Description

Summary

Party City is perceived by longs as an Amazon-resistant manufacturer and retailer of party goods that holds a self-help margin expansion story and trades at a cheap multiple of cash flow. The common short thesis on the slow death of brick and mortar retail has been perceived as inevitable and is well-understood. However, there are several elements unique to Party City that make for a timely short.

The Company IPO’d in April 2015 after being owned by THL since June 2012, who levered the business up over 6x. Current leverage stands at 5x and management insists it will bring down to 3.0 to 3.5x by 2020. The Company has supported weak comps with franchisee acquisitions ($550 million since IPO), which are now slowing as there are really no more to acquire. Thus, to maintain top line growth, the Company needs to rely on re-accelerating comps, which will be very difficult.

In the near-term, the Company ought to miss Q4 2018 and Q1 2019 comps due primarily to nationwide helium shortages, which channel checks suggest have remained ongoing through January 2019, contrary to management’s Q3 assertions that “the helium situation should resolve itself in the second half of the fourth quarter.” Not only are helium / balloons ~20% of revenues, but a core driver of traffic and the Company’s differentiation; no one’s going to order balloons from Amazon, but one can certainly find paper plates, greeting cards, costumes, etc. there and at many other retailers. The helium miss in Q3 was largely bought by analysts (see Barclays November 9 upgrade) as “one-time” in part due to the wackiness and the opacity of the market. However, this shortage is structural and over the longer-term could impair PRTY’s core business.

Bulls may argue that the Company doesn’t need comp or owned store growth / revenue growth at all but can continue to grow EBITDA / cash flow through margin expansion, citing vertical integration, “share of shelf,” etc. There are several risks / fundamental challenges to this that are not being properly discounted, namely: COGS pressure in helium (as well as labor, freight, etc.), management’s willingness to discount / promotions to drive traffic amidst weak comps, cannibalization, the effect of falling volumes in the manufacturing business on a fixed cost base, and management’s own margin-dilutive initiatives. Given that net leverage is 5x, the situation could become reflexive / balance sheet could start driving the business.

The Company is bringing lease liabilities on balance sheet in Q1 2019 and as it owns none of its over 900 stores and only a few of its DCs, this may become an additional point of concern, especially if net store openings turn to closings and the Company gets stuck in leases.

THL has been selling shares through secondaries since the IPO, now down to 37%. Further selling from THL ought to be expected.

PRTY ought to ultimately trade in line with retailer comps (BBBY, DKS, BBY, KIRK, GME, etc.) that trade at ~3x to 6x EBITDA (and are un-levered and/or own real estate while PRTY is levered and owns none). Street calls for $427 million in 2020 EBITDA, which ought to come down. At 6x the Street’s $427 million in EBITDA, shares would trade to $7.77 or 31% downside. Given the cap structure and view that EBITDA will be lower, 5x $400 million in EBITDA is 87% downside (both EVs include effect of est. interim net cash generation / capital return while excluding est. leases coming on B/S). Short interest is relatively high at 23% of float but borrow is widely available and the stock trades over $20 million per day.

Company Overview

Party City Holdco is the leading party goods and Halloween specialty retailer. The business operates ~950 company-owned and franchised stores in North America, sells direct through PartyCity.com, and sells on Amazon. The Company operates a vertically-integrated model; it has both retail and wholesale segments, but retail ultimately drives the bus as roughly half of wholesale revenues are sold to retail through Company stores.

The Company offers 60-70K SKUs (claims 30K per store, 40K available online) across 5 categories (costumes and accessories, tableware, decorations, favors stationary other, and metallic balloons). The Company has acquired several businesses through the years (excluding franchisees) for example Anagram (balloons; acquired 1998), Christy’s (costumes; 2010), Travis Designs (costumes; 2015), etc. Third-party sourcing remains most of the wholesale business.

Investment Thesis

Helium shortage is longer lasting and more impactful than management has communicated to the Street

For context, the government / BLM is pulling out of the helium industry. This is fascinating in its own right, as it fundamentally changes the structure of the entire industry (even if it’s a small industry). See some links here, here, and here for context. Helium is used in rockets, MRI magnets, hard drives, microscopes, etc. and of course balloons. In its 2016 Goldman conference presentation, the Company claimed to be “The largest manufacturer of metallic balloons in the world” and names “metallic and latex balloons” first in its list of products manufactured. In the 2017 ICR conference, the Company noted its biggest category was “Every Day” at over 80%. For Party City’s business, balloons and helium are around 20% total revenues.

