Description

Note

Our original intent was to post this report one full trading day prior to the company’s third quarter 2018 earnings release scheduled for tomorrow, Thursday, December 6. However, due to President George H.W. Bush’s passing, the market was closed today. Nevertheless, our core thesis would remain valid in any case other than a severe washout (a possible but unlikely event) in the stock on Thursday.

Description

The Michaels Companies is North America’s largest specialty retailer of arts, crafts, framing, floral, wall décor, and seasonal merchandise. The company owns and operates more than 1,200 stores in 49 states and Canada under the Michaels and Pat Catan’s banners.

Investment Thesis

Michaels is a compelling short at current prices given its premium valuation, high leverage profile, numerous headwinds, and the likelihood for a U.S. recession in the coming 18-24 months. Management has prioritized stock repurchase over greater debt pay down for a considerable period of time, positioning the company poorly for a likely economic downturn. Furthermore, the company’s sponsors have owned the name for more than 10 years and represent an overhang (and a ceiling) on the stock. We believe the company has for the most part managed to resist e-commerce competition but is increasingly threatened by online rivals, and to compete with those players will suffer margin deterioration from its e-commerce sales. At 7.5x our fiscal year 2019 EBITDA estimate, MIK trades at more than two multiple points richer than its comps which trade at 5.2x and would decline by 24% based on a single turn multiple contraction and 49% based on a 2x turn compression, valuations that would be likely in a recession. As such, we see a compelling opportunity to short the stock at current levels.   

Exhibit 1: The Michaels Companies

Source: Company presentation

Capital Structure

Exhibit 2: Capital Structure

*Stockholders’ deficit exists due to accumulated deficits related to the highly levered private equity deal by Bain Capital Investors and The Blackstone Group.

Exhibit 3: Debt Details

Source: 2017 10-K

* Approximately 82% of debt is variable-rate

** In addition to debt, MIK has $2.2 billion of operating lease commitments, which include non-cancelable leases for property and equipment.

Market Overview

The arts and crafts industry is a $35 billion per year industry in the United States with “approximately 55% of households (68 million) participating in at least one crafting project” each year, according to a market study conducted by Michaels.

While Michaels is the largest player in the retail arts and crafts industry by store count and revenue, this niche of the retail sector remains highly fragmented and competitive.

Exhibit 4: Industry Fragmentation

Source: Company presentation

The largest craft and fabric chain store competitors are privately-held retailers, such as Jo-Ann Stores (owned by Leonard Green & Partners) with 850 stores in 49 states, Hobby Lobby (founded and owned by David Green and his family) with 800 stores in 47 states, and A.C. Moore Arts & Crafts (owned by Sbar’s, an arts and crafts merchandise distributor) with 130 stores mostly on the East Coast. Along with Michaels, these companies comprised approximately 34% of the industry.

Mass merchants, such as Walmart (WMT) and Target (TGT), comprise approximately 26% of industry despite their more limited assortments and service. Specialty stores, which account for another 24% of the industry, represent independent shops that are more community focused.

Online sales, which include internet-only retailers, including Amazon and its Marketplace, as well as e-commerce sales at traditional retailers, comprise about 5% of industry sales. Nonetheless, management contends that online sales are likely to remain relatively small for this industry, given high private brand penetration (i.e. lack of national brands), slow inventory turnover, low average unit retail, and the project-to-project nature of purchases.

Exhibit 5: E-commerce penetration

Source: Company presentation

Our Perspective  

E-commerce likely to erode market share and compress margins

Despite management’s argument that digital sales in the industry are likely to remain small (refer to Exhibit 5), we suggest that management’s prediction is not only flawed but also contradicted by its own stated “Vision 2020” strategic plan.

Whereas management considers the current 5% share for e-commerce sales in the arts and crafts industry as indicated of “structural barriers”, we think that this merely underscores the tremendous growth potential for e-commerce. In addition, downplaying the relevance and growth potential for e-commerce is self-serving for MIK, since this retailer actually underperforms the industry. In fiscal 2017, MIK generated a mere $100mm of e-commerce sales, representing just 1.8% of overall sales. Thus, MIK underperforms industry e-commerce penetration by more than 300 bps with a share 2/3 lower than the industry average.  

