along with new square footage.  Inventory has also increased in the D.C.s (by $9 million in the prior quarter) because the company bought in heavily on some deals they thought were better than usual.  They call these “pack and holds,” and the idea is to get higher gross margins when they get into the stores 6 to 9 months later, because they were able to buy some great brands at fire sale prices.  The increase makes sense in the context of troubles that demo and other high end urban apparel chains have experienced in recent months.  I don’t think any of these are troublesome reasons and I doubt other investors see them as troubling.

 

But inventory is also up on a comparable store basis by 12%, which is much faster than comps of 3.4% (on a comparable store, comparable week basis).  It is also on top of a comparable store inventory increase of around 22% the prior year, so inventory per store has been running 35% to 40% higher then those same stores 2 years ago.  Management first mentioned they thought inventory per store was too high in Q106, so this is getting to be a chronic issue.  Store visits confirm that these stores are really packed with inventory.

 

Excess inventory leads to increased markdowns and inability to move appropriate seasonal and/or fashion appropriate inventory into stores because there is no more room.  No doubt this leads to other problems as well such as shrink and payroll management as mentioned below.  The company has taken several steps to deal with this issue, has already seen inventory come down a little (August was a high sales month), and expects inventory per store to come down to levels in line with sales comps by the end of Q4.  Furthermore, they have decided to externally hire an executive who will head up inventory planning/allocation.  It is likely that problems in this area will persist into 2008, and that increased markdowns will be needed to clear unwanted inventories.  But this strikes me as a temporary problem that will go away eventually, though it may get worse before it gets better and certainly means markdowns are coming.  I estimate “deferred markdowns” to be $5 to $10 million.

 

To get an idea of how out-of-control inventory is, I compared inventory/sq ft with ROST.  Surprisingly, ROST is much higher, at $58.5/sq ft as of the end of 2006.  Some of this is due to higher percentage of pack-and-hold inventory.  Backing pack-and-hold out of both ROST and CTRN numbers, I get 2006 year-end numbers of $36.3/sq ft for ROST, and $22-$25/sq ft for CTRN (which didn’t break out exact $ or % for pack-and-holds, so I’m extrapolating from CC comments).  While CTRN probably has lower average cost inventory, the fact that the inventory per square foot is roughly 2/3 of ROST gives at least a tiny bit of comfort and sanity check.

 

Increased shrink – Theft of merchandise (primarily employees) has increased over the past 1.5 years but only last quarter was bad enough to break out as a separate item.  Q2 shrink was 2.3% and management expects to see elevated shrinkage levels (2.0%) for at least another 2-4 quarters until the issue is addressed.  Management believes that improved training, better store level management, and a recent executive level hire (Senior VP of Human Resources who comes from one of the major off priced retailers) will bring this down to 1.5% in 2008, a level that is consistent with industry norms.  They are also testing a third party 24/7 monitoring service in Q3, which could get rolled out to all stores if it proves to be cost effective.  Note that inventory is counted on a cycle basis, and accruals are made for all the rest of the stores based on the count, so the company never has an exact inventory count at any given point in time.  The Gross Margin decrease in Q2 was entirely due to the hit from shrinkage (includes the accrual).  Store management turnover is a leading indicator for shrink problems, so management believes it will take months after turnover slows (which has just started) before the shrink numbers improve.

 

Payroll management inefficiencies – some stores have seen negative comps this year, and the company was not able to adjust payrolls in a timely fashion to accommodate the decreased volumes at the individual store level.  The company has developed faster reporting procedures and has engaged consultants to help assess current procedures and implement improvements.  The company indicated on a 10/18/07 conference call that this was already 75% fixed for Q3.

 

Taken together, the inventory, shrink, and payroll management issues suggest the company is behind on the infrastructure, processes, and management needed to absorb rapid growth, but the steps outlined by management to deal with these issues seem reasonable and will likely resolve most or all of these three issues within a year, if not sooner.  While I am by no means certain that everything will be fixed within a year, I do think that top management’s extensive retail experience implies an ability to solve problems that arise – and they have clearly turned their attention to these issues.

 

 

Competition:  Many of CTRN’s stores are located in neighborhoods where most national clothing retailers refuse to go.  The only sizeable competition I’ve been able to find in CTRN’s niche is DD and AJ.

 

AJ has never been profitable, despite exceeding CTRN’s total square footage by 2006.  A year ago, TJX decided to close 34 of its 162 AJ’s in an effort to cull out unprofitable stores and increase efficiencies by focusing on the stronger/denser geographical areas.  The company has drastically slowed down store growth and is attempting to emulate CTRN’s urban fashion brand success.  CTRN management claims that they have not been able to measure any impact from AJ stores opening or closing near Citi Trends stores.  I find that hard to believe.  But at the moment, there are only 20-25 AJ locations anywhere near CTRN locations, so it hardly matters.  Eventually, I think AJ will matter as CTRN starts opening more stores in AJ markets, and AJ learns to better service the African American market.

