Summary

We focus on smaller companies with “Ft. Knox” balance sheets and large & sustainable free cash flow yields and we are typically seeking a mid-teens FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation, through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.  We also focus on small and micro-cap stocks because there is a much better chance to find an attractive investment opportunity which is under-followed or undiscovered.

Reitman’s (RET-A.TO) is the largest women’s specialty retailer in Canada with 823 stores as of January 2015.  RET operates multiple store brands including Reitman’s (341 stores), Pennington’s (139 stores), Addition Elle (105 stores), RW & CO. (76 stores), Thyme Maternity (68 stores), and Smart Set (94 stores).  RET also operates 21 Thyme Maternity shop-in-shop boutiques in select Babies R Us locations in Canada.  FYE Jan 2015 revenue, adjusted EBITDA, and free cash flow (we define as cash from operations less capital expenditures) were $939m, $65m, and $35m, respectively.  RET is trading at about 27% of revenues, 4x adjusted EBITDA, and a 13% unleveraged FCF yield.  RET trades at 3x our projected adjusted EBITDA of $85m for FYE Jan 2017.  Further, RET has a “Ft. Knox” balance sheet, with $190m in net cash at FYE Jan 2015 or about 40% of RET’s market cap of $450m. 

We like RET’s focus on delivering fashionable clothing to women at value-oriented prices.  We believe, post-recession, women are focused on good quality and fashionable merchandise at value prices.  We believe RET has some of the strongest specialty retailing assets in Canada and a larger network of stores in Canada than any other women’s specialty retailer.  We believe RET’s average transaction size is about $40 to $80, depending on the brand, so RET is serving middle income women in Canada, not unlike Ascena (ASNA) in the U.S. market, which we believe is an attractive market segment. 

Since FYE Jan 2006, RET has endured several years of declining revenues and adjusted EBITDA due to increased competition, including foreign entrants, weaker consumer spending, increased online purchases by consumers, a decline in the Canadian dollar versus the U.S. dollar which significantly reduced gross profit margins, and excessive investment in new stores.  RET’s adjusted EBITDA was reduced from $184m in FYE Jan 2011 to $65m in FYE Jan 2015.  There were several missteps during this period, including a disastrous foray into the U.S. 

There is some evidence that RET’s multi-year slide in revenues and adjusted EBITDA might be at least stabilizing, with growth in adjusted EBITDA possible in FYE Jan 2016.  RET’s comp store sales were positive in Q2, Q3, and Q4 of FYE Jan 2015, the first time in a long time that has happened.  Further, adjusted EBITDA grew sharply in Q4 of FY15 from $8m to $14m, which followed adjusted EBITDA growth in Q3 of FY15 from $21m to $31m.  For FYE Jan 2015, RET comp store sales were +1.2%, which were the first FY of positive comp stores sales in the last seven years.  In December 2013, RET sharply reduced dividends from $50m per year to $13m per year.  Capital expenditures were also reduced from $84m in FY13 to $39m in FY14 and $29m in FY15, as RET halted new store openings and closed under-performing stores to focus on its strongest banners and the shift towards online purchases.  We believe RET’s net cash position could build substantially over the next two FY’s and this could be a catalyst for its under-valued shares.

We believe that RET can stabilize its revenue decline and improve adjusted EBITDA margins over the next two years.  We believe RET could achieve adjusted EBITDA of $85m+ in FYE Jan 2017 and have a net cash position of $250m+ by FYE Jan 2017.  We believe RET could trade for 6.5x adjusted EBITDA of $85m in FYE Jan 2017 plus its net cash position of $250m or a market cap of about $800m.  Based on 65m shares outstanding, RET could trade for $12.30 per share, or 80% higher than today’s price of $7 per share.

Strong Business Model

RET has an attractive business model with high gross margins (60.4% in FY15), modest capital expenditures (3.1% of revenues), and well-controlled working capital ($115m average inventories vs. almost $940m of revenues). We believe RET can eventually get adjusted EBITDA margins to 10% (well below historical peaks) with modest capital expenditures and working capital.  RET is generating strong free cash flows even in its current turnaround mode: in FYE Jan 2015, RET generated free cash flow of about $35m.   CEO Jeremy Reitman is leading an aggressive program to reduce costs, close under-performing stores and banners, and stabilize comp store sales performance.  The Reitman’s are the largest shareholders of RET, with the only voting-stock, and we believe they are extremely focused on increasing RET’s dividends back toward historical levels.