In our view, there is no credible reason why over the long-term the 5% share cannot at least double to the low double digits similar to the jewelry industry (with its slow inventory turns and high private brand penetration). Moreover, the office supplies business has many low average unit retail (AUR) products (i.e. pens, paper, paperclips, staples, etc) and that hasn’t precluded that industry to transform to nearly 50% digital penetration. Further, while we are unsure of what exactly is included in the “Toys/Hobbies” category, suffice to say that “Arts and Crafts” is a type of hobby, as well. Therefore, the spread between the 5% level in Arts and Crafts and the 22% and Toys/Hobbies appears unsustainable.

At the same time that MIK downplays the relevance and potential for e-commerce, management clearly has prioritized omnichannel in its “Vision 2020” plan. In fact, management is focused on building new digital platforms, strengthening its buy online, pick-up in store capabilities, and e-commerce fulfillment processes. Therefore, we think this is a critical acknowledgement for the likely growth in e-commerce sales, especially as 38% of fiscal year 2017 capex ($48mm) was for “information systems”.  

Given this reality, we suggest that as e-commerce grows in the industry, MIK’s market share is likely to decrease and margins to erode. There will be increased price competition, as customers more easily comparison shop. In contrast to management’s insistence that its high private label assortment (58% in 2017 with a long-term goal of 70%) insulates the retailer from the Amazon effect and other “pure e-commerce players”, we hypothesize that private label in the arts and crafts business is less important to customers than is price and therefore customers are savvy enough to look past the private label and focus on the product type when comparison shopping online. Moreover, while private label offer retailers, such as Michaels, higher merchandise margins, the offset is greater inventory risk.  

Ultimately, however, even if MIK customers continue to stay loyal to Michaels while shifting their shopping online, that simple change, while sustaining the top-line, would be margin crushing as shipping costs (i.e. free shipping) erode profitability. We think MIK will endure market share losses (i.e. Amazon effect), which would compound the margin erosion as fixed expenses are de-leveraged.

Rise in e-commerce expected to be partly fueled by changing demographics

There are broad industry trends towards accelerating e-commerce gains as a share of overall sales, underpinned by changing demographics. Specifically, millennials and Generation X are becoming the majority of retail consumers. As the exhibit below depicts, 57% of MIK’s customers are under 45 years-old.

Exhibit 6: Age Demographics

Source: Company presentation

However, with MIK, there is a more fundamental demographic issue that we predict will not only ignite e-commerce sales but also contribute to declining in-store sales and potentially overall sales declines. According to the MIK investor presentation, there are two customer groups: enthusiast and casual. The enthusiast is MIK’s best customer, since she crafts frequently, is creative, and yields “good, positive comps”. However, the casual customer lacks the expertise and/or time to more frequently tackle projects yet she is inspired by Pinterest (i.e. social media).

Exhibit 7: Dual Customer Segments

Source: Company presentation

Based on Exhibit 7, we believe that the core enthusiast is more likely to be retired and/or a Baby Boomer, whereas the core casual customer is more likely to be a millennial or Generation X, notwithstanding pictures of both segments implying that they are both millennials. If true, then there is a significant long-term strategic headwind for management to address, given that the majority of customers are now under 45 years old, are casual hobbyists, and are likely to prefer e-commerce shopping. Further, MIK acknowledges that casual customers “are taking longer to gain traction”.

Additional support for our theory that the casual customer is younger and gradually becoming a majority of the MIK’s overall customer base is that same-store sales (constant currency) were down 0.4% in fiscal 2016 and up 0.7% in fiscal 2017, while current guidance for fiscal 2018 is flat to up 1.5%. If the enthusiast customer generates “good positive comps” then the casual customer is likely generating equally (if not greater) negative comps resulting in the total comp to be flat to up marginally. Moreover, the mix between enthusiast and casual is likely 50/50, or perhaps even skewed to casual now, consistent with the fact that 57% of overall customers are younger than 45.

This is likely the reason why Michaels is now so focused on growing its omnichannel presence through e-commerce, social media, customer relationship management (CRM).  Unfortunately for MIK, as discussed earlier, this secular transformation in retail (e-commerce) and demographic shift (younger) is a recipe for eroding market share and/or declining margins. Providing more convenience likely means growing e-commerce and free shipping promotions, while strengthening value perception may yield more competitive pricing (and lower gross margins). In addition, since casual customers are inspired by social media, perhaps they have less of a need for in-store customer service, as they watch YouTube videos (and research online) how to do various projects and therefore self-learn.  

