Description

BACKGROUND

Party City Holdco (PRTY) is a vertically-integrated supplier of decorated party goods. 

Wholesale segment [25% of revenues] 

One of the largest global designers, manufacturers, and distributors of decorated consumer party goods with products found in over 40k retail outlets including independent party supply stores, mass merchants, grocery stores, e-commerce merchandisers, and dollar stores. 

Retail segment 

Retail operations include over 900 party supply stores (including franchise stores) in the US and Canada, as well as an e-commerce site, and a network of 250-300 temporary Halloween City stores. Products are available in over 100 countries with UK, Canada, Germany, Mexico, and Australia among the largest end markets outside the US. 

The retail business (Party City) and wholesale business (Amscan) combined in 2005 and since then the company has rolled up the party specialty retail landscape. The company’s wholesale positioning was enhanced over the years by acquisitions as well (M&D Balloons, Christy’s Costumes, Anagram, among others) which provided the company valuable character licenses, costume capabilities, and balloon manufacturing while also improving its distribution capabilities. Following each retail acquisition the company would convert the units to Party City and then re-merchandise the stores to leverage its wholesale/manufactured assortment. This drove operating margin expansion as the company was able to capture additional wholesale or manufacturing margin thanks to its vertically integrated operating model. 

Given the roll up of the market, PRTY is the largest specialty player with a national presence and there is no direct specialty retail competitor. The company competes with mass merchants such as WMT/TGT, independent stores, Dollar Stores, and Amazon – though many of its competitors are also wholesale customers. 

Reasons for cheapness

Tariff related issues in 2H’18: higher freight and distribution costs for products acquired from company’s wholesale operations as China tariffs caused non-recurring logistical challenges

Helium shortage for the past several quarters: this was particularly problematic as balloons are an important driver of customer traffic 

INVESTMENT THESIS

Helium shortage and tariff issues are largely resolved now, with Halloween inventory a further tailwind in 2H’19. Expect comps to turn positive in FY’20. 

The company has been able to shift some of its sourcing to mitigate tariff related issues. 2H’19 would see a $2m tariff related impact absent any mitigation efforts. 

In 2Q the company entered into an agreement with a supplier for ~35% of its monthly helium needs. A tentative agreement has been reached with another supplier and is expected to come online in October that would the company above 100% of its required amount. 2Q’19 comps were -210bp of which helium was a -200bp headwind (including the estimated effect on non-balloon sales). Ex-metallic balloons, wholesale revenues improved +6.7% y/y. Resolution of the helium issue will therefore be a material tailwind beginning in 4Q. 

Halloween inventory will also be a 2H’19 tailwind. The company had all of its Halloween related related inventory in place by September 1 this year as compared to significant delays last year due to supply chain challenges. 

Management is guiding for FY’19 comp sales to be flat to down 1% and I expect comp sales to inflect positive next year hitting at least +1-1.5%. 

The retail business model benefits from a number of positive aspects 

Party City is the leading retailer in the $10bn retail party goods industry with 80%+ unaided brand awareness and no direct specialty brick & mortar competitor. 

Party goods benefits from being a ‘destination’ retail category, meaning traffic is high quality as customer intent to purchase is high. So assuming the store has the right product assortment/availability, conversion should be high. Party City stores carry 30k+ SKUs giving them a significant advantage as a one-stop shop vs. mass retailers that can only carry seasonal items and ~4k SKUs in the category. Destination stores typically enjoy more pricing power as well relative to other retailers. 

Given the company’s scale it is able to secure some of the best on-trend licenses in the business (Disney, Marvel, Mattel, NFL/MLB, etc.) PRTY has channel exclusivity for the vast majority of these products which is an important differentiator for its product selection.

Although the ongoing increase of e-commerce within the retail landscape can’t be ignored, PRTY is less exposed to this threat given the category favors in-store browsing and the low dollar amount of the typical basket size makes e-commerce uneconomical. Additionally, helium balloons, which account for ~15% of sales, can only be purchased in store which helps drive traffic.  

PRTY’s vertical integration allows them to participate in its competitors’ growth to some extent: To the extent Amazon carries the same SKU as PRTY, for example, these products are usually sourced from PRTY’s wholesale business Amscan. 

Vertical integration is a competitive advantage that will drive margin improvements as share of shelf increases. 

The company’s wholesale share of shelf is 77.6% while manufacturing share of shelf is 27.3%. With self-manufactured products the company can capture the full manufacturing to retail margin which is materially higher vs. products sourced via 3rd party. PRTY intends to double this share of shelf over time which will help drive annual margin improvements. Increased vertical integration also allows the company to respond more rapidly to changing customer needs as it gives PRTY greater control over every step beginning with design/production. Additionally, as integration increases, wholesale capabilities can be further informed by retail insights and vice versa. 

Store count rationalization 

Store count grew at a ~6.5% CAGR from FY’12-FY’18. New store productivity began declining in FY’18 as did overall sales per sq. ft. Accordingly the company implemented a store count optimization program this year – with 34 stores liquidated as of July 31 and 55 total closures expected for the full-year. Closures have primarily been locations in close proximity to another Party City store and unit growth going forward will focus on more underserved markets. Initial results following closures indicate that anticipated sales recapture rates are being achieved by the remaining store in the given market.  The company plans to redeploy some capital from closures toward increasing customer-facing store associates in existing stores.   

These accelerated store closures have contributed to gross margin erosion this year given markdowns taken when liquidating stores and recording provisions against inventory. As the store optimization will be largely complete by year-end this should be a tailwind for y/y margin improvement in FY’20. 

Compelling valuation and strong free cash flow generation to drive deleveraging 

I expect 4Q’19 FCF to be positive following several quarters of cash burn and FCF should increase significantly over the next couple of years with shares trading at 30%+ forward FCF yield. LTM net leverage is high at 4.2x but I expect this to decline rapidly as FCF ramps up. Additionally a $120m asset sale closed in October which will be used to pay down debt. Management is committed to using capital to reduce debt and I expect net leverage to be below 3.0x in FY’20 and below 2.0x by FY’21.  

Shares are trading at ~4.0x my FY’20 estimates as I expect the company to exceed consensus estimates of $1.50 next year with $2+ of EPS potential possible farther out. A 7-8x multiple on $1.75 EPS yields a 1-yr price target of ~$12-$14/share or ~85-110% upside from current levels. 

Catalyst

Earnings upside/above consensus, same-store comps turn positive, increasing FCF, deleveraging