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Pier 1 PIR
December 30, 2007 - 5:10pm EST by
bafana901
2007 2008
Price: 5.22 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 460 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

I am recommending Pier 1 Imports (PIR) as I expect the positive signals from the turnaround strategy to continue.
 
Summarizing my thesis the EV of PIR is $560mil. Adjusting this EV for 1) the $70mil assessed loss tax shield and 2) The $100mil value of the head office* implies an EV for the retail stub of $395mil. The initial phase of the turnaround strategy should see PIR generating at least $80mil EBITDA by Feb 2009 which implies a 4.9 multiple for the stub.
(* The sale of the head office is under review.)
 
Looking at the longer term prospects for the turnaround PIR’s EBITDA peaked at $250mil in 2004. While this target is much too aggressive for now, I think there is a good chance the turnaround strategy ultimately takes us back to 2001 EBITDA of $195mil which will obviously boost the stock to much higher levels. (I have chosen 2001 as it also reflects a period of challenging macroeconomic activity.)
 
 
BACKGROUND
 
Before I get to my thesis I must congratulate rand914 for being bang on the money in his write-up of PIR as a short in January 2006. The central thesis of his argument was that SSS had been negative since 2003 and he warned that the trend would continue. Margins had also been declining.
 
Rand914 was right. For  the year ended Feb2007 sales declines by 8.6% to $1.6bil. SSS declined 11.3% and merchandising margins fell from 46.8% to 40.7%. The net operating loss for the year was $226mil which included $114mil of non-recurring losses. On top of this, the dividend was suspended.
 
These dismal results forced a change in management and Alex Smith (ex TJX) was appointed as CEO in February 2007. He immediately began to work on a plan to restore PIR to profitability. After 8 weeks on the job he made the following incisive comments on the Q42007 conference call.
 
“Fiscal 2007 was a truly horrible year for Pier 1. The year-on-year negative comp store sales prompted dramatic and untested changes to our merchandise, significant increases in our discounting activities, and an excessive marketing spend. Pier 1 has been bleeding, not because of the economy, not because of competition, but, from self inflicted wounds, specifically a failure to evolved and adapt in merchandising and a failure to become more streamlined and cost effective.”
 
“For the past year at least, our customers found that our merchandising strategy involved a dramatically reduced sku count and a narrow assortment in a very specific color palette and they didn’t like it. Going forward, our emphasis is on providing a broader assortment with less depth, and more color options”
 
“The historical strength of Pier 1 was catering to a very broad group of customers and that is what we are going to try and get back to. Pier 1 cannot survive as a tightly focused niche retailer, it just doesn’t work. We have to be pretty broad in our appeal.”
 
These quotes capture the essence of the plans to restore SSS revenue growth. The plan for the top line was combined with an aggressive cost cutting program which is on track to slash SGA costs from $695mil in 2007 to $420mil in 2009.
 
Eight months after hring Smith the Q3 2008 results (released December, 20 2008) contained early signals that the turnaround strategy was working. These early signals saw the stock price jump 41% in a day to $5.30.
 
 
TURNAROUND PLAN
 
Alex Smith has emphasized 7 priorities to return PIR to profitability.
 
  1. Improve operational efficiency. Goal, rights size the cost base by driving down costs.
  2. Review the store portfolio. Goal, close down uneconomic stores that are not expected to return to profit after tweeking.
  3. Provide a compelling merchandise selection. Goal, offer a broader range of merchandise at the correct price points.
  4. Create a new team to control inventory levels, markdowns and purchase order management. Goal, ensure merchandise mix and availability is optimized at each store.
  5. Review supply chain efficiencies. Goal, reduce breakages and unlock expected efficiencies.
  6. Create a cost effective marketing plan. Goal, bring down the unrealistically high marketing budget to 5% of sales.
 
These strategies are detailed in the 2007 10K and it would be redundant for me to repeat them here. Instead, I will describe how these strategies are progressing by reviewing the results from the last four quarters.
 
Following the strategy from quarter to quarter is the best approach as the strategy was implemented over time, no big bang. Also, it gives a feel for the base which is about to be lapped.
 
 
Q4 2007 (FEB2007)
Stock Price = $7.70
 
Sales                                     474mil
COS                                    (281mil)
Merchandise Profit               193mil
Occup Costs                        (  76mil)
SGA                                    (165mil)
EBITDA                              (  48mil)
Depreciation                        (   12mil)
Oper Profit                          (    60mil)
 
Sales declined by 6.4%.
SSS declined by 11.0%.
Merchandise Margin = 40.7% (Normalized = 47%)
 
Turnaround strategy is announced for the first time and the initial effects on the income statement are
1)      Merchandise profit is understated by $32.5mil because of the aggressive liquidation of modern craftsman merchandise.
2)      SGA is overstated by $13mil of non-recurring write-offs.
3)      Adjusting for these abnormal amounts the loss would only have been $15mil.
 