Foil balloons were called out in Q2 2018 as a “continued” positive driver,

So while total Share of Shelf was essentially flat for the quarter, this model continues to drive margin expansion through manufactured Share of Shelf gains. In the quarter, that was a result essentially of 3 primary drivers. We saw continued accelerated growth in our foil balloon business. We continued to leverage up our manufacturing assets, including ACIM, and then we accelerated the Granmark integration. So those 3 points drove the gains.

However, in Q3 2018, PRTY missed comps, posting -1.0% vs. +2.0% consensus. Helium was mentioned 23 times in the conference call. Per the Company, helium turned from a tailwind into a headwind,

We also experienced accelerating helium supply shortages in the quarter, providing a headwind to the growth trajectory for both the latex and metallic balloon categories, which have been key sources of growth to date.

However, balloons are a core Party City traffic driver vs. a Target, Wal-Mart, Amazon, etc. It stands to reason that customers may not bother coming into Party City stores at all if there is the common knowledge that stores don’t have helium / balloons. “You can’t buy a helium balloon online” per CEO James Harrison in April 2015.

Thus, the impact could ultimately be greater than expected, should the shortage be longer than expected. Regarding forward guidance and setting expectations, management was more constructive on this being a one-off event,

But with all the puts and takes on the headwinds you mentioned and whether they resolve themselves, we believe the helium situation should resolve itself in the second half of the fourth quarter. We'll find that out pretty soon.

And we fully expect to be totally in stock with helium for the December selling season, which obviously includes New Year's, which is a very, very big holiday for balloons. So we're guardedly very optimistic that the helium situation, as well, will resolve itself later this year and not be a true headwind next year as well.

The stock was later up 14% on November 9 after Barclays upgraded from equal weight to overweight. The basis of the upgrade was a backstopped valuation (shares down 34% over last 60 days vs. S&P down 5%) and “transitory” pressures (namely Helium). Per Barclays post-ICR,

“While the company does not disclose specifics, helium balloons are a significant portion of the business. Management noted that helium supply has improved, but continues to be tight. While PRTY does not see it as a headwind in 2019, the company will monitor it closely.”

However, these aren’t transitory issues. Articles like these and these are easy to find,

“It’s very tough for us right now,” said Ethan Truong, owner of HD Balloons in South Sacramento. “If it keeps happening like that then we are going to close down the business.”

Truong says selling helium is a big part of his business, approximately 90 percent.

Five years ago, a helium tank would cost him $25 to fill up, but now the owner says it’s close to $300 and that’s if he can even get it.

“We can’t get any helium from anywhere,” he said.

Delivery of the element has been periodic.

“They just ran out,” he said.

Numerous people are complaining that they can’t get it (this is maybe one-fourth of the complaints on Twitter over the period). Peruse at your own risk / pleasure (note the last one from Party City’s own Twitter account),

Nov 10 https://twitter.com/ScottKingMedia/status/1061283116290109440

Nov 13 https://twitter.com/_daniiiip/status/1062501959612186625

Nov 15 https://twitter.com/Emily_Gomez18/status/1063229026922164224

Nov 23 https://twitter.com/SarahLucero/status/1066015972107145216

Nov 28 https://twitter.com/desttt_iny/status/1067949731706327040

Nov 30 https://twitter.com/tayyzim/status/1068622017799340032

Dec 13 https://twitter.com/mooka_duhh/status/1073255969663188997

Dec 17 https://twitter.com/LITdiaOfficial/status/1074707013496651776

Dec 27 https://twitter.com/TAYder_totts/status/1078383916019527681

Jan 3 https://twitter.com/theboujiebre/status/1080978088643694592

Jan 14 https://twitter.com/SlimBald_/status/1084822912488620032

Jan 14 https://twitter.com/NikhoDhaKhid/status/1084887035989626880

Jan 15 https://twitter.com/undraftedones/status/1085253443877593088

Jan 17 https://twitter.com/dellafig/status/1086096849717641216?s=12

Jan 19 https://twitter.com/Frannie831/status/1086716895598952448

Jan 21 https://twitter.com/_jasminlopez/status/1087448228587552775?s=12

Jan 25 https://twitter.com/PartyCity/status/1088829820920827905

And a personal favorite from grandma yamz, Jan 23:

Recent calls to stores confirm that they’re either totally out or low on helium. Some managers & employees acknowledge the shortage even if they have it in stock. One store noted that all the stores around them have been running out, so they act as a hub of sorts, selling their excess helium to the other stores. One said that they could fill a 100-balloon order that night, but “you’ll have to check back tomorrow” because the helium might be gone by then. One store noted that they had been out for about two weeks as their vendor had simply stopped shipping them helium and hadn’t said anything to them since. You get the idea… On pricing, there wasn’t much to indicate that there has been Company-wide a directive to raise prices, so it may be likely that PRTY is eating some margin in addition to the comp hit.

Fundamental challenges and balance sheet will be more overwhelming than bulls anticipate

The bull thesis holds that the low ASP and high SKU count is a differentiator to the model, preventing Amazon / online from encroaching on top-line, as a low ASP won’t cover the cost of shipping. However, this makes little sense, as the CEO himself will say that “Our consumer is coming for a planned event. Our stores are generally located in strip malls. We don't depend on walk-in traffic really for transactions. We are a destination purchase” suggesting that most purchases will be of a higher dollar basket size, hence overcoming the shipping concern. Moreover, the Company itself implicitly admitted that online works when it decided to sell on Amazon in August 2018, where it now competes against a variety of low-cost manufacturers. In all, there is little that is unique to PRTY’s retail model (excluding balloons, as addressed above) that can’t be replicated online or by Wal-Mart, Target, Dollar Stores, etc.

Management and longs also refer to the Company’s seemingly historically consistent results (see below, notwithstanding acquisitions considerably aiding this picture) as reason in and of itself to support the notion that the Company ought to have a right to play.

This also ignores the nature of the slow underlying deterioration of these businesses. See from an article detailing Party Plus Warehouse, which has been in business for over 25 years and is just now going out of business, noting pressure both from Amazon and helium.

From balloons, to baby shower supplies, wedding cake toppers, and plates, if you want it for a party, the Party Warehouse probably has what you’re looking for.

Their most popular item though has to be the balloons, but now that item that keep them afloat, may be grounded indefinitely.

Kim Hodges, one of the owners of the warehouse says right now, “only national contracts can get helium right now and the majority of those are obviously your hospitals, there are some chain stores that had a national contract and are able to get some helium but not as much as they’re used to as well, so we have been out of helium since November.”

That shortage stemming from several factors, including sanctions on overseas supplies, and lower U.S. production, but balloons aren’t the only thing hurting business.

“A lot more people shopped on Amazon instead of getting out and coming into the store," says Hodges. “And the thing with Amazon sales is you have 30 days and you can turn it back, and I know probably a lot of people bought their costume, wore it and send it back....It’s hard these days for brick and mortars especially when you have such a big building , you’ve got your rent your utilities, your employees."

The helium situation also comes at a time when the Company isn’t really shooting the lights out on organic growth.

There may also be a honeymoon effect of acquisitions supporting these comp figures due to measurement of acquired stores which are then converted to Party City stores, as per the 10-K:

Acquired stores are excluded from same-store sales until they are converted to the Party City format and included in our sales for the comparable period of the prior year.

PRTY has spent ~$550 million since IPO on acquisitions. Per management, acquisitions of franchisees have been done at 3-5x cash flow / EBITDA, hence also being financially accretive, to their credit. However, this formula is coming to an end, as the Company has essentially bought back all their franchisees; 97 stores remain vs. total ~950. Leverage is also more of an investor concern as management had previously promised to bring to 3.0x to 3.5x by YE 2017 yet is now promising the same for 2020. As a point of reference, the 6.625% August 2026 unsecured trades at 96.75 or a 7.2% YTW. Party City also doesn’t own any of its real estate to support this debt-load, and its leases will be coming on balance sheet for the first time in Q1 2019. Leases are generally ten years in length. Minimum lease payments are shown below.

