Description

Consensus View: 

·        Party City (PRTY) is a troubled, shrinking, over-leveraged retail business.

·        The company is under intense pressure from online competition and will be another example of a company crushed by Amazon (AMZN).

·        The modest number of improvements the new management team has made is indicative of a company without many levers to pull.

Variant Perception:

·        PRTY is a category leading retailer through marketing scale and a large advantage in selection, but it makes nearly all its operating margin through a wholesale distribution business, a fact that is obscured by the company’s accounting. 

·        PRTY’s wholesale business (Amscan) is a great business, similar to other distributors like Fastenal (FAST) and WW Grainger (GWW).  Amscan enjoys multiple deep competitive advantages through scale, breadth of product, licensing relationships and patents.

·        PRTY is extremely internet resistant and arguably internet proof because its low-price products make it “un-Amazonable” since the prices charged by the internet behemoth are much higher than PRTY.  Additionally, balloons, which make up approximately 30% of retail gross profit, cannot be sold effectively online.

·        PRTY’s sales weakness over the last few years has been the result of several factors such as a shift in the calendar for Halloween, growing competition from big box stores, a helium shortage, and the ebbing of the Frozen phenomenon, all of which should be ending or reverting.

·        PRTY’s turnaround has been slowed by a combination of the pandemic and a customer base that shows up under 2 times per year thus slowing the gains from experiments within the store.  The improvements PRTY is making should be ongoing and compound over time.

·        PRTY trades at roughly 4X current year EPS!!  But we think it is just above 2X 2023 earnings power of roughly $1.50 per share!  We think shares will rise to at least $30 in 5 years and thus upside is over 700%!!

Further Upside:

·        PRTY is dominant in its category and finally has a real merchant (New CEO Brad Weston) in charge who is turning around the retail operations could go from a company who made close to zero margin at retail to 10% or more operating margins over time. This could more than double the operating profit at the company and more than triple the net income.

·        If retail is successfully turned, then there is room for more than 300+ more stores in the U.S., plus the potential for a smaller store more balloon oriented and a large franchising opportunity in Latin America.

Party City makes the bulk of its profits through wholesale:

PRTY reports segment accounting that shows most of its profits as being in the retail business.  This is due to accounting rules in which the profits from internal sales are reported as part of retail profits.  In the current segment accounting, retail accounts for nearly 84% of 2018 EBIT, but we believe that wholesale accounts for over 80% of profits.  (See exhibit 1 below.)   Note we calculate Wholesale’s share of G&A, Art & Development and Development stage expense as a % of wholesale revenues pre-elimination.

For further proof of wholesale’s importance to profits, you can look back and see that the businesses were separate entities and Amscan (Party City wholesale) purchased the struggling Party City retailer not the other way around.  (See Exhibit 2 below and note that franchise earnings were responsible for a disproportionate amount of Party City profits at the time.)  We think management has not done a good job of clarifying where the strength in the business truly lies and that this is in part due to retail being more in favor when the company went public in 2015.

Amscan (Wholesale) is a Great Business:

The beauty of PRTY’s wholesale business (Amscan) is derived in large part from its tremendous number of SKUs, which is essentially another way of saying economies of scale.  We estimate that Amscan’s average SKU sells about $50K of product, with many being much less than that.  Outside of PRTY’s own retail stores, Amscan’s average customer buys under $16K of product per year per store, so this is a business that no one outside of PRTY can insource in an economical way.  We note that both Michaels and Target are large wholesale customers.  Given the low shipments per customer/outlet it further makes sense for companies to consolidate their business to one provider.  This is what can drive very good returns for distribution businesses.  These distribution economics can be seen in W.W. Grainger and Fastenal which have been great businesses for decades. 

