Description

FCPO equity is a strong long idea because: a) according to my estimates, it currently sells at only 5 times levered FCF (for the 12 months ending Jan of ’05); b) the market is mispricing FCPO shares due to a same-store sales earnings blip within the context of financial de-levering and operational recovery; c) management is embarking on a prudent expansion of the store base that should unlock efficiencies and further drive operating income and share gains; d) shares trade at an attractive discount to that of FCPO’s primary competitor, Party City .

Factory Card and Party Outlet is a small-cap retailer that was written up by MPK391 in August of ’02 shortly after emerging from bankruptcy. The stock has done very well since then but the fundamentals and liquidity have also improved. Where FCPO had been an FCF de-leveraging story, it is now an emerging growth story at a very reasonable price. A q/q sales slowdown in the most recent 4th quarter is providing a very good R/R investment from current levels.

I will not go into too much detail on the basics of the business and why the company suffered a bankruptcy as those have been covered in the earlier report.

From de-levering to growth:
Since coming out of bankruptcy, FCPO has done remarkable work repairing its balance sheet (debt on revolver has come down from $23m on the exit from bankruptcy to only $4.8 m) and improving operations while modestly trimming the number of stores. Now that management (brought in after the bankruptcy) is comfortable with both the financials and the operations, it is preparing to grow the store base. Management states that it plans to add 10 stores in fiscal ’05 and 25 stores in fiscal ’06. This implies a potential 15% growth rate in the top line and an even greater bottom line improvement due to achievement of greater scale.

Why the stock sold off:
FCPO pre-announced weak same store sales (down 3.4%) in November and December. This was certainly not the robust growth that one would ideally want to see; the market reaction, however, was overblown. The Christmas season, while critical for most retailers, is not the most important for FCPO. Where other retailers, like Toys R Us, derive more than all of their profits from the Christmas season, FCPO has historically only gotten 20% of its profitability from Q4. FCPO is not destination shopping during the Christmas season but more of a “me too” retailer and its performance tends to be driven by the performance of the big boxes. Given that Wal-Mart and others did not have a particularly good Christmas, it should be no surprise that FCPO suffered. The 1st quarter (with Valentine’s Day, St. Patrick’s Day and Easter) and the 2nd quarter (Mother’s Day, Father’s Day, Graduation Day and Fourth of July) are much more important to FCPO.

Improvements continue:
Since new management took over FCPO, it has made tremendous operational improvements to the company. These include a reduction in the check-out line waits, efficiencies in inventory management using a central distribution warehouse, and store uniformity (each store manger has a meticulously detailed 3.5 inch binder on display procedure and store management). These improvements have yet to impact the bottom line.

Inventory management improvements:
The very distribution center and inventory automation system that caused the initial bankruptcy for FCPO is now one of the company’s greatest strengths. FCPO buys in bulk and operates its own automated distribution center, lowering its marginal costs and increasing flexibility of timing purchases. Managing inventory in this business is critical because so much of the inventory is seasonal. Once St. Patty’s day is over, any unsold inventory is effectively headed for the trash bin. Yet if a store runs out of stock the day before the holiday, FCPO misses out on the incremental sales. Clearly there is an art to doing this well.

Store re-branding and uniformity:
The current store base of 175 stores is a mix of stores with: a) updated single flow checkout lines, bright new multicolored signage de-emphasizing the word “Factory” with emphasis’s on “Card” and “Party”, and redone fixtures and flooring; b) stores with some portion of the re-branding and updating done; and c) old format stores. The company should realize improved traffic and SSS in the yet-to-be updated locations as it rolls out its store refresh program.

Product mix:
The company is also improving the product mix. It has had good success testing higher margin items like large inflatable bunnies for Easter, karaoke machines, and talking horses. In the sample stores, these items have made significant improvements to margins. FCPO’s goal is to roll more of these concepts out system-wide going forward. Further, management is learning to take better advantage of Halloween. Historically, this has been where Party City, its largest competitor, has done extremely well. Management has copied this format in a few stores for the most recent Halloween and plans to roll out this concept system-wide this year.

Valuation:
If FCPO were able to achieve the same MC to levered FCF ratio as Party City, this would imply an increase of 35% from here without regard to incremental operating income and efficiencies from increasing the store base.

Capital structure ($ millions):

S/T Debt: 4876
L/T Debt: 5,913 (5,713 due 4/05)
Equity: 36,300
Cash: 200
EV 46,900



Recent results and current multiple:

TTM levered FCF 4,989
Mkt cap/levered FCF 7.2

Today FCPO trades at a very reasonable multiple to TTM levered FCF (this calculation adjusts out the one-time positive changes in working capital resulting from increased payables as credit worthiness has improved). It trades at a significant discount to the larger Party City (PCTY), which is trading at TTM multiples to levered FCF of 9.8.

But factoring in store growth and the SSS-increasing efforts underway, the value in FCPO shares becomes even more obvious. Assuming an 8-store increase in average store base over the next 12 months (including the Nov-Jan quarter just ended), and a further 20-store increase by October 2005, FCPO shares look even cheaper.

01/04 – 10/04
Levered FCF/Share 2.39
Price 12.04
P/FCF 5.0

01/05-10/05
Levered FCF/Share 3.20
P/FCF 3.8

Growth assumptions:
Management is tentatively beginning a new growth trajectory. The distribution system can handle multiple store openings (it currently runs at only 60 to 75% of capacity) before needing to expand. Management appears to be picking its spots very carefully for a prudent store expansion and I assume the new stores are funded from cash flow. Assumptions include flattish SSS, increasing the store base by almost 10% by end 2005 and reducing SGA as a % of sales by 1% could drop an almost 35% increase to operating income in the next 12 months, so a well-executed store expansion could further the appreciation potential of the shares significantly.

DCF analysis produces a valuation of about $33 per share given these assumptions, a 10% discount rate and a 10X terminal multiple to levered FCF. A terminal multiple of 8X gives a value of about $27, more than 100% upside from here.


What could go wrong
1. Rapid growth in expenses to handle store expansion. 2. Poor merchandising and anticipation of consumer preferences and trends including a new focus on the juvenile market through licensed character goods. 3. A decline in broader retail SSS due to a retrenching consumer. 4. Failure to pay off trade and creditor notes in April 2005 would result in 29% share dilution.

Catalyst
The calendar is moving into FCPO’s seasonal stronghold, Q2, with Mother’s Day, Father’s Day, Graduations and July 4th. Continued updating and standardization of the store base and will stabilize SSS, while an enhanced focus on Halloween, to date not a profit driver for FCPO, could provide a boost into year-end. Finally, a well-executed and prudent expansion provides the kicker.

Catalyst