Description
Hancock Fabrics (HKF) is a retailer and wholesaler of fabrics and related home sewing and decorating accessories. At its current price of $14.20, HFK is not a screaming bargain. However, its price has been depressed recently as a result of industry conditions (described later) and as such, represents a reasonable price for a solidly run company which has been quietly reinventing and repositioning itself for expanding revenues and profits for the future. Unlike 8 months ago where bargains were everywhere, HFK is currently priced to present a patient investor with a decent return in the long haul.
HKF operates 432 retail fabric stores in 42 states and operates an Internet store under two different domain names. It generated revenues of $445 millions (TTM) as of its FY 2003 third quarter, ended November 2, 2003. Founded in 1957, HKF carries a complete selection of fabrics and accessories for the individual and the home, and sells it merchandise at guaranteed low prices. Product offerings include fabrics for fashion apparel, active wear, home decorating, quilting, bridal dresses; notions; accessories; sewing machines and accessories; quilting accessories and supplies. Its stores are typically located in strip shopping centers, and average 13,000 square feet in size.
Since the mid-to-late 1990¡¦s, the fabrics retailing industry had an excess capacity and resulted in a major shakeout, which caused depressed pricing for several years. Meanwhile, the demographics have been changing and there was less interest in home sewing for apparels, but increased interested in home decoration, craft and hobby.
In the late 1990¡¦s, HKF was primarily a retailer of fabrics to support customers who were interested in sewing. The industry shakeout as well as the change in the demographics of its customers resulted in a dramatic drop in its profitability in 1998 through 2000. In the last several years, HKF has been gradually reinventing and repositioning itself to adjust for the change in the industry and the demographics. Its strategy has three elements: reposition its store base, enhance its product offerings and presentation, and identify and communicate to a broader base of customers.
Repositioning its store base: Since the beginning of implementation of its strategy, HKF has closed or relocated 290 stores. In the last 6 years, it opened or acquired 158 stores while relocated or closed 204 stores. As a result, its total store count declined from 462 stores in 1998 to the current 432. The repositioning strategy closes smaller, overlapping stores into larger, well-spaced locations. While there will be more closings and relocations to be done in the future, its plan calls for a net increase in the store base in 2004 by 15 to 20 stores. Now that the bulk of the closings and relocations are done, HKF can focus on the growth of its store base.
To support the future growth of its store base, HKF has been making investments in a new distribution center and a point-of-sales (POS) system. The distribution center is approximately 473,000 square feet and can support up to 600 stores. It will be completed in the middle of 2004 and will position HKF with the logistics needed for future growth. The POS system has been rolled out to about 112 stores throughout various regions of the country and is beginning to provide a better checkout experience for its customers and more timely sales information for the company. In addition, the POS system is integrated with its merchandise management system. Together, the information systems will provide better information for purchasing and marketing decisions.
Enhancing its product offerings and presentation: While some of its competitors are diversifying from their fabrics-based product offerings, HKF has maintained a fabrics-based focus. HKF believes that it can achieve better results by maintaining a tight focus, but tweaking its focus to adjust for the shift that is occurring in the social and demographic trends of its customers from apparel to home decoration, craft and hobby. As a result, HKF has been increasing its product offerings in home decoration and quilting, both in fabrics and in sewing equipment and accessories. HKF is also offering products in higher growth categories such as yarn and special occasion merchandise. In support of and as a natural extension to its home decorating offerings, HKF is also offering small furniture pieces that are used as is or can be embellished with fabrics. It has also been tweaking its offerings in fabrics for apparels. In its new stores and remodeled stores, HKF installed the store-within-a-store concept for home decorating, featuring Waverly, a premier name in home decoration fabrics. HKF is also promoting its own exclusive premium brand of unique, high quality brand of decorative fabrics and accessories through the Lauren Hancock Home brand. In the quilting segment, HKF is improving its quilt fabric offerings through its own Quilter¡¦s Shades brand. It is also working with well-known quilting personalities to develop and promote quilting products.
Identifying and communicating to a broader base of customers: HKF has been focusing its advertising resources to retain its existing customer base, as well as attracting a younger customer group. Its primary approach is through life style advertising on network and cable television. It also uses direct mail materials to reinforce new products and ideas. HKF partners with quilting personalities to develop new quilting products, and holds seminars and workshops to promote quilting as a craft and hobby.
Competition: HKF competes with Jo-Ann Stores (JAS), Hobby Lobby (a private company with revenue over $1 billion), Wal-Mart and, to some extend, home centers such as Home Depot. Both JAS and Hobby Lobby are significantly larger competitors with extensive offerings in fabrics for apparel, decorating and quilting, and compete directly with HKF. Both JAS and Hobby Lobby also offer a wide selection of other art and craft items, and seasonal items that competes with the likes of Michael Stores and discounters. The Wal-Mart offerings are not as broad as those of HKF, focusing mostly on fabrics for apparel. While Wal-Mart can defeat any competitor when it chooses to, it appears that the marketing of fabric-based products does not fit into the model where Wal-Mart excels ¡V standardized products where Wal-Mart can move a large quantity with a minimal amount of store labor. I believe that while Wal-Mart¡¦s pricing power will hurt HKF in the apparel area, HKF can do well against Wal-Mart by tweaking the apparel offerings and by expanding on the decorating and quilting areas.