RET’s cash generative business model has historically enabled RET to concurrently make organic growth investments and pay large dividends.  Over the six years from FYE Jan 2010 to FYE Jan 2015, RET paid over $300m in cumulative dividends or about 120% of its current EV.  The combination of these shareholder-driven activities, concurrently executed, likely represents a very powerful driver of long-term shareholder value creation.  Over the period from FYE Jan 2010 to FYE Jan 2015, RET has generated $591m in cumulative cash from operations, or over 2x the current EV.  Clearly, the competitive environment is tougher today, but we still believe this cumulative cash from operations number speaks to the strong ability of RET to generate cash, even in today’s environment.

Attractive Valuation

RET has about 65m shares outstanding at about $7 per share for a market cap of about $455m.  RET has a Ft. Knox balance sheet with a net cash position of $192m at FYE Jan 2015.  RET has an enterprise value (EV) of about $260m.  RET is trading at about 4.0x FYE Jan 2015 adjusted EBITDA of $65m.  RET has recently stabilized comp stores sales, which have been declining for several years, with positive comp stores sales achieved in Q2, Q3, and Q4 of FY15. 

RET’s adjusted EBITDA is benefiting from a strong focus on cost reductions and closing under-performing stores.  RET has made significant investments in upgrading its IT systems, with about $26m spent of a total $36m expected investment.  RET’s upgraded IT system is expected to come online in calendar 2015 and should help achieve cost savings and create efficiencies.  RET is also consolidating its merchandising sourcing among its various brands and upgrading its merchandise systems in stores.  RET is closing its weak performing Smart Set banner and shifting most of its store base to stronger brands.  We believe RET has substantial cost saving programs in place to drive improved margins in FY16 and FY17 and store closings should help stabilize and improve comp store sales performance.

We believe that RET can stabilize its revenue decline and improve adjusted EBITDA margins over the next two years.  We believe RET could achieve adjusted EBITDA of $85m+ in FYE Jan 2017 and have a net cash position of $250m+ by FYE Jan 2017.  We believe RET could trade for 6.5x adjusted EBITDA of $85m in FYE Jan 2017 plus its net cash position of $250m or a market cap of about $800m.  Based on 65m shares outstanding, RET could trade for $12.30 per share, or 80% higher than today’s price of $7 per share.

Private Label Focus, Currency Exposure

It is important to note that most of RET’s merchandise is private label and manufactured in China and paid for in U.S. dollars.  Therefore, RET faces currency exposure, since cost of goods sold is paid in U.S. dollars while revenues are realized in Canadian dollars.  The depreciation of the Canadian dollar against the U.S. dollar over the past few years has impacted RET’s gross margin, which was about 60.4% in FYE Jan 2015 versus 64.5% in FYE Jan 2009.  RET indicates that it has hedged about 60% of its expected cost of goods sold requirements for FYE Jan 2016, as noted in its most recent financial report, and that each 1% decline in the Canadian dollar would impact operating profit by about $0.5m per year.  RET was able to significantly offset gross margin pressures due to U.S. dollar strength in FY15 through improved inventory controls and merchandising activities.  We believe RET will be able to maintain gross margins near the FY15 level of 60.4%.  However, this is clearly a risk that investors will need to monitor.

Background

RET has six established brands that cater to different consumer segments.  The Reitman’s brand (www.reitmans.com) operates 343 stores averaging about 4,600 square feet and is Canada’s largest women’s apparel specialty chain and leading fashion brand.  Reitman’s has developed strong customer loyalty through superior service, marketing, and quality merchandise.  The Pennington’s brand (www.penningtons.com) operates 141 stores and is a leader in the Canadian plus size market, with fashionable merchandise and affordable quality for plus size fashion sizes 14 to 32.  Pennington’s operates in power centers across Canada with stores averaging about 6,000 square feet.  Addition Elle brand (www.additionelle.com) is a fashion destination for plus size women with a focus on fashion, quality, and fit, with the latest fashion trends.  Addition Elle operates 104 stores averaging about 6,000 square feet in major malls and power centers nationwide across Canada.  RW&CO brand (www.rw-com.com) operates 76 stores averaging 4,500 square feet in premium locations in major shopping malls across Canada.  RW&CO is a lifestyle brand which caters to men and women with an urban focus.  Thyme Maternity brand (www.thymematernity.com) is Canada’s leading fashion brand for modern moms-to-be offering current styles from casual to work and a complete line of nursing fashion and accessories.  Thyme operates 68 stores averaging 2,300 square feet in major malls and power centers across Canada.  Smart Set (www.smartset.ca) offers stylish wear-to-work separate items, denims, essentials, and accessories with a greater focus on the junior’s category.  Smart Set has 94 stores which average about 2,400 square feet.  In November 2014, RET announced it would close its Smart Set chain and rebrand at least 70 stores.

