Description

Michael’s (MIK) has the potential to be the next Best Buy investment thesis. Years ago, Best Buy’s stock underperformed while there were worries that much of its business is “Amazonable.” However, once Best Buy showed that its sales decline was temporary and top-line growth resumed—proving its store business does have a reason to exist—its stock returned 300% in the subsequent few years.

The investment thesis today on Michael’s is very similar. Michael’s is the largest and dominant retailer of arts and craft supplies. However, in 2019, the business experienced a 1.9% decline in same store sales. Investors became concerned this was a dying retailer—and MIK now trades at only 6x earnings (or 5x EBITDA). 

In short, we believe MIK is not a declining retailer, but on the contrary, should post double-digit top-line growth when they report tomorrow. The summary of our thesis is:

1. Michael’s reports Q4 tomorrow and, based on our point-of-sale data sources, MIK should significantly beat consensus estimates. We think MIK did 12%-15% sales growth in Q4 versus ~5.5% for consensus. 

1. Further, MIK should do close to $2 of EPS in just Q4 alone, versus MIK’s current $17 stock price.
   
   

2. Just this Monday afternoon, news leaked that Apollo and another private equity firm are looking to acquire Michael’s. This provides at minimum a potential back-stop to the current share price, or a quick catalyst to further upside. (Link here.)
   
   

3. Ashley Buchanan took over as the new CEO of MIK last year. His previous role was the Chief Operating Officer for Walmart U.S. eCommerce. The plan he laid out in September during MIK’s investor day is very clear and similar to how Best Buy turned itself into a successful omni-channel retailer. Buchanan’s plan is already showing fruit in MIK’s results.
   
   

4. MIK is to arts and craft makers what Home Depot is to construction workers. In the arts and crafts (A&C) market, Michael’s has the #1 Net Promoter Score, #1 top of mind brand awareness, and more than 33% of professional makers use Michaels as their primary retailer for arts and crafts. 

1. Other specialty retailers have on average over 20% market share of their category. MIK, however, currently only has 14% market share, providing growth potential for the company.

1. Home Depot = 25% market share in Home Improvement;

2. Ulta = 21% market share in Beauty;

3. Dick’s = 20% market share in Sporting Goods;

4. AutoZone = 19% market share in Auto Parts;

5. Michael’s = 14% market share in Arts & Crafts.
   
   

5. Much of Michael’s purchases are not “Amazonable.”

1. The average item purchased at Michael’s is $4.50; Amazon doesn’t have cost/shipping efficiencies with items under $10. Further, under the new CEO, Michael’s has moved to an open stock environment and debundled many of their products. (E.g., instead of only being able to purchase a 6-pack of red dual brush pens for $12, artists at MIK can now purchase just 1 of them for $2, or mix-and-match it with other colors than just red.)

2. 65% of all of Michael’s sales is Michael’s own private label brands. Michael’s owns 16 different private brands that are highly trusted and repeatedly used by professional makers. Therefore, 65% of Michael’s sales can’t be purchased anywhere except at Michael’s. (This is especially important in paint, floral and yarns, where you need to match colors and texture—and confidence in quality matters—leading to stickiness in Michael’s brands.)

3. Many customer purchases at Michael’s are done on an urgent need basis. (E.g., a professional painter botched a canvas and now quickly needs a new one, or a child has a school art project due next morning.)

4. Many of the purchases are done at Michael’s because the customer requires tactile feel of the product. (E.g., the jeweler needs to see the exact color of the beads they need in person and not on a computer screen, or a knitter needs to feel the differences in yarn that they seek, or a painter wants to feel the bristles of the different brushes.)

5. Some customers come into Michael’s because they want the expert advice or tips from Michael’s staff—Michael’s prioritizes hiring creators as their employees, and trains them accordingly. (E.g., an artist might come in asking for help in putting together supplies for a new idea, in the same way a customer comes into Home Depot to ask about kitchen cabinets.)
   
   

6. Under the new CEO, Michael’s has rapidly developed an excellent omni-channel experience.

1. E-commerce sales at Michael’s grew 320% last year. In Q2, Michaels.com was named a top 20 US retail domain in terms of unique site visits and its digital Net Promoter Score is up more than 50% year-over-year.

2. Retailers in general are currently bearing increased freight costs due to the large increase in e-commerce sales. With Michael’s, however,  a significant portion of their e-commerce sales are fulfilled through Buy-Online-Pickup-In-Store (BOPIS), curbside pickup, and same day delivery, where customers bear the fulfillment costs and Michael’s uses its 1,200 stores as essentially distribution hubs. Hence, Michael’s reports that its e-commerce profitability is mostly equivalent to that of its store transactions.

3. The fact that the majority of MIK’s e-commerce sales are BOPIS or same day delivery signals the urgent nature of many of MIK’s customers’ purchases.

If we are right that (a) 2019 was a poorly managed year for Michael’s, and that (b) the new CEO is fixing the easily fixable issues, and that (c) MIK will show top-line growth, then there is no reason its shares will trade at their current valuation of 5x EBITDA or 6x EPS—especially when news just leaked that Apollo and others are interested in acquiring this company.