On top of the distribution economics, Amscan has three additional layers that drive better returns.  The biggest layer is its licensed products.  Roughly 20% of PRTY products are licensed.  Captain America plates, for example, are licensed.  The primary licensors (largely Disney) reward their licenses by category and by customer type.  They categorize this way to make the business more efficient and competitive.  PRTY’s position in the space allows it to be given those licenses, which is a barrier to entry and another thing that prevents stores from producing on their own Captain American plates.  Secondly, the company self-manufactures roughly 20% of its product with plans to materially increase this percentage.  The company’s in-house design team is another advantage here.  Self-manufacturing may not seem like an advantage given that most companies opt to use their size advantage as leverage to gain better pricing rather than to go into manufacturing themselves; however, Amscan does gain quicker development to production.  Further, all the company’s acquisitions have been done under 3X after earnings were improved.  A similar company, IG Design Group, which is primarily in gift packaging, self manufactures over 30% of its product.  It seems that controlling manufacturing allows the company to see synergies from increasing production that it may not be able to with negotiating as a third party.  Thirdly, Amscan is dominant in the mylar (foil) balloon business in the U.S with 70%+ share.  There is an element of the distribution economics here as well as some proprietary technology in engineering these balloons, but most importantly the company’s dominant share leads them to being given sole control of most major licenses.  We note that even Walmart who tries to avoid buying from Party City because it views PRTY as competition gets its balloons from PRTY.

Party City is extremely Amazon resistant and cannot be undercut by other internet upstarts:

Key to the sustainable success of any retailer today is that it cannot be Amazoned.  So, what prevents the internet from undercutting Party City on prices?  For starters PRTY’s most profitable item, helium filled balloons, which have a gross margin of over 90% and account for about 30% of store gross profits, can’t effectively be sold online.  For non-balloon items the average retail price is about $3, and the total non-balloon average basket size is around $18.  This pricing creates proportionately high shipping and fulfillment costs. 

Amazon owns much of its own shipping and logistics and could have lower costs up to 70% lower than competitors, its customer acquisition costs are near zero, and it could possibly get big enough to source party goods directly.  And while shipping a $3 item separately would be problematic, a $25 box of small items should be economic.  So why can’t Amazon do this and compete effectively in party goods?  The problems are how Amazon fulfills its orders and the Prime promise of 2-day free shipping.  Amazon has warehouses across the country, but these warehouses differ in what they stock apart from certain staples which are in every warehouse like diapers.  While Amazon is extremely efficient in how it picks products off the shelves often using robots, the way it does this is to place product by sales frequency in the warehouse, so whatever sells the most is closest to the front.  What this means is that the Spiderman napkins could be in one location and the Spiderman cups in a completely different area, in fact the cups could very well be in a completely different warehouse.  If the items are all in one warehouse (which is very unlikely) the picking costs alone are likely to be over $0.25 per item, and this about 10% of the price.  It is more likely that the items will have to be moved from one warehouse to another to consolidate into one box.  But consolidating is time consuming, and Amazon must get this to the customer in two days (possibly in one), so Amazon likely makes separate shipments to the customer.  The result is that the total picking and shipping costs could be close to half the price.  On top of those costs, the costs for Amazon to fully staff and manage a department is over 10% of sales.  So how can Amazon solve this?  It could offer slower fulfillment, which would break the prime promise so not an option for its brand.  It could have a warehouse fully dedicated to party goods, but the party category is not big enough to justify that.  (The only category that currently has its own warehouse is shoes.)  It could bundle products together leading to one pick and one ship.  The problem here is that there is a huge variety of choices, with different sizes, shapes, and quantities of each item.  Take for example creating eight-pack bundles of items and assume that there are three different choices, then there would be 6,561 combinations for customers to choose from, and this assumes that the customer even wants all eight of those items.  We spoke to someone from Amazon who told us that customers have not embraced the prepacked party kits.

Amazon cannot beat Party City on prices; however, it still wants to offer party goods.  Thus, Amazon opens it up to third parties, which allow it to offer a full selection for the everything store and make a profit off these sales.  AMZN charges the third party 17% of sales.  The third parties can ship through Amazon and recover those costs through higher prices or ship themselves and charge for shipping.  Party City is now a third-party seller on AMZN.  We would further add that party goods are an area that is not heavy on repeat purchases (such as groceries, which Amazon views as a key category) nor an area that could lead to a potential disruptor (such as furniture with Wayfair where Amazon is focused).  So, Amazon will likely continue to offer party goods through third party suppliers making a healthy margin for the foreseeable future.

For proof of Party City’s better prices, we did a spot check for large party packs and individual items.  Party City was 27% - 40+% cheaper for party packs, and the difference was even larger for small items that had to be individually shipped.