 

ROST opened the first DD in 2004 and the model proved promising enough to rapidly expand it.  The number of stores doubled from 26 to 52 in 2007 as ROST purchased over 40 Alberston’s locations, half of which were used to open new DD’s.  Early indications are that some of the Alberston’s locations are underperforming existing DD stores.  My best guess as to why is that many of them are not in optimal locations for the concept.  ROST intends to grow DD’s by 10%/year starting in 2008.  DD Discounts just recently opened its first stores in states with Citi Trend stores (TX, FL) and more will be coming, so it may be possible to measure the impact soon.  I do think the DD stores will be real competition for CTRN at some point, based on what I saw on my visit to a DD’s.  But it will be at least a couple years before the geographic overlap is significant.

 

The most intense competition is probably from a number of smaller format women’s-only chains (see 10-K for names) that are often located in the same strips as CTRN stores.  Men’s sales have been growing faster at CTRN then women’s sales, so I wonder if the competition is intensifying – but I’m not sure if there’s an easy way to find this out.

 

I have noticed that some analysts compare CTRN with Pacific Sun’s demo concept, a mall-based retailer of full-priced urban brands.  But CTRN’s sales trends are hardly correlated with demo, which has seen a sizeable sales erosion over the past year (negative double digit comps and 1/3 of stores closed).  The locations and prices are so different that I don’t see how this can be considered relevant competition.

 

Overhang (and offering expenses) from Hampshire Equity Partners – CTRN was privately held by Hampshire until it was brought public in 2005.  Hampshire’s stake at that time was 58%, which was reduced to 45.7% by March of 2007.  Since then, Hampshire has accelerated sales and as of the 10/8/07 S-3 filing owned 28.7% (most was sold in the summer when the stock price was around 40).  Every time Hampshire files to sell more, the company incurs underwriting expenses which are not deductible expenses for tax purposes.  Hampshire’s interests may or may not be aligned with that of the rest of the shareholder base, yet undoubtedly wields more influence than the average shareholder (see 10k discussion about Hampshire).  I have not been able to find out much about Hampshire, though I have found that the performance of this and at least one other Hampshire fund has not been good.  It appears that the CTRN investment was the only big success in its particular fund, which I believe was started in 1997.

 

Stock buybacks not happening – The company answered a question about buybacks on the Q2 CC:  They said they’ve had discussions about it but decided that there was insufficient liquidity in the stock (despite $8 million+ worth of share trading daily) and that they don’t want to buy back stock until Hampshire Equity is done selling.  I thought this was a bizarre answer and suggests to me that Hampshire Equity is influencing their stock buy back decisions though I don’t understand why Hampshire would be motivated to stop the buybacks.  Perhaps to prevent the appearance of a conflict of interest?  At any rate, either the company has a poor understanding of when it makes sense to buy back stock, or they will do what Hampshire says until this entity owns no more CTRN stock.  Either way, I’m not thrilled.

 

Management – Top management at CTRN has experience.  CEO Anderson has a strong financial and retail background, which includes leading the retail chain Rose’s Stores out of bankruptcy.  President and Chief Merchandising officer George Bellino has been in off-price retail for nearly 2 decades – and obviously has the right touch with connecting the right fashions for the customer base, given CTRN’s track record since its 1999 transformation (when he was CEO of CTRN’s predecessor).  A year ago, the prior CFO was hired away by Cato and eventually replaced by Bruce Smith, former Hancock Fabrics CFO.  The actual performance of this group suggests average management – good on fashion and focusing on the customer but behind the curve on developing the appropriate hiring, training, and infrastructure processes in place to support rapid growth.  The plus on capital allocation is that the company has been laser focused on its successful concept with its low CapEx.  The minus is odd comments about stock buybacks.

 

Macro – CTRN management has mentioned several times in CCs that they have not encountered significant correlations between any macro issues and their customers’ buying patterns during the past few years, though they are concerned by rising food prices and the impact of rising unemployment, if it were to happen (most customers don’t own homes, many don’t own cars . . .).  Recessions and fashion shifts are usually helpful on the purchasing side as more and cheaper clothes become available for purchase.  I have no doubt that if macro issues were intense enough, CTRN would be impacted.  But given how well CTRN did from 2001 through 2005 in the face of rising unemployment and dropping incomes among its customers (see prior comments), this is not one of my bigger worries.  Obviously, recent stock price action suggests that most investors are expecting all clothing retailers including CTRN to get hit very hard by a consumer recession over the next few years.  I think investors are wrong to lump CTRN with the rest, but the share price may decrease further in the short term due to these concerns.

