Description

Factory Card Outlet shares are an opportunity to buy a healthy business at under 2.5X FCF. Headquartered near Chicago, the company sells greeting cards and party supplies through a chain of 172 superstores throughout 20 states. Factory Card recently emerged from bankruptcy, which might help to explain why the stock is so cheap. Another explanation might be liquidity – at these levels, the market cap is a mere 9.5M. My personal favorite is the fact that suppliers got most of the equity in the reorg and have been selling indiscriminately. The suppliers aren’t natural holders of equity, and most of them didn’t get more than 1% of the company.

Importantly, Factory Card didn’t go bankrupt due to any fundamental problem with its business model. The model works, as evidenced by the success of competitor Party City (PCTY) and by both companies’ 5 straight years of comp store sales growth. FCPO went bankrupt when its debt-financed expansion plan stubbed its toe on two operational missteps.

The first of these came in the spring of 1998, when Factory Card relocated its HQ and distribution center. Systems conversion problems screwed up inventory management, resulting in out-of-stocks, goods being sent to the wrong stores, and bloated inventories at the warehouse.

The second misstep came in the fall of 1998. At that time, the company’s practice was to reduce holiday merchandise at the end of each season by packing it away for next year, rather than by marking it down. Problem was, you run the risk of bringing a lot of obsolete merchandise to the stores the following year, and that’s just what happened during the critical Halloween season, resulting in YOY sales declines of 22.4% for the month of October (though comps were still up 1.5% YTD at the time). Coupled with the high leverage, a cash crunch ensued, and suppliers demanded COD payment terms. Factory Card filed for Chapter 11 in May of 1999.

In bankruptcy, the company took the opportunity to reject leases on 38 locations, bringing the store count down to 172. Factory Card curtailed the pack-away inventory practice. Finally, the company has made management changes. Persons directly responsible for the inventory screw ups are gone. Former CEO Charles Freeman – who led the company out of bankruptcy – recently resigned and has been replaced by Gary Rada, President and COO.

Capital Structure:

Borrowings on 40M facility 22,743
Trade conversion note 3,130
Creditor payment due 2005 2,600
Financing agreements 896
Capital leases 188
Deferred rent liabilities 161
Total 29,718

Market cap 9,500
Excess cash 0
Enterprise value 39,218

Credit risk appears manageable since interest coverage for FY2002 will be roughly 3.5X, and the only required principal payment consists of the $2.6M creditor payment due in ’05. The $3.13M Trade Conversion Note is a convertible issued to certain suppliers which is payable in cash – at any time - at the company’s option. Management fully intends to pay down this note over the next 3 years in order to avoid dilution – the note is convertible into about 30% of the equity). As the table below shows, FCPO should have ample free cash flow with which to do this:

2003:
Net income 3,114
Taxes (add back) 2,076
D&A 2,549
7,739

Maint. capex (1,500)
FCFE 6,239

(Note: FCFE means FCF to equity holders) The above numbers are based on management’s projections, which assume the following:

Comp store sales growth of 2.9% in 2002 (Note that comps were 6.7% for Q102.)
Comp store sales growth of 4.0% in 2003
3 store openings in 2003 (off a base of 172 stores) and no closings
3% inflation rate
2003 gross margins flat vs 2002
2003 SG&A margins improve 20bp (to 43.5% of sales) vs 2002

I consider all of this to be reasonable. Please note that I’ve added back the tax expense that you will find in the Disclosure Statement projections, since the company has about $52M of NOLs, which would offset taxes for over 6 years in a scenario of no real growth. The projections did not factor in the NOLs because there was some small chance the company would not have the use of the NOLs at the time the projections were made. It’s now clear that they do. A call to the company will confirm this.

Also, note that the 1.5M of maintenance capex is at the high end of the guidance I got from the company. This includes the 2003 cost of a roughly 94 store 3-year renovation plan.

Valuation:

For simplicity’s sake, I’m assuming that all the warrants and options issued in the reorg do get exercised. I’m assuming that the trade conversion note does NOT get converted into shares, because management should have both the means and the desire to pay it in cash.

To creditors 1,350,006
To old common 74,553
To old common (warrants) 153,467
To management 75,000
To management (warrants) 31,000
Options 166,667
Fully diluted shares 1,850,693

FCFE per FD share $3.37
Current price $7.00
P/FCFE 2.1

So, it appears that the shares are trading at around 2.1X 2003 FCFE.

Although the Disclosure Statement talks about 37 new store openings between now and year end FY05 (falling mostly in 04-05), management is actually still evaluating its plans to grow the business. Given this uncertainty, I prefer to see what the valuation looks like assuming zero growth, rather than make unfounded assumptions about store growth. So long as one can assume that future growth will not be value-destroying, this should give a low-end estimate of fair value. My DCF assumes 3% inflation, 3% comp store sales growth, 13% discount rate, and a 10X terminal multiple of FCFE. I get about $24.50 per share. You can fiddle with the assumptions all you want, but at 2.1X FCFE this is still absurdly cheap.

If you’re interested, you might consider trying to purchase a block of shares from one of the 4 or 5 suppliers who got the biggest chunks of equity. They were all on the Creditors Committee, so check the Disclosure Statement for the names.

Catalyst

Overhang goes away as equitized suppliers sell their shares. Continued good execution proves that this a decent, viable business.