Description

It's December, and we are on the lookout for deeply out of favor companies that are tax-loss selling candidates, have the wherewithal to buy back a lot of stock, and are trading at <4x earnings multiples.

With this in mind, I think MIK is an attractive speculative long. 

MIK was the subject of a well-written short report by NYCHRG just one year ago.  Kudos to NYCHRG for this impeccably timed report. The stock declined from $16 to $7 since the report.  While the equity valuation was more than cut in half, the business has not changed too much. In the interest of keeping this investment memo succinct, I recommend reading NYCHRG's report, and/or going to visit a store to go see what Michaels does. 

In brief, Michaels is an arts & crafts big box retailer in which the average item price is $4 and the average ticket is $22. They have 60% private label penetration.  Bain and Blackstone hold 46% of the company. Since taking the company private in 2006 for $6 billion, Bain and Blackstone have taken their money out through recapitalizations and stock sales.

Our field visits reveal a ho-hum operation in steady decline. The most recent quarter yielded -2% comps. The new CEO is uninspiring. Their new strategy entitled "Build the Business Better" is just about all you need to know about management and company strategy.  If you listen to their most recent earnings call and eat a peanut every time they use an MBA buzzword yet really say nothing of meaning, by the end of the call you will have had enough peanuts that you can go into hibernation (as a bear is wont to do) until springtime. 

Perhaps the most notable change since NYCHRGs report is that the company extended its debt maturities to provide it with a runway for the next 4.5 years.  The 1st lien term loan was extended to August 2024.  The company took out its 2020 sr. sub notes with 2027 8% senior notes that currently trade in the low 90s. According to the recently filed 10Q, the company has $768 million of unused borrowing capacity available on their revolver that matures in August 2024.  This gives the company adequate breathing room. 

My base case scenario is that Michaels is likely to continue serving their typical customers in average fashion, selling customers $20-30 of items 1.4x a year.  I shop there for my kids' school/art/extracurricular projects a couple of times a year, and I know a number of other customers in my neighborhood, who have too many Amazon boxes on their doorstep each week, yet, like me, also go to Michaels as it's quick and easy and cheap.  It's easy to get glue, paper, felt, stickers, holiday decor, posterboard, etc.  The typical customer is not too price-sensitive for $20 of items that you need the night before the science project is due, the school fair opens, or the Halloween decorating party happens. Of course, you can also get these items online (though you typically pay the same price or more and you often have to buy in bulk), and you can also get this stuff at Target or Walmart, but I believe there's a segment of the market that likes going to Michaels.  

The company's recent guidance is for EBIT of $565-575 million, with $152 million of interest expense and 125 million of capex.  As a point of reference, D&A was $124 million in 2018.  Earnings guidance for 2019 is now $2.07-2.12.  In EV/EBIT terms, the valuation is 6.6x current EBIT not counting leases as debt.

With the stock at $6.70, the shares trade at 3x earnings. 

MIK has dynamics which make it very interesting as a short-squeeze candidate.  

Currently, the company has 146mm shares outstanding.  73 million shares are held by private equity holder (Bain and Blackstone) resulting in a 73 million share float.  Of this float, 28 million shares are short, leaving 45 million shares outstanding excluding those which are already short, or roughly $300 million in market value.   This $300 million compares $294 million remaining on the company's buyback authorization. 

Lest you think this is a company with a buyback authorization that's all talk and no action, the company repurchased $80 million of stock in the most recent quarter. YTD the company bought back $107 million in stock.  In 2018, 2017, and 2016, the company repurchased $405 million, $254 million and $457 million of shares. 

With earnings of $2 per share or $300 million per year, the company can use one year of earnings to repurchase the entirety of the float.  In two years, at the current share price, they can buy out all the public holders except for Bain and Blackstone.  

In Margin of Safety there’s a story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”  This is a trading sardine.

Other old school value investors may look at this investment and think that it's a cigar-butt.

More optimistic types will get excited and view this as a public way to be a private equity investor.  Here you are, alongside Bain Capital and Blackstone, at 3x earnings in a highly leveraged buyout.

Trading sardine, cigar butt, or publicly traded private equity stub, MIK will make for a nice Xmas stocking stuffer for your favorite curmudgeonly value investor. He or she probably already owns Google, Amazon or Facebook and will appreciate this as a reminder of the good old times when they actually bought low P/E value stocks trading at 3x earnings without any worry that clients will redeem upon hearing about such investments.

And who knows?  Santa may come early this year with a China deal, in which case I believe the stock will be up 30% on the elimination of the 12/15 tariff hike.  

Happy Holidays VIC members!

Catalyst

Buyback

Short-squeeze

China deal postponing or eliminating 12/15 tariffs

Conclusion of tax-loss selling season