Description

Gymboree is a well-run, high quality (25-30% ROIC), growing retailer trading at an inexpensive price with the potential to be bought out within the next few months. The company should end the year with more than $8/share in cash which will put it currently at 5.0x forward EBITDA and 10x cash-adjusted EPS. The stock should outperform as the company beats Q3 earnings estimates and announces another buyback prior to year-end 2010. Even if no buyout emerges, shares are worth $60/share by the end of 2011 (FYE 01/12) based on 10x forward calendar 2012 cash-adjusted EPS of $5.00 plus what will then be more than $10/share of excess cash.

CAPITAL STRUCTURE

⁽¹⁾ Management commentary

BACKGROUND

In 1976, Joan Barnes opened a workout center that offered exercise classes for babies and their parents. She started franchising the concept a few years later and by 1986, Gymboree had grown to more than 300 centers. Barnes then opened a children's apparel retail store under the Gymboree name and by 1989 Gymboree was operating 32 retail stores. The company went public in 1993, and has generally grown store count and sales on a fairly consistent basis ever since.

The original exercise class concept, now called Play & Music, has grown to 673 franchisees and 8 company owned stores. Play & Music provides a lot of goodwill for the brand and an introduction to young parents, but is fairly irrelevant because it contributes only $0.11 to EPS ($5MM of EBITDA on $14MM of sales). In comparison, the retail segment is much bigger. Currently, the company operates 633 Gymboree (37 Canada, 2 Puerto Rico, and 2 Australia), 147 Gymboree Outlet, 120 Janie & Jack, and 129 Crazy 8 stores. These stores collectively control about 3-4% of the children's apparel market, competing against other specialty retailers such as Baby Gap (GPS), Old Navy (GPS), Children's Place (PLCE), and Carter's (CRI). The company also fully owns its only distribution center, which is located in Dixon, California.

⁽¹⁾ Results include online sales but exclude the Play & Music segment

Core Gymboree stores average around 1,900 square feet and target kids between the ages of three and four. A typical store might cost $350k in capital expenditures to build out and another $50k in NWC for a total cash cost of $400k, on which it would yields more than $100k in income for cash on cash returns of > 30%. In addition, unlike a lot of other sub-sectors of the retail apparel space, it is a growing demographic where consumers cannot defer purchases for prolonged periods of time (try putting your three-year-old in their clothes from last year). The space also has last exposure to fashion risk. Over the short-term, new product hits virtually every month versus other retailers who might be in the penalty box for getting fashion from anywhere between few months to as long as a year. Over the longer-term, children's apparel brands tend to be popular because the clothes are well made and last after multiple washes, which makes brands less prone to becoming "last year's fashion" versus other apparel retail sectors. Gymboree ranks fairly well here, a search on eBay for "Gymboree" yields 301k items for baby and children's clothing versus 66k "Gap," 43k "Carter's," 33k "Old Navy," and 26k "Children's Place."

The company's other concepts hit the entire spectrum of price points. Janie & Jack stores are higher-end boutiques with much higher price points while Gymboree Outlet and Crazy 8, go after the lower-end segment of the market.

Gymboree's business is all about promotions, with the stores continually cycling a combination of promotions and discounts that can result in consumers paying 60% off original price. This enables shoppers, the vast majority of which are moms, to spend a few hundred dollars on matching outfits yet boast about the massive savings they received on the purchase to their significant others. The company strategically segments its customers by combining various incentives such as Gymbucks, a 5% discount for using a Gymoboree Visa credit card, and other seasonal sales. There are actually guides online explaining how shoppers can get the best bang for their buck at the stores, with some of the more experienced shoppers arguing that the heavily discounted prices they pay at Gymboree beat the prices on lower-quality but similar items at Walmart.

HISTORICALLY CONSERVATIVE GUIDANCE SUGGESTS Q3 BEAT

Management has proven relatively adept at managing street expectations by continually under promising and over delivering on quarterly earnings. The tables below show the company's earnings versus consensus since McCauley took over.