In addition, if our hypothesis is correct that the core enthusiast customer is retired and/or Baby Boomer, then another headwind is the decline in newspaper print subscriptions. Management says a “substantial portion” of its marketing budget is for circular advertisements in local newspapers. As a result, reduced frequency of print circulars is likely to continue to negatively affect sales and profitability, especially for this enthusiast customer base.

Exhibit 8: Casual Customer Strategy

Source: Company presentation

Private-equity shareholders still own considerable stakes along with myriad of conflicts of interest

Bain Capital Investors owns 52.8mm shares (31%), while The Blackstone Group 20.4mm (12%). These private-equity investors led Michaels 2014 IPO, which was priced at $17. While Bain’s most recent stock sale was more than 2 years ago, between the IPO and the third quarter of 2016, Bain sold 28.7mm shares in the mid-$20s. Since the IPO, Blackstone has sold 61.1mm shares in the low to mid $20s, with the most recent sale in the first quarter of 2017 when the stock trade in the low $20s. In addition, due to harvesting, these private-equity holders may be under pressure to continue selling shares. Given the propensity for Bain and Blackstone to sell at levels above $20, this is likely to place a ceiling on the stock for the foreseeable future and therefore reduce the risk for shorting the stock.

In addition to these equity stakes, Bain and Blackstone have three board seats. Further, while private-equity investors routinely promote cross-selling between companies they own, these arrangements are not always in the best interest of all shareholders. Unfortunately, Michaels is no different. Blackstone owns a majority equity position in Excel Trust, Inc., Blackstone Real Estate DDR Retail Holdings III, LLC, and Blackstone Real Estate RC Retail Holdings, LLC, which are vendors that MIK’s utilizes to lease “certain properties”. In fiscal year 2017, MIK paid these entities $7.2mm (up from $5.2mm in fiscal year 2016). Blackstone Group also owns a majority equity position in RGIS, a vendor used to count store inventory. In fiscal year 2017, MIK paid RGIS $6.3mm (up from $6.0mm in fiscal year 2016). Further, certain affiliates of Blackstone have “significant influence” (per the company’s most recent 10-K) on US Xpress Enterprises, a vendor that MIK utilizes for transportation services and paid $1.5mm to in fiscal year 2017 (up from $1.1mm). Perhaps most noteworthy of these related party transactions is that Blackstone held $89.2mm of Michaels’ amended term loan facility.

Management owns a minimal 1.4% equity stake

Despite the 43% combined equity interest by Bain and Blackstone, the management team owns a minimal 1.4% stake. Of this, Carl Rubin (Chairman/CEO) owns 1.0%, representing 1.9mm shares.

MIK camouflages deteriorating performance with share buybacks

Nonetheless, with shareholder funds, the board has directed the company to buy back stock instead of allocating those funds for further debt reduction. MIK spent $254mm and $405mm on share buybacks in fiscal year 2017 (average price $20) and fiscal year 2016 (average price $23), respectively. In addition, in the first 6 months of fiscal year 2018, MIK spent $252mm to buy back stock (average price $23). In sum, during the past 2.5 years, MIK has spent approximately $911mm on share buybacks, including some of which were bought directly from private-equity sponsors as part of secondary offerings. For example, when Blackstone sold 18mm shares in a secondary in January 2017, MIK purchased 8mm shares at approximately $20 per share.  

With the company repurchasing roughly 40mm shares over the past 2.5 years, the diluted share count has reduced by approximately 18%. Share buybacks have camouflaged weakening fundamentals and earnings. While an efficient way to buyback stock, we argue that de-levering would be a better capital allocation strategy for equity holders.

For example, in the company’s second quarter earnings release, managed raised fiscal year 2018 guidance by $0.10 (raising guidance by 4.5%) while at the same time announcing the repurchase of 10.7mm as part of its accelerated share repurchase program, which reduced the share count by approximately 5.5%. At the same time, management cautioned investors about “higher than expected headwinds from distribution-related costs”, which we interpret as corporate-speak for rising shipping costs from e-commerce. In addition, during the second quarter, gross margin was down 210 bps to 35.4% and EBITDA fell 11%. Moreover, with this EPS guidance boost, the consensus estimate for fiscal year 2018 is $2.35 implying 7.3% year over year growth, despite net income expected to be flat and EBITDA even worse down 6.6%.

