Description

Investment summary

Contrarian opportunity in underappreciated, stable FCF stream in the most-hated sector of 2017, consumer retail.  Mature, market-leading niche retail concept with scale advantages, relative immunity from broader economic trends and minimal threat from online disintermediation, with attractive margins, high FCF generation and 20% avg ROIC, trading at a 12% FCF yield.  Company is nearing the end of a 10-year deleveraging path post Bain/BX ownership (2006 LBO) that has taken ND / EBITDA from over 7.0x to 2.8x currently, and we believe a change in capital allocation priorities can drive significant gains in equity value.  Significant FCF generation plus free upside option on comps improvement (as market currently pricing in no-growth scenario) yields exceptional risk/reward profile.  $30+ PT (50% upside) on 8x 2018 EBITDA or a 9% FCF yield.

Business summary

• Largest arts and crafts retailer in NA, with 1,367 stores in US and Canada.  Non-mall based destination retailer with strong seasonal assortments that drive traffic.
• $30B+ Arts & Crafts Industry grows roughly with HH formation and exhibits very low correlation with the broader economy (crafting purchases less-discretionary than most retail).  During the last recession (2008/2009 years), industry sales fell -15%/-1% and MIK comps were -4.6%/+0.2%.
• Tactile nature of arts and crafts (in-store experience critical for customers) and low per-transaction economics ($3 AUP and $21 avg ticket) provide advantages vs online/shipping-based models.  Moreover, large number of highly diverse SKUs (stores hold same number of SKUs as HD with 20% of the floor space), low inventory turnover, and infrequent per-customer transactions (2.5x / year) represent a barrier to entry (high upfront working capital requirements) for new entrants, even WMT and AMZN.
• Stable business model with exceptional economics for a retailer (5-yr avg GM% / EBITDA% / ROIC = 40% / 17% / 20%) and strong FCF, driven by minimal WC requirements for maintenance/growth and low capex (2.2% sales)
• Mature concept with LT growth algorithm of +LSD unit growth and comps +1-2%
• Scale advantages (MIK > 2x size of next two comps combined) + new China direct-sourcing benefits from Lamrite West deal (2016) enhances buying power on low-ticket items
• Deep and growing private label offering (57% sales are PL) provides GM% tailwind (every 1% PL sales = 10bps to GM)
• SG&A leverage on comps +1.5% creates low-threshold for operating leverage.  Minimal risk from labor inflation as MIK already pays well-above min wage nationwide ($12/hr avg in-store)
• Border Tax risks are minor – MIK directly imports 35% of COGS and can offset margin pressure with pricing.  20% Border Tax can be fully-offset with +LSD price increase across all SKUs.  Given the $3 ASP, we think the pricing side of the story is an underappreciated risk management option on tax changes.

Comps trajectory

• MIK is a mature concept in a mature category, so comp profile has always been modest.  5-yr avg comps from 2011-2015 = 2.2%.
• 2016 comp weakness is what drove stock sell-off (along with general retail sector pressure from a weak holiday season + border tax risks).  Comps turned negative in 2H16 as company cycled several quarters of above-avg growth (2015 comps +3.2% ex-FX, with 2H15 comps +4% ex-FX) driven by a single successful product (adult coloring books), the custom framing business (10% of sales and highest-ticket items in the store) remained weak, promotional intensity increased among smaller competitors, and MIK executed a major flex-space change across a number of stores.
• Upside to current low 2017 comps expectations (street +1%) most likely comes in 2H17 = no coloring book headwind + no election slow-down + no seasonal headwinds (from flex space changes) + implementation of EDV program on basic craft items in-store with no promotions + flow-thru of new, higher-spending loyalty program customers (enrollments 2x plan in 2016 at 14m users).
• Low FCF leverage to comps trajectory provides downside support = every +/- 1% comps = +/- $52m in sales, $9m in EBITDA and $5m to FCF.  Even at 0% comps in 2017, we believe business can generate ~$860m of EBITDA (trading at 7.4x) and $435m of FCF (11.3% yield to equity) going forward

Capital structure catalyst

• MIK has dedicated close to 90% of the $1.1B of FCF generated to deleveraging the balance sheet the last 3 years
• Current leverage sits at 2.8x ND/EBITDA (4.5x lease-adj), within the target range of 2.5-3.0x set by mgmt
• MIK has 5.7x interest coverage as of Q416, and no near-term maturities (5.875% senior sub notes due 2020)
• June 15th Investor Day (the 1st since June 2014 IPO) likely to provide new capital allocation catalyst – we believe company may significantly lift its current $300m+ buyback authorization and could effectively repo $1B worth of stock the next 2 years

Valuation and assumptions

• Base case = $30 stock (~50% upside) at 8x 2018 EBITDA or 10% FCF yield.  Assumptions = +1% unit growth, +1% comp growth, 16.3% EBTIDA margins in 2018 = $895m EBITDA and $468m of FCF.  Assumes $800m share repo at $24 avg price and 162m shares out by yr-end 2018.
• Bull case = $35 stock (~70% upside) at 8.5x 2018 EBITDA or 9% FCF yield.  Assumptions = +1% unit growth, +1.5-2% comp growth, 16.6% EBITDA margins in 2018 = $920m EBITDA and $484m of FCF.  Assumes $950m share repo at $24 avg price and 156m shares out by yr-end 2018.
• Bear case = $25 stock (~25% upside) at 7.5x 2018 EBITDA or 11% FCF yield.  Assumptions = +1% unit growth, +0% comp growth, 16% EBITDA margins in 2018 = $869m EBITDA and $453m of FCF.  Assumes $600m share repo at $24 avg price and 168m shares out by yr-end 2018.

Catalyst

June 15th Investor Day, Q117 comps beat / re-acceleration in Q2