In order to prevent the sell-side from eventually getting it right by simply adding a significant number to guidance, every time the company provides conservative forward guidance they provide some reason or note of concern about forward sales that is credible enough to keep the most bullish of the bunch from straying too far from the pack. For example, last year the company reported a strong Q3. Sell-side estimates for Q4 2010 had been creeping up from $1.07 to $1.12. To prevent analysts from using the strength of Q3 to raise Q4 estimates to unobtainable levels, management reset the bar to a level they could beat by guiding to $0.95-1.03 on 11/18/09, causing most of the street to immediately lower their numbers to $1.06. Then on 01/07/10 they raised guidance to $1.03-1.06, which was then again raised post-quarter on 02/04/10 to $1.08-1.10. When they eventually reported actual results on 03/30/10, earnings were $1.11, pretty much in line with the initial street levels.

For Q2 2010, management guided to $0.40-0.42 on 08/05/10, about a week after the quarter was completed, but "surprised" with $0.44 when they reported earnings two weeks later. This was up from $0.30-0.34 on 05/19/10 and $0.33-0.37 on 07/18/10. For Q3 2010, current guidance of $1.25-1.30 should have been an indication for analysts to start with $1.33 but commentary on a slow start to back-to-school and negative comps kept estimates in check at $1.30. However, if past guidance is any indication of what is in store for Q3, its likely management will ultimately report $1.35-1.40.

CONTINUED BUYBACKS SHOULD DRIVE 2011 UPSIDE

Historically, GYMB's growth has required a negligible amount of NWC, which has enabled the company to generate significant excess cash.

⁽¹⁾ Accrued Liabilities includes operating costs, compensation, unredeemed gift card, deferred revenues under the company's Visa program and unpaid sales tax

In fact, for the five quarters between Q2 2007 and Q3 2008 the company's quarterly cash balance was kept between $24-58MM. It appeared as if management was comfortable with this level of cash until mid-2008 when these buybacks stopped and the company began to horde cash in order to ensure its survival. At that time, it was unclear just how the slowdown would impact their business and Crazy 8 was a cash consumer as it ramped to breakeven.

About a year later, in November 2009, the company announced a $40MM buyback which it completed on 05/24/10 for an average price of $42/share. Then on 06/08/10 the company announced a $100MM buyback. At the time, this represented 8% of the company. While the terms of the buyback allowed management to execute it any time over the next 12 months, less than a month later the company reported that it had aggressively repurchased $96MM at an average price of $44/share. Sell-side estimates for 2011 show $4.41 in EPS or $120MM of net income, which implies 27.2MM shares, roughly where the company is today. These estimates should prove too low if management completes another material share repurchase. While some investors fear that recent weakness in retail may cause some management teams to retrench into hording cash again, on 08/24/10 the company increased the amount it is allowed to buyback under the terms of its revolver with Bank of America. Thus, it seems likely that GYMB will announce another buyback before year-end.

INTERNATIONAL GROWTH OPPORTUNITY

Long-term goal of 18% EBIT margins would imply $4.72 in EPS on next year's estimates sales. In addition to Crazy 8, management believes that they have a $100MM sales opportunity by expanding their offering in boys. Internationally they can increase their base of stores from 37 to 50-60 in Canada ("in 2011 we will probably start testing Crazy 8 perhaps some Outlets as well"), from 2 test stores to 50 in Australia ("sales have been very good at those stores" and Azadea has announced plans to open more stores in, "Saudi Arabia, Egypt, Kuwait, Qatar, Oman, Bahrain, Jordan, and Lebanon") and from 2 to 50 franchised stores in the Middle East through a partnership with Azadea Group ("our partners very excited about the performance at this point.")  In Q3 2009, the company also tested its product wholesale in two London stores, and subsequently said that the results of those tests were successful. All of these represent opportunities to expand earnings with very limited cash risks. While the company trades at a non-growth multiple, management has indicated to investors that they think they can maintain their mid-teens earnings growth rate.

You can look at our historical store growth, kind of look at what we just put out there. And if the trend continues, there's no reason that should change too dramatically...we view ourselves as a growth company. - Jeff Harris (CFO) 03/10/10

Crazy 8 alone could sustain this for a few years but there remains a healthy degree of investor skepticism that the company can maintain its growth rate as that concept matures. However, a little known fact is that Play & Music has been actively growing internationally. The company's website lists a number of international locations (www.gymboreeclasses.com/b2c/customer/DynamicInternationalSites.jsp) with Russia, Brazil, Pakistan, Dominican Republic, and Venezuela listed as "Coming/Opening Soon" as well as a surprisingly large number of stores listed in China. These were opened recently under a franchise agreement with GymChina, which had 112 Play & Music centers operational last year and another 46 in process, representing about a quarter of the Play & Music franchisee base and giving it 16% of China's early education market. As we get into 2011, it is highly likely that the company will announce plans to leverage its brand by expanding its retail concept into Asia, which could enable the company to continue growing into the foreseeable future, and enable the stock to trade at a higher multiple.

