Description

Party City is a nation-wide "value" super store specializing in party merchandise, viz. Halloween, Christmas, New Years, birthdays...you get the idea. Operating 500 stores, 247 of which are Co. owned (253 are franchised), it is the predominate player in its niche. Additionally, its direct competitors are financially or operationally weak. The free-float percent is only 68%, as several large shareholdings exist -- most notably Tennenbaum Capital, whose eponymous managing menber currently serves as Vice Chair of the Co. (formerly Vice Chair of Investment Banking Bear Stearns). They own 28%, and have placed several retail specialists on the board. Owing to past operational deficiencies,PCTY has an acting CEO (past CEO of Gymboree), and has been searching for a permanent replacement.

Obviously, this is a highly seasonal business, with the Dec QTR (Q2)of paramount importance (Halloween, Christmas, New Years). Recently, the Co. announced Oct. sales results, and they were encouraging: five week sales up 13.9%, Company-owned up 12.4%, Company same store sales up 7.2%. In FY2003 (Jun), thirteen stores were acquired in Seattle, and sales there were up 20%. Ex acquisitions, the Co. opened 22 stores last fiscal year. Gross margins last quarter were negatively impacted (27.6% vs 29.3%) by sales of discontinued merchandise (Co. attempting to reduce its 20,000 SKU and to consolidate vendors), which should be a non-recurring event. A point-of-sale IT rollout negatively impacted FY03 as well.

The investment thesis here is pretty self-evident: iron-out the operational issues (not altogether clear that this has been accomplished), locate viable real estate, recruit franchises (in part to create future acquisition candidates), replicate. With several highly motivated sophisticated shareholders, and little headwind from competition (ASP up about 7% recently), the results should continue to improve.

Valuation:
est. PEG 0.7x
est. Sales growth 20.5%
est. PE'0406 15.0x
est. PE'0506 12.4x
OPM 5.0%
ltm OPM 4.7%
ATM 4.1%
EV/ OCF 4.6x
P/ sales 0.5x
TD/ OCF 0.4x
ROE 16.5%

If PCTY can achieve sales growth of 3.5%, OPM of 5.2%, then it should earn $0.80 fd. If it can grow sales 4%, and OPM to 6.5% (in FY02 it was 8.1%), it would earn $1.00 fd. Not unsurprisingly, these projections are the crude bounds of current estimates for FY04 ($0.82-$1.08). Longer term this is an execution idea: just getting the basics right. As trite as it sounds, there are no fashion problems, no highly trained employees, no new paradigms, and, thus far, no pricing pressure. If they can earn $1.20 in Jun-05 (the current estimates are $1.01, $1.22, $1.25), the stock should trade at 16x, ergo, a possible target price of $19 in 18 months -- a reasonable prognosis in an equity universe most vicars, myself included, find pricey.

Catalyst

New CEO
Strong Q2 report on 6-Feb
Acting CEO has vascillated on buy-backs, but FCF> EPS, no LTD, no div.