 
 Q1 2008 (May2007)
Stock Price = $8.30
 
Sales                                     356mil
COS                                    (194mil)
Merchandise Profiy              162mil
Occup Costs                        (  75mil)
SGA                                    (133mil)
EBITDA                              (  46mil)
Depreciation                        (   10mil)
Oper Profit                          (    56mil)
 
Sales declined by 5.2%.
SSS declined by 5.4%.
Merchandise Margin = 45.5% (Normalized = 52.2%)
 
 
The impact of the turnaround plan hits the income statement as follows:
1)      Merchandise profit is understated by $24mil because of the continued liquidation of modern craftsman merchandise which is now complete.
2)      SGA falls by $15mil compared to prior year. The savings have come from a $9mil reduction in marketing expenses, a $6mil reduction in store payroll and $4mil in other costs. The savings were offset by a $3.5mil severance charge related to layoffs.
3)      Adjusting for $25mil and $3.5mil the loss would have been $28.5mil.
 
Further details of the restructuring plan are announced including
1)      The intention to exit all non-core businesses. This involved closing down 24 clearance stores by July2007 and Pier 1 Kids (33stores) by October 2007. Revenues are expected to fall between $50mil and $60mil as a result of these closures.
2)      In addition, 26 Pier 1 stores were identified for closure leaving 1 101 stores.
3)      The liquidation of craftsman merchandise opened space to begin increasing the number of sku’s in the store. The stores had been running with 2 500 sku’s which management wanted to increase to 4 500 by January 2008. (Note: The store sku count had declined from 4 200 to 2 500 over the last several years.)
4)      More clarity is given of the marketing strategy. Internal marketing goals are directed at making the stores easier to shop. Plans are announced to switch to more department store layouts with frequent changes to the promotional area. The backbone of the external marketing will be the monthly mailer which will be mailed to third party lists and to PIR’s extensive customer database.
 
Television advertising and catalog adverts were to be scrapped because they had not provided a good return on investments. These changes would result in the marketing budget falling by $67mil to $50mil per annum.
 
 
Q2 2008 (Aug2007)
Stock Price = $6.15
 
Sales                                     345mil
COS                                    (183mil)
Merchandise Profit              162mil
Occup Costs                        (  74mil)
SGA                                    (118mil)
EBITDA                              (  30mil)
Depreciation                        (   10mil)
Oper Profit                          (    40mil)
 
Sales declined by -7.0%.
SSS declined by 3.6%. (excludes clearance stores and Pier 1 Kids)
Merchandise Margin = 47.0% (Normalized = 49%)
 
 
The events of Q2 affected the income statement as follows:
 
1)      Completed the closure of the 24 Clearance stores. Closed 6 of the 33 Pier 1 Kids stores.
2)      Traditionally Q2 has the lowest margin because of the semi-annual clearance sales in June/July. 
3)      Merchandise profit is understated by $7mil resulting from the liquidation of stock in the Kids and Clearance stores.
4)      SGA falls by $36mil compared to prior year. The savings have come from a $14mil reduction in marketing expenses, a $14mil reduction in payroll and $5mil in other costs. The savings were offset by a $7.4mil of special charges.
5)      Adjusting for $7.0mil and $7.4mil the “normalized loss” would have been $25.6mil.
 
Further details of the restructuring plan are announced including
  1. Anecdotal evidence that the new sku’s which are beginning to flow into the stores are making a difference.
  2. In response to concerns about the weak macro-economic environment for the home retailers management reveal more about the merchandising strategy. Investors are told that Pier 1 is reducing it’s reliance on high ticket furniture items by developing a stronger assortment of lower ticket “impulse pick-up” items and smaller decorative furniture items.
  3. Management highlights the need to increase conversion rates.
  4. On the marketing front, a 40 page mailer will be mailed to 20 million names ahead of holiday sales.
 
 
Q3 2008 (Nov 2007)
Stock Price = $5.30
(The stock price jumped 41% on these results.)
 