I think if you kind of look forward, we've talked a lot about brand presence and how we've created presence with Play & Music. We're very strong in Asian countries, Japan, Korea, China. You can walk in China and ask just about any parent that has a child if they've heard of Gymboree. It's a very well known brand. We've won awards there. It's one of the most respected children's brands. And so yes, we have a strong presence. We're very interested in Asia. It just takes time to find the right way to enter that market and make sure that, because we have such brand equity there, we want to make sure we get the biggest bang for our buck when we enter those countries, and so that's the process." - Matt McCauley (CEO) 03/10/10

LESS ECONOMIC EXPOSURE THAN FEARED

It should be noted that while North American Gymboree does make up the lion share of the company's stores, the concept has grown only moderately over the last decade from 548 stores in 2000 to an estimated 633 by the end of this year. While the higher-end concept Janie & Jack had 64 stores in 2005 and has doubled to 120 today, the main driver of the company's growth in the last few years has been the rapidly growing Gymboree Outlet which was started in 2005. These stores target a slightly lower-end consumer by selling prior year's product at a 20% discount to normal Gymboree stores. Management has said that these stores have the highest contribution of any of their concepts and our channel checks suggest that they were inversely related with the overall macro environment over the last two years, with sales increasing as the consumer traded down and decreasing as the consumer traded back up. This served as essentially a counterbalance and enabled the overall company to post flat comps in 2008 and (4%) in 2009.

The company's current growth concept, Crazy 8, is priced lower than Gymboree and is thus arguably a budget-priced concept as well. The company targets kids between the ages of five or six, which is about a year older than Gymboree and is less focused on having matching outfits. The stores average around 2,000 square feet and are being put into lower-end mall locations. Crazy 8 started the year with 65 stores and should end close to 160. Management believes that the concept has the potential to be more than 600 stores and our analysis suggests that ROIC of an incremental unit is around 25%. This is slightly lower than a Gymboree store, but this number should be increasing this as the concept is further refined and gains scale. Combined with Gymboree Outlet, these two concepts have become a meaningful portion of the sales mix, but because the individual concept sales are not reported, most investors often overlook the differences and continue to be surprised by the company's overall stability.

UNDERAPPRECIATED MANAGEMENT TEAM

Today's current multiple seems particularly low in light of the fact that the company increased sales, margins, and EPS every year for the last five.

Thus earnings trajectory has been lead by the company's CEO, Matthew McCauley, who was became CEO in January 2006 (Q4 2005). McCauley joined GYMB in 2001 after brief stints at Payless and then Gap. Since that time, management has done a remarkable job operating the business and is typically held in high regard. The top four executives have historically received more than 75% of their annual compensation in the form of restricted stock for meeting performance goals tied to EPS, IMU, and growth.

When we saw the economy trending down, the management team was fairly proactive and looking at managing these expenses.  We actually proactively reduce corporate distribution center and field management salaries anywhere between 10 to 15%. And those are permanent reductions, so employees understand that that is the new salary, there is no intention to reinstate those cuts in the future. The deal that we've made with the employees is that really to the extent that we performed better then our expectations will share some of those profits with them in the form of incentive compensation. - Jeff Harris (CFO) 09/28/10

Interestingly, the company's last proxy contained a fairly unusual statement, which suggested management led by example.

In December 2008, our executive officers requested that the Compensation Committee reduce executive base salaries as part of an overall Company strategy to reduce costs, including compensation costs, in light of deteriorating economic conditions and the challenging retail environment. Based on this recommendation, on December 9, 2008, the Compensation Committee approved a 15% reduction in our Chief Executive Officer's salary in addition to salary reductions for the other executive officers and all other officers at the level of Vice President and above... At the beginning of fiscal 2009, our Chief Executive Officer informed the Compensation Committee that he and Mr. Lambert, Mr. Garcia and Ms. Armstrong chose not to participate in any formal incentive bonus programs for the year. At their request, we suspended our formal cash bonus program for the year for those senior executive officers.

