Description

Factory 2-U Stores is a management turnaround story. You have an A+ management team taking over a company with a D- history. Specifically, Bill Fields the ex President and CEO of Wal-Mart is taking over an operation that took paid in capital of $127 from shareholders and generated -$80 million in retained earnings. In 1999 the company reported $1.69 in EPS. After eight quarters of sequential negative same store sales, the company reported a loss of $2.20 last year. Under the new team, FTUS just reported its first positive quarterly same store increase.

Factory 2-U Stores occupies a unique niche in discount retailing. The company was founded to serve migrant workers in California and continues to target consumers with an average annual income of $35,000 or less. Management believes that any customer who shops at Wal-Mart or Kmart is a potential FTUS customer. Their surveys show that the company has a low price reputation among its customers and that once customers become familiar with FTUS, they tend to shop at Factory 2-U before going to a “Mart”.

The customer base allows for some unique opportunities. FTUS customer base buys clothes when needed and does not “buy forward”. They buy cool clothes when it’s warm and warm clothes when it’s cold. As a result the company is able to buy heavily discounted in-season closeout merchandise and excess inventory from other discount chains and apparel manufacturers. Factory 2-U Stores’ ability to move relatively small quantities of in season goods to its customers is a key competitive strength.

FTUS aims to provide low income families with name brand goods and focuses its retailing strategy accordingly. The company locates its shops in neighborhood strip malls, provides bilingual signage, offers in-season merchandising as mentioned and makes roughly 10% of its sales on a layaway basis. Unlike discounters like TJ Maxx and Ross Stores that target middle class consumers and compare their merchandise mix to better quality department stores, FTUS compares its product mix to Wal-Mart, Marshall’s and Mervyn’s.

It is important to understand what went wrong in order to understand the probability that a new management team can fix the problems. In retailing, if the problems stem from a change in demographics, high debt and/or poor store placements, retail turnarounds can be difficult. Poor execution issues on the other hand can be solved fairly easily by executing previous management. In our view the latter is the case here.

In 2000 with the economy slowing substantially for Factory’s core customers, the previous management team was upscaling the chain’s pricing and inventory. When prices rose above Wal-Mart levels, customers became confused and left. At the same time, management left its core Washington to Texas markets, expanding into Missouri, Louisiana, Arkansas and Tennessee. The move not only outran the company’s distribution capabilities but also significantly lowered its marketing leverage by entering highly competitive markets where they had no brand recognition.

Since Mr. Fields became CEO in November 2002, he has replaced virtually all of the district managers and half of the store managers. The new team has closed down outlying stores and is refocusing spending into its home markets to better leverage their marketing spend. In addition, Mr. Fields has centralized distribution into a new San Diego center closing two smaller centers. These actions should, eventually drive operating margin gains which is the key to this story.

The best way to get a sense of the relative risk, valuation and potential leverage inherent in FTUS is to compare its operating statistics to some of its competitors. The closest comps are Dollar General, Dollar Tree Stores, Family Dollar and the A.J. Wright division of TJ Maxx. I have thrown in statistics on Wal-Mart as well to show the statistics of a well run competitor.
Factory 2-U Dollar General Family Dollar TJX Cos. Ross Stores Wal-Mart Average
FTUS DG FDO TJX ROST WMT ex FTUS
Valuation
FY2 P/E 23.1 20.3 23.5 15.0 14.9 25.4 19.8
Price / Book 2.1 5.1 5.3 7.9 5.6 6.4 6.1
Price / Sales 0.2 1.1 1.5 0.9 1.0 1.0 1.1
Selected Financials (LTM)
Sales ($ Millions) 522.7 6,280.1 4,600.0 12,104.2 3,591.0 246,282.0
EBITDA 0.5 588.8 466.3 1,148.9 391.1 17,536.0
Cash Flow from Ops - 14.0 358.9 367.1 650.8 249.5 13,024.0
Free Cash Flow - 25.5 185.6 130.4 174.1 100.6 2,390.0
FCF p.s. - 1.63 0.56 0.76 0.34 1.31 0.55
Profitability
Gross Margin 33.5 28.6 31.8 24.0 24.5 21.8 26.1
EBITDA Margin 0.1 9.4 10.1 9.5 10.9 7.1 9.4
EBIT Margin - 2.7 7.1 8.3 7.7 9.3 5.7 7.6
Net Margin - 5.4 4.4 5.3 4.5 5.6 3.3 4.6

Leverage/Liquidity
LTD/Cap 28.1 19.6 0.0 33.7 7.1 34.2 18.9
(EBIT / Interest) - 7.2 10.8 NMF 27.8 NMF 13.6 17.4

Current Ratio 1.1 2.1 2.1 1.4 1.5 1.0 1.6
Inventory Turnover 5.3 3.8 4.2 5.4 3.8 7.8 5.0


The inherent risks should be clear up front. The company continues to run EBIT and free cash flow negative and its current ratio is low relative to most. The company has raised capital recently and will probably need to raise additional capital over the next year.

The value is clear as well when measured on either a price to book or price to sales basis though not on a P/E basis. Clearly the company is under-earning its sales and book. The new team is focused on margins which is the inherent leverage point in any retail turnaround. Small changes in margins lead to very large changes in EPS. If for example, the company could return to a 1.3% net margin (vs. 4.6% for the comps) on $520 million in sales the company would earn $0.50. In time, I see no reason why the company couldn’t earn in excess of $1.50 as it did in 1999.

It’s worth noting that several of the operational statistics shown above are promising and show the inherent strength of the franchise. Gross margins are high relative to peers. The company’s problems come into play further down the income statement where management has more ability to control them. Second, inventory turns are above 4x which is the norm for most retailers (four seasons = four turns.) The ability to raise turns above 4x means that the franchise should be more efficient than the norm at utilizing its fixed plant. I can only guess that this contributed to the company’s ability to hire Mr. Fields.

Risks: Turnarounds are never smooth. There will be rough quarters and there will be a need for further funding. I generally stay away from negative FCF stories, but the imprimatur of the new management team combined with the inherent leverage gave me confidence.

One of the first hires that Mr. Fields made was Larry Kelley as EVP for Merchandizing and Marketing. Mr. Kelley left during the second quarter. While unfortunate, this should not affect the company's buying ability, which is performing well (so far.) Mr. Fields has taken over the GMM position on an interim basis, but his next hire bears watching.

Catalyst

New management team.