Now let’s look at the example of a startup seeking to sell party goods online and then we can discuss the colossus from Seattle.  The gross margins for PRTY without balloons and rent are nearly 44%.  That number, however, is with the wholesale margin included.  Without wholesale margin included, gross margins are about 30%.  A lot of scale is needed for any startup to be able to fully source direct, and complete direct sourcing may never happen in licensed product, but for argument’s sake we will assume that a company could get there.  Now the big remaining costs are shipping, packaging, customer acquisition, and overhead.  Unfortunately, shipping eats up over half of gross profit and corporate overhead, and customer acquisition costs eat up more than the rest.  As you can see from Exhibit 3 below, an internet seller of Party Goods would have to sell above Party City prices to be economic.  If the lack of wholesale margins is taken into consideration and likely far higher customer acquisition costs, the prices must be far higher.

While the share for online party goods companies is small from what we have heard, it is well under 10%.  But clearly there are some internet party supply companies, so what are they doing?  We spoke to a founder of one of these businesses who previously worked for one of the larger online upstarts.  He said that online companies are not interested in taking on PRTY and that they would rather focus on small niches.  A niche could be an extra special prop or a license that Party City does not offer.  He said his biggest product was his Bob Ross collection,  https://primeparty.com/collections/bob-ross-classic.  Some online companies make higher end and very crafty products such as individual, custom labels for bottles (which take a lot of effort to use).  The basics that these online companies package and sell seem to be sourced from Amscan, too.  These businesses may chip away slightly at PRTY, but given that they mostly source from Amscan, it’s unclear if they are even a true negative.  If it is negative, then the impact is extremely minimal.

PRTY SSS Weakness Pre-Pandemic was Temporary and has Ended:

PRTY’s brand comp sales were very weak from 2016-2019, declining every year culminating in a 3.0% fall in 2019, we can divide this for now to the 2016-2018 period, 2019 and the pandemic impacted 2020-2021 where the company miraculously survived and actually grew by 2021.  From 2016-2018 brand comparable sales declined a cumulative 1.8%.  2016-2018 was during a growing economy when we would have expected Party City’s sales to keep up with inflation and maybe added more due to population growth, so we would have expected 6-8% growth, but PRTY got a 1.8% decrease.  So, what explains this 8-10% variance?  The bears would of course point to the rise of the internet, but as we discussed above the internet is not a major factor.  We believe that we have triangulated the true sources of PRTY’s sales weakness, and these sources are temporary.

For starters, the day of the week on which Halloween falls can be a major source of variance in sales.  Halloween fell on a Saturday in 2015 and on a Wednesday in 2018.  That shift in Halloween to a weekday versus a weekend cost PRTY 2% in sales. 

Disney’s movie Frozen which came out in late 2013 has had an outsized effect on the party industry for a couple of years through Frozen themed parties.  Frozen likely burnished PRTY’s 2015 sales by 2%. 

A helium shortage cost the company 1.2% in sales.  Helium shortages are regional.  To measure the shortages impact, the company compares stores with helium to stores without helium.  We note that helium is a plentiful element and that the shortage was temporary having more to do with distortions in the market caused mostly by an ending of a U.S. government stockpile than any real dearth of supply.  The company has now locked in its helium needs with a new contract, so this will not be an issue going forward. 

The last piece of PRTY’s weak sales (that even the company does not seem to be aware) is growing sales from big box stores (WMT and TGT) which likely cost the company nearly 3% of sales over the 2016-2018 period.  Walmart and Target expanded the amount of square feet dedicated to party goods which led to growing sales in the category.  The expansion was not the result of outperformance from party goods as the department is not standout for either TGT or WMT according to our calls with former employees.  Rather the expansion was a result of areas struggling that were adjacent to party goods, primarily scrapbooking but also candles.   In Target’s case, this led to a 36% increase in the party goods.  With scrapbooking nearly gone, there is limited space to continue to grow the party goods area.  What’s more is that the added space has made the area less productive than it was before, so it is unlikely to expand more.  We believe expansion of party goods floor space at Target and Walmart cost PRTY 0.5% and 1% in sales.  Further, WMT improved its focus on regional holidays such as Diwali, which led to a 2% shift to WMT from PRTY according to our sources. 