We believe RET became highly focused on right-sizing its store network and cost structure when it was forced to significantly cut its dividend in December 2013 from 80 cents per share per year to 20 cents per share per year.   Since late 2013, RET has aggressively focused on right-sizing the existing business to its strongest banners, closing under-performing stores, reducing corporate overhead, and sharply reducing capital expenditures.  We think this approach of right-sizing RET’s existing footprint into its strongest operations is the right approach.  Further, we believe this turnaround will not require significant amounts of capital, as existing stores are being closed, expenses reduced, and inventories appear to be tightly controlled.

RET has reduced its capital expenditures from $84m in FYE Jan 2013 to $29m in FYE Jan 2015.  RET greatly reduced new store openings and instead focused on closing under-performing stores.  We believe this is the correct strategy in a Canadian market which is likely fully saturated at this point.  We believe reduced capital expenditures and reduced dividends will result in stronger cash generation by RET over the next couple of FY’s.  We expect RET to focus on its strongest banners, where it has a strongest competitive position, specifically, the flagship Reitman’s banner, and its two plus-size banners, Pennington’s and Addition Elle.  Combined, these banners total almost 550 stores of the Reitman’s chain.  In November 2014, RET announced that it would close its under-performing Smart Set chain of 97 stores, and convert about 70 of the stores to stronger banners, while closing the rest.

Overall, we believe these actions will result in a stronger, more focused, and more profitable RET business model.  Comp store sales have started to reflect some of this turnaround, with RET posting positive comp store sales in FYE Jan 2015 for the first time in seven years.

Solid Competitive Position In Women’s Specialty Retailing

We believe the RET has a well-established competitive position in women’s specialty retailing in Canada, particularly in the plus-size market.  RET is the largest player in women’s specialty retailing in Canada, with about 823 stores across the country.  RET has a strong focus on plus-size retailing, with its Pennington and Elle brands totaling about 250 stores.  There are limited competitors that specialize in the plus-size category in Canada.  We believe plus-size customers generally prefer to make purchases in specialty stores that cater to their niche, as compared to a department store.  RET also offers a much larger selection.  RET merchandise is primarily private label, with a modest fashion element.  RET sells its merchandise at very competitive prices while offering an attractive, higher quality fashion option, with great selection, as compared to discount chains like Wal-Mart or Target. We believe RET’s merchandise is positioned above what customers could find in a Wal-Mart or Target or department stores such as Sears and Hudson’s Bay.  Further, Target has recently exited Canada after a disastrous foray in 2013-4.  We believe RET’s banners are well-established in Canada with long customer histories and relationships.

Strong Cash Generative Business Model and Attractive FCF Yield

RET has a highly cash generative business model.  RET currently trades at an attractive 13% unleveraged FCF yield based on about $35m of FCF generated in FYE Jan 2015 and an EV of about $260m.  Further, we believe RET has good prospects to grow adjusted EBITDA and FCF in FY16 and FY17 as management continues to execute its turnaround program.  Over the six years from FYE Jan 2010 to FYE Jan 2015, RET generated cumulative cash from operations of about $590m or about 220% of the current EV, and paid cumulative dividends of about $300m.

We believe RET’s cash generative business model and strong balance sheet will give management the flexibility to execute programs to improve sales, stabilize gross margins, and reduce operating costs over time. RET’s recent focus on its strongest store banners will continue to result in lower capital expenditures, as new store openings are curtailed and weaker, unprofitable stores are closed.  We expect modest capital expenditures in FYs 2016 and 2017 of about $35m per annum as compared to about $50m over the prior five years.  Further, RET has historically tightly managed inventories, with net sales of about $940m supported by average inventories of about $115m.  We believe RET’s management is aggressive about marking down slow-moving inventories.

“Ft. Knox” Balance Sheet with Expected Steady Build Up in Net Cash Position

RET has a “Ft. Knox” balance sheet with a net cash position of $192m at FYE Jan 2015.  We believe RET could generate $40m of FCF per year in FYE Jan 2016 and 2017 and could end FYE Jan 2017 with net cash conservatively at $250m+.  We think RET’s growing net cash position, on a year over year basis, will highlight its improving business model.  RET’s “Ft. Knox” balance sheet gives management the flexibility to execute its turnaround plan and drive shareholder value over time.

Improving Financial Results for FYE Jan 2015, Especially for Q3 and Q4

FYE Jan 2015 revenues were $939m or down 7% versus $960m in prior year and adjusted EBITDA was $65m versus $71m in prior year as RET closed under-performing stores and reduced operating expenses to stabilize comp store sales and adjusted EBITDA.  Importantly, comp store sales for FYE Jan 2015 were positive 1.2%, which is the first full fiscal year positive comp store sales result in seven years for RET.  Recent quarters have been solid, with Q3 comp store sales up 0.2% and adjusted EBITDA increased from $20m to $30m versus prior year.  Q4 results were also solid, with comp stores sales up 2.1%, and adjusted EBITDA increased from $8m to $14m.  RET appears to have good momentum heading into FYE Jan 2016.