Sales                                     374mil
COS                                    (176mil)
Merchandise Profit              198mil
Occup Costs                        (  72mil)
SGA                                    (124mil)
EBITDA                                   2mil
Depreciation                        (   10mil)
Oper Profit                          (      8mil)
 
Sales declined by 7.1%.
SSS declined by 1.7%. (excludes clearance stores and Pier 1 Kids)
Merchandise Margin = 53.0% (Normalized = 54.3%)
 
 
The impact of the turnaround plan hits the income statement as follows:
           
1.      The primary reason for the 7.1% decline in sales was the closure of 98 stores since q3 2007. Management were happy with the SSS comp considering how promotional PIR was in the prior year. They also stated that they could have achieved positive SSS comp if PIR “elected to sacrifice margin and bought sales with costly promotions.”
2.      Merchandising profit is understated by $11mil because of the Kids 1 liquidation of merchandise.
3.      SGA expenses decline by $30.9mil compared to prior year. The savings came from $21.2mil in marketing expenses, a $10.8mil in payroll and $5.4mil in other costs. The savings were offset by a $6.5mil of special charges.
4.      Adjusting for the $11.0mil and $6.5mil PIR would have shown a profit of $9.5 and EBITDA of $19.5mil. (If this run-rate is sustainable PIR’s earnings power is easily $80mil per annum.
 
 
Further details of the restructuring plan are announced including
  1. The highlights of this quarter included the closure of the remaining Kids stores and the introduction of “thousands” of new SKU’s. Management were “extremely pleased by the response of our customers” to the new merchandise.
  2. PIR closed the quarter with 1 128 PIR 1 stores. The plan is to have 1 025 stores in the US and 83 in Canada by year end. (ie close a further 20)
  3. During the quarter PIR held their prices, increased conversion rates, units per transaction and the average sale. These positive trends continued over November and December.
  4. The strong merchandise margins were attributed to “more appealing merchandise, sharper price points and a strategic markdown strategy.
  5. Marketing: PIR is starting to see increasing response rates from the mailers, including a strong improvement from previously inactive customers.
  6. Management start to talk for the first time about substantial amounts that can be saved in the supply chain.
 
 
PROSPECTS FOR Q4 2008
 
Management have provided the following guidance for q4
  1. Positive trends have continued and they expect positive SSS for December. (The December sales will be announced on January,10 2008. The announcement of a positive SSS comp is the most important catalyst for a stronger stock price.)
  2. The clearance sale begins on December,26 2007. This continues for a month before the spring merchandise arrives in the store. The clearance sale will depress margins below q3 levels, but, will be better that last year. (Merchandise margins were 40.7% in Q42007, normalized 47%)
  3. No once-off costs are expected.
 
 
BASE EFFECT
 
With this guidance the Q4 2008 results are going to “shock and awe” the Q4 2007 base which reported an operating loss of $60mil.
 
My forecasts sales for Q4 2008 assuming a 10% reduction in the store base and +1.5% SSS are as follows.
 
Sales
Q4 2007 sales     =  $474mil
Close 90 stores   = ($  50mil)
New Base           = $424mil
SSS(+1.5%)       =  $    6mil
Forecast Sales    =  $430mil
 
After choosing a conservative merchandising margin of 49% (same as q2 normalized, also a clearance quarter) my forecast income statement looks like this
 
Sales                                     430mil
COS                                    (219mil)
Merchandise Profit              210mil
Occup Costs                        (  70mil)
SGA                                    (118mil)   **q3 normalised
EBITDA                                  22mil
Depreciation                        (   10mil)
Oper Profit                               12mil
 
I believe these forecasts are conservative because I believe a 50% merchandising margin is achievable. I also did not build any further cost savings into sga expenses.
 
Besides the Q4 base, the next 3 quarterly bases are also easy to beat. Below is a list of the reported and normalized gross margins over the 2008 financial year.
 
Q4 2007  Actual = 40.7%   Normalised = 47.0%
Q1 2008  Actual = 45.5%   Normalised = 52.3%
Q2 2007  Actual = 47.0%   Normalised = 49.0%
Q3 2007  Actual = 53.0%   Normalised = 54.3%
 
Even if PIR only hits these normalized margins over the next few quarters the lower sga costs and the absence of once-off costs should see PIR easily beat these bases.
 
 
SUMMARY
 
The stock price was $7.70 on the April,20 2007 when prospects were at their worst with no clear turnaround strategy. I find it difficult to comprehend that the stock is now trading at $5.22 even though the turnaround strategy is showing clear signals of working. The return to positive SSS comps plus the low base effect should see the stock price returning to similar levels in the short term and even higher as the effects of the turnaround continue to restore the earnings power of the franchise.
 
In addition, 20% of PIR’s float is short. As PIR begins to demonstrate that the earnings power of it’s assets (EBITDA) is at least $80mil per annum and continue to thump the 2008 base these shorts will lose faith and cover.
 
 
 

Catalyst

My first catalyst is the reporting of positive SSS comps for December on January,10 2008. The second catalyst is the reporting of q4 earnings early April 2008.
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