MIK misses opportunity to de-lever balance sheet further, allocating capital to share buybacks instead  

Part of our short thesis is that MIK, like other highly levered retailers, are most vulnerable during recessionary economic cycles. Currently, we estimate that MIK is 3.3x levered 2018E EBITDA. Further cause for unease is that more than 80% of the retailer’s $2.7bn debt is variable-rate which adds pressure to an already weak balance in a rising interest rate cycle.

If management allocated the approximately $900mm spent on share buybacks to further debt reduction instead, net leverage would be at the more healthy 2.1x level.

Adjusted ROIC is inflated by factoring in shareholder deficit

We suggest that the company’s investor presentation overstates adjusted ROIC. By factoring in the $1.7 billion shareholder deficit, the company says that ROIC has been 27% for the past four years (2014-2017). However, by including the shareholder deficit in the calculation, the dominator is significantly reduced. Depending on the varying methods to calculate ROIC, we estimate that ROIC (calculated without the shareholder deficit) would be in the 12% to 15% range, a fraction of the 27% that the presentation depicts.

Exhibit 9: Overstated ROIC

Source: Company presentation

Financials

As our earnings model in Exhibit 10 illustrates, we forecast below consensus EPS in 2018 ($2.30 vs $2.35) and 2019 ($2.03 vs $2.50), primarily from increased competition from traditional and online retail as well as deteriorating margins from e-commerce order fulfillment.

Exhibit 10: Earnings Model

As e-commerce increasingly becomes critical to its business, MIK is investing heavily in its digital capabilities. In addition, as a traditional retailer, MIK must also allocate capital to store remodels, as well as new store opening expenses. Unfortunately for MIK, rising capex requirements (estimated $165mm in fiscal 2018 and growing to $195mm in fiscal 2021, up from $114mm in fiscal 2016). As a result, the rise in capex combined with lower projected EBITDA results in a deteriorating FCF yield (including growth capex) that drops by roughly 40% from 14% in F2016 to 6% in fiscal 2021.

Exhibit 11: Free Cash Flow Model

Comparable Valuation

Despite all the headwinds from e-commerce and changing customer demographics, MIK trades at a premium to its peer group. The peer group trades at 5x EBITDA yet MIK trades nearly 2x higher at 7x. Therefore, we think MIK’s 7x EBITDA is likely to come under pressure over the next 12 to 18 months.

Exhibit 12: Comp Table

Valuation

Given the significant debt leverage on the balance sheet, a valuation multiple of 1 to 2 turns can have devastating effects on the stock price. The stock currently trades at 7x our $780mm fiscal 2018 EBITDA estimate. We suggest that the stock should trade in the 5x to 6x range on our $737mm fiscal 2019 EBITDA estimate. Therefore, our 12 month price target is $6 to $10, representing roughly 40% to 60% downside.

Exhibit 7: Implied Stock Price

Exhibit 8: Implied Stock Price Variance

Risks

Stronger than expected same-store sales growth – Sustainable low to mid single digit sales growth (i.e. at least 3%) would imply that management’s growth strategy is working.

Stable or growing margins – This would demonstrate that the company’s efforts to grow e-commerce is not at the expense of profitability.

Share repurchases – Continued share repurchases would prop up the stock, at least in the near-term.

Conclusion

Michaels, an arts and crafts retailer, is richly valued and faces multiple headwinds including (1) the likely rise in margin crushing e-commerce competition; (2) a shifting customer base from enthusiast (older) to casual (younger); and (3) a highly levered balance sheet in a rising interest rate environment as the broader economy decelerates and possibly slides into a recession in the next 2 years. At 7.5x fiscal year our fiscal year 2019 EBITDA estimate, shares trade at a significant premium to its peer group that trade at 5.2x. If MIK’s multiple were to compress by even 1x turn, then the stock would decline 24%. We therefore see a favorable risk-reward profile as a short idea with multiple contraction (as well as earnings declines) likely over the next 12 to 18 months.

Catalyst

Continued flat to negative same-store sales – This would provide further evidence that MIK’s enthusiast customer is becoming a minority of the overall customer base.

Continued EBITDA erosion – This would be the result of competitive pressures on price, as well as rising costs of e-commerce order fulfillment.

Private equity selling – Additional stock sales by Bain and/or Blackstone would validate the short thesis, as they would signal a lack of confidence in the retailer’s prospects.