Lastly, portable helium tanks became available at big box stores during this time.  One reason they became available was that they were partially seen as the answer to the helium shortage which was hyped in the news as a bigger than it was.  There was also a practical reason to have them for parties in areas where balloon delivery is inefficient.  We believe that this took another 1% of sales from PRTY.  Luckily, the portable helium tank is not a formidable competitor to PRTY’s store-bought filled balloons.  The tanks are more expensive than store bought balloons, hard to use, lack a variety of balloons, and lose helium as soon as they are opened.  The product gets very poor reviews, which would likely lead it to be taken off the shelves at big box stores once the helium shortage has passed.  As you can see from exhibit 3 below, the total impact of these non-recurring events was nearly 10% and thus the adjust compass could have increased nearly 8% over this time in line with what we would have expected.  In addition to all of these factors, the big box stores did a better job of stocking the area, with TGT expanding its private label into the area.

So, if this is true, why did things get even worse in 2019 and how can the decline be over?  The decline in 2019 comps was worse than the reported impact from helium.  As we said above, PRTY compares stores with helium to those without helium to measure the effect of the shortage on comps.  However, this approach misses the compounding effect of helium shortages.  The helium shortage lasted multiple years, but it appears that when a store was out of helium that it not only missed out on some balloon sales then but also some secondary sales from customers that either walked out empty handed without other goods and/or didn’t come back for future trips.  Remember the average PRTY customer goes to the store less than 2X a year so this effect can take a while to seep through.  When asked at an investor meeting if there were any PRTY stores that had never been affected by the helium shortage, the company responded by saying that there were about 25 unaffected stores and the comps of those were about 2% (this is well above comps + the reported helium impact).  Another bear thesis is that Amazon is still taking share despite being higher priced than PRTY, since people just assume that AMZN is cheaper on party good like it is in nearly every other category.  However, when we consulted credit card data, we found that the more consumers spent at AMZN then the better their comps were at PRTY.  The only area of concern is Halloween and costume-in-a-bag where Amazon can compete very effectively.  In addition, Spirit is a very well run pop-up shop that has taken share.  To combat this PRTY is moving more to one-of-a-kind items to let people build their own outfits.  We see 2019 as a new floor for PRTY to rebuild off of as all of the areas of share loss and sales decline are now nearly all in the past.   

PRTY’s Turnaround is Just Starting to Take Shape:

To understand Party City you must understand how it was formed. Amscan, PRTY’s wholesale business, operated independently of PRTY as a far superior business, but PRTY was its largest customer.  After Amscan acquired PRTY in 2005, the company rolled up other medium-sized competitors.  PRTY saw the stores as very poorly run and sloppily maintained.  So PRTY cleaned them up but they admitted they are not merchandisers; they are wholesalers so they filled it with product.  The result was an overcluttered store saturated with inventory that didn’t move.  The stores' performance was middling at best for years despite being dominant in the space, as the company is more than 4x the size of their closest competitor.  Through sheer size and depth of product, there simply is no room for anyone to be anywhere near as big as PRTY. 

Enter current CEO Brad Weston, who was appointed to be CEO of retail in July 2019 and promoted to CEO of the company on April 1, 2020, just as Covid started.   Brad has a deep background in retail as a merchandiser.  Investors should be excited at all the potential Brad sees. Quite frankly, the past management left a lot of low hanging fruit.  Firstly, Brad removed excess inventory from the store. The effect of a cleaner-looking store was that  customers thought  there were more products in the store.  PRTY also refocused its pricing using data to see where they had to be more competitive with Walmart and Target, we would note that this was done by 2020, so we shouldn’t expect to see any more margin pressure or lost market share going forward.  Then PRTY set out to redesign the stores, putting balloons as a separate section and the main attraction, making a more modern racetrack design, with lower lines of sight allowing customers to see the store better.  The results have been very good so far, and the company estimates a sub two-year payback on the new store format.  The company has also refocused on balloons with innovations in product and new ways to offer delivery.

While the ideas of the new management team seem to be excellent and indeed comps drastically improved in 2021 and are ahead of 2019 despite the pandemic, the speeds may still be slower than what investors were hoping for.  We note that the company ended 2021 with just 95 NXTGEN stores.  There are structural and unique factors that have held back the speed of the turnaround.  The company runs a lot of tests to see what works. However, the pandemic obviously made this a unique environment and tougher to run tests.  Additionally due to the infrequency of visits tests take longer to run and the effects take longer to see.  We think the effects here compound over time, so PRTY improves the shopping experience, and that shopper is more likely to return. However, that shopper may not have a reason to for another year so it is likely that the effects from store improvements will compound over time vs. the typical retailer where changes have a more immediate effect.  We also think that there was some confusion over the magnitude of the store remodel as many investors believed that the new stores were doing double the balloon sales, but in reality, they were doing double the comp.  What we see happening is a ton of incremental changes rolled out slowly which compound over time and arguably with each other, so we believe that comps will be elevated over say the next 5+ years to mid or even high single digits rather than a one-year double digit burst. 