In the last 2 years, the competitors have been engaged in constant promotions. The promotional activities have accelerated in the last several months, with competitors engaged in price reduction by as much as 50% on a broad selection of fabric products. HKF has so far resisted matching the discounting activities, in an attempt to maintain its gross margin, which has typically been at around 50%. However, same store sales growth has slowed to 2.4% in the first 9 months of Fiscal 2003, from 7% in the same 9 months last year. Worse, same store sales declined by 0.5% in the 3rd quarter ended on November 2, and declined at a rate of 4% so far in November.
Results: While HKF¡¦s results have suffered recently, its results over the last several years had been excellent and reflected a patient, conservative approach focused on long-term results, rather than short-term successes. In the last several years, it has grown revenue by approximately 6% a year with a smaller number of stores. Growth in same store sales in 2001 and 2002 was 6.3% and 8.3%, respectively. EPS grew from a low point of $0.18 in 1998 to $1.06 in 2002. EPS growth in 2002 was in excess of 25%. In the first 9 months of FY 2003, EPS declined from $0.61 to $0.56. Its recently announced 3rd quarter results were particularly disappointing. EPS came in at $0.24 versus a consensus forecast of $0.32 and $0.32 a year ago.
Its ROE has steadily increased to 16% over the last several years. By tweaking its product offerings, sourcing more in low cost regions, maintaining a tight control over inventory and resisting discounting, it has increased its gross margin steadily to approximately 51% in 2002. Recently, its gross margin declined somewhat to 50%, a result of competitive pressure as noted above.
On the re-merchandising side, its sales relating to decorating has increased to approximately 29% of sales. Even in the current environment, comparable sales in this area increased by 6% year over year. Hence, it appears that its strategy is gaining traction.
HKF has used its cash flow well. Over the last 5 years, HKF has paid over $28 millions in dividend, purchased $55 millions of its own stock (it has retired over 13 million shares of its own stock in 8 separate buy-back authorizations, leaving approximately 19 million shares outstanding), paid down debt by $10 millions and invested $55 millions in capital expenditure. Yet it only has $28 millions of debt, which it expects to pay off by the end of next year.
There are 2 structural concerns. It maintains a pension and post-retirement health benefit program for its employees. It also has a generous stock options program. While good for employee morale, these 2 programs are expensive and will reduce EPS results in the future. Its pension program, while not significantly under-funded after substantial cash contribution in the last 2 years (which mostly caused the $28 million debt), still has a very optimistic assumption of 8.75% rate of return of its assets. This will result in continued cash funding requirements in the next several years as HKF adjusts down its rate of return assumptions. Its stock option program has over 2.2 million shares outstanding (over 1.5 million shares exercisable), over 70% with a strike price below its current stock price. While the exercise of stock option will generate cash, it also dilutes EPS. This will be offset, to some extend, by the active share buy back.
Near term concerns: The pressure on discounting is unrelenting from JAS and Hobby Lobby. It also appears that these competitors are driven by short-term results and inventory liquidation in making their pricing decisions. It is not clear if HKF can continue to maintain its strategy of holding its line on gross margin without continued decline in same store sales and market share. It is a game where no one will win, but yet the competitors are not letting up. In addition, the cost of finishing the distribution center and its HQ building in the first half of 2004 will put some pressure on results in the next 6 months.
Investment thesis: the repositioning and the re-merchandising efforts are mostly behind HKF. While tweaking will still be required, it has a model that produces above average results and cash flow. Its tight focus on fabrics, rather than diversifying into art and craft (as JAS did) will serve it well in the long run. With the bulk of store closing behind it, store count will start to grow in the future. With its re-merchandising efforts gaining traction, comparable store sales growth of mid-single digit appears to be achievable. HKF has a clean balance sheet and strong cash flow, pays a dividend of $0.40 a year (which amounts to approximately 3%) and is conservatively managed. At today¡¦s price of $14,20, it is selling at a PE ratio of 11, based on an EPS estimate of $1.30 (my estimate) next year. With a mid-single-digit store count growth, a mid-single-digit same store sales growth, and some leveraging of SG&A expenses, a mid-teen EPS growth is achievable (assuming a continued share buy-back that at least negates the effect of stock options dilution). The EPS growth coupled with an expansion of PE to the mid-teen, a return on investment in the range of 20% over the long term is possible. This investment will not be a get-rich-quick scheme, but will be a solid investment in the long haul.
Comparison with JAS:
HKF JAS
Price per share ($) 14.20 20.05
Market Cap ($millions) 265 836
EV($millions) 280 1,070
D/E 0.19 0.64
PE ratio (TTM) 14.4 10.7
PS ratio (TTM) 0.59 0.50
PEG ratio 0.84 0.90
EV/EDITDA 7.9 8.9
Profit Margin (%) 4.2 2.3
ROA (%) 8.1 5.2
ROE (%) 15.4 13.4
Yield (%) 2.9 0.0
Risks: The primary risk is in the area of heavy competition and price discounting by JAS and Hobby Lobby, which will dampen HKF¡¦s growth and margin strategy. Another possible risk is that Wal-Mart will reposition its fabric lines to compete in the home decoration area. This is less likely as it does not fit well with Wal-Mart¡¦s high inventory-turn business model, but one should never underestimate Wal-Mart¡¦s prowess and resolve to compete.
Catalyst
Catalyst:
1. Continued execution of growth strategy
2. Reduction in discounting within the industry