Michael’s Position in its Ecosystem

Michael’s has ~1,200 arts and crafts (A&C) stores around the U.S. MIK’s target customer is who they call “Core Makers.” These are individuals who create handmade products at least quarterly, but most are making crafts monthly or even weekly. They make up approximately two-thirds of Michael’s revenues. They are a large group and strategically impactful to MIK’s success. 

Buchanan has returned MIK’s focus to serving this core customer group who relied on Michael’s the way construction workers rely on Home Depot. Access to a physical retail footprint and experienced team of experts become meaningful differentiators, similar to the expertise and assistance often required to shop the home improvement category.

This is why the below specialty retailers all have a reason to exist, and all have at least 20% market share. Buchanan thinks there’s potential for Michael’s to do the same, if the company goes back to being properly run and devoted to serving its core customer.

Since Buchanan took over, he cites proof that MIK is repairing its relationships with its Core Makers: 

“Yes, it is working. The proof NPS has increased by more than 500 basis points. Top of mind awareness has grown by more than 300 basis points, which is more than double our nearest competitor. And more than 33% of Makers say Michaels is their primary retailer shop for arts and crafts. Now, this is up 250 basis points over a year ago for us. And this level is higher than all our closest competition, all mass chains and Amazon.”

Easy Fixes

Under the previous CEO, Michael’s was poorly operated. Speaking with former Michael’s employees, they described MIK pre-2020 as a place that started cutting employees to save on costs, so the expert help was no longer present when Core Makers came to the store for advice. Inventory became extremely poorly managed—the top complaint of surveyed Makers was that MIK many times had an item out of stock after the customer traveled all the way to the store. And omni-channel for MIK barely existed. 

One anecdote from a former employee paints the picture: 

“The stores hadn’t been touched in years. They were just outdated collections. I’ll give you a really good example. Tabletop frames and wall frames—I mean people have been using digital photography for years and scrapbooking and printing so many less photos that they would frame. But that department was still sized the same as it has been in the early 90s when people were framing everything on their walls. And so there just wasn’t productive space taken from them and given to more relevant and better selling categories. Instead, new categories that were selling very well remained landlocked to 15 feet when they should have been multiples of that, while Frames was still at 300 feet for years. That’s an example of the stagnation at Michael’s from 2015 to 2019.”

As Buchanan said shortly after he took over as CEO: 

“For years, we didn't refresh the products Core Makers wanted. We over-assorted our stores with not only too much product, but too much irrelevant product. We used an antiquated supply chain that left key items malnourished across our stores. We've allowed our marketing strategy to tip from our balance of inspiration and discounts to a chaotic stream of daily promotions, deals and coupons. Our omnichannel shopping experience provided limited options that were challenging to use, but no longer. We listened and we've been working tirelessly to address their needs through three strategic implementation pillars.”

…

“There is already evidence, our strategy is starting to work over the last six months: products are getting to Makers more consistently; prioritized categories are outperforming other departments; our e-commerce business has increased more than 300%. And further, we've been named a top 20 US retail domain in terms of unique visits and have driven higher digital OSAT scores at the same time. From an overall brand perspective, key indicators are all moving in the right direction. In the last six months, we've seen top amount of awareness, primary retailers share and NPS, all improve. And speaking of NPS, we've improved this measure by more than 500 basis points. This signals to me that Makers are taking notice and they're telling other Makers that Michaels is improving. I'm confident the direction we are heading will deliver long-term, double-digit EPS growth.”

Valuation

Buchanan stated: “We believe we will continue to generate significant free cash flow and expect cumulative free cash flow to approach $2 billion between fiscal 2020 and the end of fiscal 2024.” That means MIK will generate almost its entire market cap in free cash flow in the next 3 years.

Adjusting for the cash we believe MIK will generate this Q4 and our estimate for 2021 (FY2022) EBITDA, we believe that MIK is by far the cheapest specialty retailer compared to its comps, trading at just 5x EV / EBITDA:

As Ashley Buchanan continues turning around the company and fixes its legacy issues, we believe MIK will continue to comp positively. Buchanan has guided for MIK to be able to grow its EPS at a low-double digit annual rate. Should that be the case, there’s no reason for this company to trade at 6x EPS.

Additionally, the company will generate substantial FCF to de-leverage its balance sheet. Similar to Best Buy, we believe this will cause a significant re-rating in its stock. A niche, specialty retailer usually gets valued at 8x EBITDA. At that multiple, MIK would be worth $35 today, or double the current share price.  

Furthermore, the news leak of a potential acquisition of Michael’s by Apollo or another private equity firm provides a backstop to the current share price. We think that should MIK wind up getting acquired, it’s highly likely it would be above its current multiple of 5x EBITDA.

MIK’s 2021 (FY2022) Earnings Power

We believe Michael’s has the potential to earn close to $3 of EPS this year. This assumes only 2% annual top-line growth from Michael’s 2019 (FY 2020) revenues, its historic average of 39% gross margins, 2% growth in SG&A expenses, and a 25% tax rate. We will post the model in the Q&A section in order to not throw off the formatting here.

Catalyst

• Likely significant beat when MIK reports tomorrow.
• Resumption of top-line growth under the new CEO.
• Leak of news that Apollo and another PE firm are interested in acquiring MIK.