The company’s long-term goal is to become a party platform. We thought that it would be tough for it to get there, but the company has most of the capabilities (such as the ability to design invitations) and is starting to make real strides.  PRTY just announced in their last earnings call a redesigned website with a focus on experiences rather than SKU search and on, of course, balloons.  Now users of the website will be able to see what a bouquet of balloons looks like as they add it to their digital basket.

PRTY Valuation:

PRTY trades at under 5X 2022 consensus EPS.  Even 2022 EPS is depressed.  First off, the Omnicron Covid surge likely clipped off about 10% of PRTY’s 1Q sales, with close to 50% incremental margins that likely cost the company at least $20 mln of EBITDA, additionally a delay in being able to increase prices with the surge in inflation may have cost the company another $20 mln.  Additionally, we feel that management was extremely conservative with guidance, so we think the current EBITDA power of PRTY is $340 mln or higher.  Lastly, the earnings power is being held back by high interest debt that will eventually be reset as the company’s fortunes improve.  Currently the company appears to be paying an interest rate of over 7%.  If it was to get that down to a more appropriate 5.5%, it would save the company over $20 mln in interest expense.  All in we believe that PRTY’s 2023 Earnings power is over $1.50 per share (see Exhibit 5 below), thus PRTY is trading barely above 2x that number.

We believe that conservatively PRTY should be earning over $2.00 per share by 2026, and if the potential of retail is fully brought out as we discuss below then the potential is likely over $4 per share.  As for what that means for the share price, keep in mind before the pandemic and the turbulent 2016-2019 period that PRTY had grown EBITDA in 22 out of 24 years prior, it’s a business that caters to large gatherings but somehow survived the pandemic.  PRTY also has shown itself to be recession proof over its history.  Due to the steadiness of the business, it has been able to be financed with large amounts of debt, equating to 7X EBITDA at times.  So, while it is possible to see this trading at 10X when the dust settles, it’s more likely to be 15x to even 20X for a stable and growing business.  We believe that PRTY will be worth at least $30 per share in 5 years with the potential for much more!!

PRTY’s Huge potential Upside if Retail were to be Functioning Properly:

Most investors who look at PRTY view it as a whole company instead of separating retail and wholesale. They also base their expectations on the past and especially the recent past.  This approach causes investors to assume a few percentage points of improvements and thus miss the full scope of the upside at retail.  Let’s take a step back and imagine if you did not know what PRTY’s retail EBIT margins were--what would you guess for a category dominant retailer where 20% of their sales have 90% gross margins?  Most people would guess 10%+. We do not see why that is not possible soon.  If PRTY gets there (and we believe it will), it will mean an additional $256 mln of EBIT and $1.73 of EPS.  This is a combination of the uplift from increased margins as well as the added sales to get there and the added wholesale margins on those sales.  You can see the math in Exhibit 6 below.

Further Upside from New Stores and Beyond:

If retail operations can be stabilized or turned around then there is opportunity to add an additional 300+ stores, or 40% more locations, which would add roughly another 25% of operating profit even at current lower levels of store profitability.  The opportunity could be even greater, if PRTY can successfully open a smaller more balloon-oriented store, which is where most independents focus.  The last leg of the retail turnaround is the very large potential of further franchise expansion in Latin America.  We would point out that there were 100s of franchised PRTY locations till the company started buying them back a few years ago, despite the struggling operations combined with a 5% franchise fee.  If you ever looked at franchisee economics, you quickly realize that they are not that great.  We believe that if PRTY can get retail margins up to just 7% that could be a tipping point for a massive expansion below the border where there is already an existing base of PRTY franchises, there could be room for another 1K stores, which could close to double operating profit.

Other small opportunities exist outside of improving retail.  While the company has gone away from focusing on increasing manufacturing and wholesale shelf space, there are some incremental opportunities for this.  Alternative markets for wholesale is also an area with growth. 

Catalyst

• PRTY could be buying back shares by 2024.
• According to credit card data sales are tracking pretty well, despite the Omnicron surge early in the quarter, it appears that PRTY will have positive comps for the quarter.