 

One last issue – federal minimum wage has started to rise and will have two more increases over the coming two years:

 

$5.85 July 24, 2007

$6.55 July 35, 2008

$7.25 July 25, 2009

 

This could pressure margins, as many employees make close to the minimum wage.  Management does not have an opinion as to whether this will impact customer purchases.  While income will increase, jobs may be lost.  If enough jobs are lost, this could negatively impact CTRN.  I do think it is worth noting that the entire gains in income of the last three decades by the low-to-mid income African Americans happened in the 90s when the minimum wage increased several times, while unemployment dropped (see earlier link).  So perhaps the minimum wage increases could be good for CTRN, but I don’t think this is possible to forecast.

 

 

CTRN has been growing its square feet by over 23%/year for the past 3 years and sales by 34%/year, while still generating significant free cash flow, which makes it obvious that store level economics are very good.  Even if we pessimistically assume the company is “only” able to continue to grow square feet by 20%/year without going free cash flow negative, and that comps moderate to 3%/year (after 5 years of comps that averaged over 9%), that’s still 23%/year sales growth, which presumably should be able to translate into at least 20%/year per share earnings growth (Assuming no further deterioration of currently depressed margins, but moderate amounts of stock dilution and costs associated with the ongoing stock distribution from Hampshire).  There’s over 5 years to go before saturation becomes an issue if the company grows at this rate.

 

The company could of course choose to slow down square footage growth for a year or two, which might be prudent given the types of operational issues that have developed over the past year.  But the company would then become a big free cash flow generator.

 

At any rate, with EPS pessimistically growing at 20%/year for at least the next 5 years, all you need is for the current valuation ratios to remain constant to earn a 20% annualized return.  Those ratios, based on estimated depressed margins/earnings for the current year, are:

 

14m shares (estimated average basic shares for 2007)

$228m Market Cap

$57m Cash

$171m EV

 

$450m 2007 Sales (estimate)

$25m 2007 EBIT (estimate)

$35m 2007 EBITDA (estimate)

 

6.8 EV/EBIT (estimate)

4.9 EV/EBITDA (estimate)

 

Obviously, there’s more upside than a 20% annualized return if operating margins rebound or the valuation ratios rebound to growth stock type multiples.  Both are likely to happen once the company works through its growth pains.  The estimated FY07 5.6% operating margin is significantly below the 6.1% of FY04 (a normal year) and far below the peak margins of 7.3% and 7.9% in FY05 and FY06.  Both FY05 and FY06 margins were unsustainably high as the company experienced a huge sales surge just after the hurricanes (vouchers), which caused markdowns to be far lower than usual, and thus higher gross margins.  FY06 was also higher due to distortions caused by a 53^rd week.  But operating margins in the 6.0% to 6.5% range are what CTRN did from FY02 to FY04, and I think it more likely than not the company returns to this range by 2009, if not 2008.  It is also reasonable to expect modest margin expansion several years out, thanks to operating leverage, increased buying power, and increased efficiencies.  Therefore I think a reasonable “normal” range to be 6.0% to 7.0%.

 

An optimistic but not outlandish scenario might look something like:  5 years of 20% square foot growth combined with 8.5% comps leads to 30% annualized sales growth, or sales of $1.67 billion 5 years from now, and perhaps net income of $75 million.  A $1.5 billion valuation 5 years out for such a fast grower does not seem out of the question.  That would be better than a 5-bagger from today’s prices (close to 40% annualized returns), even allowing for some dilution.

 

While there are of course the usual risks inherent to retail operations, and this company’s greater focus on fashion means it is subject to higher risk from fashion shifts than TJX and/or ROST, I think the biggest risk is temporary – that the company takes longer than a year to get its operational issues solved and perhaps decides to slow down square footage growth until these problems are solved.   There is also likely to be at least another quarter or two of big earnings misses as markdown activity increases in order to clear out slow moving inventory (perhaps $5 to $10 million cumulative).  Comps could also turn mildly negative if sales of branded items continue to drop, as these items have higher average selling prices than the non-branded inventory.

 

So the company has probably not yet reached bottom in terms of markdowns, operating margins, and tough branded sales comparisons.  And it is entirely possible that macro factors such as rising food prices and/or a big spike in unemployment could have a significant impact on sales (or at least further drive down the stock price short term from investor fear).  But given the valuation, the limited competition, and the company’s early stage of growth, the risk/reward is now good enough to endure the couple of lousy quarters this company must get through before the inventory is cleaned up and the numbers start to look better.

 

And, while I am not particularly expecting it, one has to wonder if TJX or ROST would be interested in purchasing CTRN at current prices.  The company has always done much better than AJ Wright or DD Discounts, and it is interesting to note that the current EV for CTRN is less than what TJX has sunk into AJ Wright for a very poor return to date.

 

 

 

Catalyst

 

Resolution of inventory, shrinkage, and payroll issues