On the margin side, there are several risks to the expansion story that are not being properly discounted by longs. First, given the view that comp growth and store acquisitions will no longer be sources of growth going forward, it is natural to see margin contraction, especially in a higher fixed cost manufacturing business. Second, again seeing falling volumes, management may be tempted to discount or promote to drive traffic to stores, sacrificing gross margins. Cost inflation also remains in labor and freight; the Company must hire 35,000 temp workers each year and cost are rising 15-20%, per CEO Harrison. Manufacturing share of shelf has risen from 20% “triples” (manufacture, wholesale, and retail) in 2016 to 23% today, while the goal remains reaching 50% in 5 years. Given history and difficult comps to work from, this seems aspirational. With respect to the filling the “Toys R Us” gap, the Company doesn’t manufacture any of this business; it’s merely a retailer, which carries weaker margins. Pop-up stores are a nice talking point, but (1) remain a small portion of total sales and (2) cannibalize the Company’s existing store base. Initiatives like broadening distribution to souvenir cups at Patriots games and popcorn buckets at Regal cinemas also won’t be margin-accretive and again indicate that the Company’s core business is challenged; management is throwing things at the wall to see what sticks.

Margin pressure is already occurring; gross margins were slightly stronger in Q3, but management also shifted spend to Q4,

Our consolidated gross profit margin was 36.5% or 60 basis points above the same quarter last year, partially a result of the shift of promotional spend to Q4.

Nevertheless, margins will remain flat to down,

So look, as we said in the prepared remarks, we expect gross margin rates to be flat to slightly down for the year, and this outlook reflects about 150 basis point gross margin pressure in Q4. And that is a combination of the one-off items that we've discussed so far as well as some of the structural inflationary challenges. On the one-off side, we feel very comfortable that about 2/3 of the pressure in Q4 is of the one-off nature.

Given the view that Helium is not a one-off but longer lasting than management has communicated to the Street, more like two-thirds or more of this margin pressure is structural / recurring and ought to be felt in 2019 and beyond.

Valuation

Optically, PRTY could be considered cheap at just less than 8x EBITDA, but this is a highly levered, no growth manufacturer / retail operation that doesn’t own its real estate; it’s a value trap. Comps are below. Included are both retailers and other businesses which seem like appropriate comps for the manufacturing business (which names paper plates, cups & napkins, plastic cups, etc. as its core products). Nevertheless, the manufacturing business is a small portion of total and ought to trade at a discount to peers given it’s levered to retail (i.e. ~50% customer concentration). Note that as PRTY doesn’t even own any of its real estate, one could adjust EVs even further if desired, yet the equity still trades at a premium to retail peers.

PRTY ought to ultimately be recognized as an undifferentiated retailer and trade in line with retail comps. (BBBY, DKS, BBY, KIRK, GME, etc.) that trade at roughly 3x to 6x EBITDA (and are un-levered and/or own real estate while PRTY is levered and owns none). Cap table / valuation shown below includes interim cash generation that will go to capital return (debt paydown or buybacks), while excludes leases from the balance sheet (~$650 million present value).

This downside ought to be realized in the next several quarters as comps continue to slow / turn decidedly negative, the Company fails to expand margins, and the balance sheet becomes a greater concern.

THL also sold a block of 12 million shares in a secondary at $15 in May 2018, pushing shares down ~5%. On August 9, 2018, the Company announced that it would be testing the sale of products on Amazon and expanding products in Q4 for Christmas and New Year’s, with a potentially greater emphasis in 2019 as well. Coincidentally, the Company also announced a 10 million share secondary from THL. It seems that timing here was deliberate. THL now owns 37% and further secondaries could also serve as catalysts.

Risks

Management has been purchasing shares. They may know something more or they may end up as bagholders.

Reinvigorated model to drive organic growth. Though this seems low likelihood and may require capex (more far-reaching store remodels etc.)

Purchased by PE / strategic, though not sure why this would occur given no real estate ownership and already aggressive debt levels.

Catalyst

Comps misses

Leverage