As a result, McCauley's total compensation of $4.4MM in 2009 was a decline of more than 50% from $9.3MM in 2008. We are hard pressed to find many other executives who lead by example. One potential reason is that McCauley is in his late 30's, making him one of the youngest CEOs around, and leaving a fairly long runway ahead of him. While most retail executives debate whether or not they will ever see the light at the end of the current economic downturn within the duration of their careers, we suspect McCauley might have a slightly longer-term horizon than the typical CEO.

BUYOUT CANDIDATE

On 09/30/10, the WSJ reported that the company was in the early stages of exploring a sale.

Bankers for San Francisco-based Gymboree have been soliciting interest from potential buyers of the company, said people familiar with the matter, but they cautioned there is no auction process... The company has considered a leveraged buyout in the past and frequently gets queries from buyout shops that consider Gymboree an attractive target, these people said.

Then on 10/05/10 the New York Post reported additional information.

Gymboree hired the investment firm last month after it was approached by at least two firms -- one of which was Apollo... a slew of buyout firms including Bain Capital, KKR, Apax Partners and Irving Place Capital have also expressed interest in acquiring the retailer,

While this by no means guarantees a takeout, it does highlight the underlying value of the company at current market prices. The top four executives own about 4% of the company and a LBO transaction would enable them to meaningfully increase their ownership. The sell-side has published LBO models suggesting prices ranging between mid-$50s to the low-$60s (shares traded above $55 less than six months ago). A very rough snapshot of what an LBO might look like is below.

We estimate maintenance capex runs around $40MM a year while stock-comp is around $20MM so FCF in the above scenario would be closer to $100MM. With reasonable growth assumptions, a buyer could pay off the debt over the next five years, and then take the unlevered company public at a 13x multiple for an IRR of ~ 15%. This assumes modest revenue growth and that management ultimately accomplished but does not materially exceed their long-term 18% EBIT (21-22% EBITDA) margin goal.

RISKS

Takeout fails. Even at today's price, GYMB trades at 5.4x 2011 EV/EBITDA versus 4.9x for PLCE and 5.8x for CRI. Shares would likely trade down, but the commentary has also served to highlight the significant value embedded in the company. Given that retailers trade based off P/E multiples, even if the company was not able to find a buyer, a leveraged recap in the public markets anywhere near current prices would still create substantial long-term value.

The consumer is dead. If we enter into a new recession, and the government does not provide additional stimulus, retail sales will be clearly impacted. However, Gymboree should fare better than most as the consumer trades down to Gymboree Outlet and Crazy 8. And while the path to a recovery will most certainly be a bumpy one, overall retail sales three to five years from now will likely be higher than they are today. In the interim, Gymboree is far more likely than most of their peers to take advantage of market volatility through aggressive buybacks. While this certainly does not lend much comfort to those investors whose business model is dependent upon making any given year, it will enable the company to take advantage of irrationally low share prices to the benefit of long-term shareholders.

Excess channel inventory will hurt near-term margins. Most economics apparently modeled our government's stimulus as a recurring item. Unfortunately, a lot of management teams got this wrong as well, which has caused excess inventory in most retail channels over the summer. While a good amount of this has been worked off already, there is some concern that it will result in an overly promotional Q3 and weigh upon margins. However, sales seem to have recovered from their sluggish August as September progressed, which should help this normalize over the next few months and, perhaps more importantly, management's initial guidance took a more promotional environment into account.

Cost inflation due to the recent increases in cotton, labor, and the Renminbi. After falling from a high or $100/pound in 2008, cotton bottomed at $55 in early 2009 and has since rallied to $100. Cotton futures decline to $90 in 2011 and $80 in 2012. Relative to other retailers the company only sources about a third of its product for China as it has been moving sourcing to India, Bangladesh, and Madagascar. Gymboree also has more of an EBIT margin cushion than its peers at 16% versus 14% at CRI and 9% at PLCE.

Crazy 8 will cannibalize existing Gymboree stores. Management budgets some cannibalization into its models before deciding on adding new locations and so far cannibalization has been less than expected. The current market share appears to be small enough that they are pulling more than enough sales away from competitors to make up for the difference.

Catalyst