Seasonality

RET’s business is subject to seasonal fluctuations, based on the spring and fall seasons, with strongest revenue quarters being Q2 (ended July 31), representing the summer season, and Q4 (ended January 31), representing the fall season.  RET’s strongest quarters for adjusted EBITDA are typically fiscal Q2 and Q3.  RET’s inventories generally peak in fiscal Q1 and Q3, ahead of the key selling seasons, with strong cash generation in fiscal Q2 and Q4.

Leaner Cost Structure Should Help Drive Stronger Adjusted EBITDA

RET has made several difficult decisions to improve operating performance and we believe results are starting become apparent.  RET exited the U.S. maternity business, exited other banners, and recently announced plans to exit its poor-performing Smart Set banner, over the next year.  Key drivers of improved margins are likely to be: (a) continued closing of unprofitable stores; (b) reduced corporate overhead; (c) improved IT systems; and (d) lower cost sourcing of merchandise in Asia.

Smart Shareholders, Motived Management

RET has attracted some smart, value-oriented shareholders in Canada, including Fairfax Holdings (Prem Watsa), which owns about 13% of RET’s fully diluted shares outstanding, which we believe were purchased for about $6 per share.  Also, Chou Funds (Francis Chou), which has an excellent long-term value-investing track record in Canada, has purchased a significant position in RET.  While the presence of these successful investors is no guarantee of success, we believe it can sometimes indicate an under-valued investment opportunity.  We also note that the Reitman family is the largest shareholder of RET, with approximately 14m voting shares, and we believe is extremely motivated to turnaround the business.

Private Equity and Strategic Acquisition Focus on Specialty Retail

There have been numerous private equity transactions in the specialty retail industry which we believe reflects the strong cash generation characteristics of the industry.  These include Burlington Coat Factory purchased by Bain, J. Crew purchased by TPG, Gymboree purchased by Bain, Claire Stores purchased by Apollo, Charlotte Russe purchased by Advent, Talbots purchased by Sycamore, PetSmart by BC Partners, and Eddie Bauer purchased by Golden Gate.  Other rumored potential transactions include The Children’s Place, Chico’s, and Express.  While clearly all of these transactions have not been successful, we believe the continued interest of private equity in the specialty retail industry reflects its favorable financial characteristics.  There has also been significant strategic interest in specialty retail, including, most recently, Ascena’s (ASNA) announced acquisition of ANN Inc. (ANN).  Overall, we believe these acquisition transactions reflect the inherent value that investors see in well-run specialty retail operators.

Attractive Upside Potential

In FYE Jan 2015, RET generated about $65m of adjusted EBITDA and $35m of FCF.  We believe RET can grow adjusted EBITDA and FCF in FYE Jan 2016 and 2017 based on stabilized comp store sales, continued brand refinements, aggressive cost reductions from reduced corporate overhead and closing unprofitable stores, and tightly controlled capital expenditures and working capital. We believe the increased focus on stronger brands and strategic investments in IT systems will help RET stabilize its revenue base in FYE Jan 2016 and 2017 and adjusted EBITDA margins will increase as these investments and cost programs are fully implemented.

We believe RET can achieve adjusted EBITDA of $85m+ in FYE Jan 2017 and build its net cash position to $250m by FYE Jan 2017.  We believe RET could trade for $550m or 6.5x adjusted EBITDA in FYE Jan 2017, with net cash of about $250m, or a market cap of about $800m or, based on 65m total common shares outstanding, or a share price of about $12.30 per share, about 80% higher than current price of $7 per share.

Share Repurchases and Dividends

RET paid about $300m in cumulative dividends from FYE Jan 2010 to FYE Jan 2015, which is about 120% of the current EV.  Clearly, the competitive environment is tougher in RET’s industry and we believe the company is unlikely to return to prior levels of cash generation.  However, we think RET can make improvements to get financial performance well above current levels.  We believe the Reitman family will seek to reinstate a higher dividend if RET is able to stabilize its operations and as its balance sheet continues to get stronger over time.  RET’s ability to invest in its business and concurrently pay significant dividends highlights the cash-generative nature of its business model.

Conclusion and Target Price

Based on 6.5x our adjusted EBITDA estimate of $85m for FYE Jan 2017 and net cash of about $250m, we believe RET could trade for a market cap of close to $800m or $12.30 per share or more versus $7 per share today (+80%).  If RET continues to execute its turnaround plan and its women’s specialty retail business performs as we expect, we think our target price can be achieved.  Further, RET’s business has a well-established competitive position in Canada with well-known brands and strong store locations and could be an attractive acquisition to a strategic or private equity acquirer.

** includes 51m Class A shares which are non-voting and 14m common shares, which are primarily owned by the Reitman family.