Description

I believe Tilly’s (TLYS) is a compelling long at these levels. This will be a fairly simple pitch of what I believe to be a deep value opportunity with a large margin of safety. Tilly’s is a specialty clothing retailer that is consistently profitable, cash flow positive, growing, and trading at just 6.8x FY19 (Jan ‘20) EPS, 2.5x earnings ex cash, and just 1.2x EBITDA. The stock has sold off YTD due to weak holiday comps announced in January and more recently with the broader market. YTD the stock is down 48%, while its Enterprise Value is down a rather astonishing 75%! I view this recent miss that catalyzed the dramatic stock decline as truly a one-off after years of consistently solid results that has created a highly favorable asymmetric risk/reward. I believe the stock can reasonably be nearly a double from here, with very limited downside due to its huge (and growing) cash balance and consistent profitability. While there is some hair here, which I will note below, the current valuation is implying a terminal brick-and-mortar retail situation, which is simply not the case.

Background on Tilly’s

TLYS is a California based outdoor/surfwear-focused apparel retail chain that serves primarily a teen/young adult demographic. It was founded in 1982 and IPO’d in 2012. They have 240 stores in 86 markets, with over 40% located in California, followed Arizona and Florida each at around 8%. A bit over half (58%) of their retail locations are mall-based, with the remainder being off-mall (36%) and outlets (6%). Additionally, about 15% of overall sales come from e-commerce. A quarter of their sales come from their own branded items, while 75% come from 3rd party brands, including Nike, Adidas, Levi’s, O’Neill, Rip Curl, North Face, as well as emerging brands not typically found at other retailers. 

Under current CEO Ed Thomas (appointed October 2015), TLYS has grown their store footprint only modestly from 219 in FY15 to 240 as of February 2020, instead focusing on remodeling/refreshing 90% of their stores within the last 3 years. They’ve also been slowly growing their e-commerce business as a percentage of revenue from 12.5% of revenue in FY15 to about 15% now. The company, however, over the past year has endeavored to accelerate growth by increasing the pace of new store openings somewhat. In FY19, they opened 14 new stores and plan to open another 15 this year; they also believe there’s meaningful room for e-commerce growth from the current 15% of revenue to at least 20%-25%, which would bring them closer to being inline with other apparel retailers addressing a similar age cohort. 

The company has been profitable every year since 2007 (the earliest year disclosed in their 2012 S-1) and has been a cash flow machine, with FCF exceeding net income by a healthy margin for the last 6 years. This FCF generation has resulted in a very strong balance sheet with $100M of cash (with just a $159M market cap) and no debt and has allowed them to pay special dividends of $1.00/share in each of the last 3 Februarys (2018-2020) and $0.70/share in February 2017. 

Co-founders Hezy Shaked and Tilly Levine own a combined 26% of S/O, while other management and directors own another 4.5% (including vested options/RSUs). 

Financial Summary

While the stock is plenty cheap on trailing earnings at just 2.5x ex-cash, this even somewhat understates the situation, as FCF has consistently exceeded net income. This is true in each of the last 5 full fiscal years (FY14-FY18) and on a most recent trailing 4 quarters basis through Q3FY19. Over the last 5 fiscal years FCF (CFFO less CapEx) has averaged 156% of net income: 

The biggest reason for this is that CapEx has been consistently less than D&A despite modestly growing their store count over this period. Even with a slightly more aggressive store count expansion they’re now pursuing, CapEx should remain at or below their run-rate D&A. The biggest reason for this dynamic was their overly aggressive store expansion under prior management in the 3-4 years after their 2012 IPO. Under the current CEO, expansion has been more deliberate, leading to the ongoing lower CapEx requirements. 

Historical Financials

Recent Miss

Prior to announcing weak (and negative) holiday same-store sales, which will cause Q4FY19 same-store sales to be (2%)-(3%) based on updated guidance from January, TLYS had reported 14 straight quarters of flat/positive same-store sales growth. The (2%)-(3%) now expected compares to guidance given in early December of +2%-5%, so a fairly large miss. With the benefit of hindsight, their original guide seems like it was fairly aggressive, as they were facing a tough compare of +5.8% in the prior year’s Q4 (versus +3.1% compare YTD through Q3). Additionally, there was a shorter holiday season this year due to a later Thanksgiving. That said, QTD through their report in the first week of December comps were tracking strongly so the guide was seemingly well-supported at the time. The company will report its full results this week (March 12). What they saw was a very sharp surprise drop for several weeks in December across all markets/categories, which was actually followed by a nice rebound Christmas week/post-Christmas. It really sounds like the temporary difficulty they saw was an aberration after years of consistently strong comps. They discussed the cadence they experienced over the course of the quarter at ICR in January. 

Coronavirus/Recession Stress Test

As a thought exercise, I went through and estimated the FCF impact for a potential recessionary scenario. Here are the key assumptions:

• FY20E Revenue of $654M takes a 20% hit

• Estimated Product (variable) margins of 47%

• Hold fixed COGS (store leases, store employees, distribution costs) constant

• Hold SG&A constant

• CapEx reduced modestly from $20M to $15M

This extremely bearish scenario results in EBIT margins going from an estimated 5.0% to (5.5%) and FCF going from +$25M to ($25M). This would be a big hit, but this is under a very pessimistic set of assumptions. I don’t view it as realistic, but am including given the current environment. Based on an estimated FY19 (Jan ’20) ending cash balance of $109M, this implies they would have 4-5 years of cash at this burn rate. Note that the company was solidly profitable during FY08-FY09, averaging 8% EBIT margins during the period while growing revenues. This is not another brick-and-mortar impending bankruptcy or anything close, despite being valued as such. 

Lastly, using a conservative $9M of FCF generation in Q4FY19, I estimate TLYS will end their FY19 year with $109M in cash and no debt vs $100M as of Q3FY19 (Oct ’19). The Q4 estimated cash amounts to $3.65 per share, or 69% of the current market cap. 

Negatives/Risks

• Trends change quickly in their target demographic of young people and any missteps on merchandise/inventory can cause a hit to results
  • This risk is somewhat mitigated by the broad portfolio of brands they carry
• While the recent miss amounted to only a couple extremely weak weeks in December which was subsequently followed by improvement, I haven’t heard any satisfying explanation of what caused this. I frankly don’t think management knows what caused this and if they do, they’re not sharing it, which is somewhat concerning.
• While the company’s capital return policy has been quite generous in recent years, it has been solely in the form of large special dividends
  • I believe a regular quarterly dividend and/or buybacks (especially at these depressed levels) would be much better for shareholders. The founders are the largest shareholders and their preference is for these large special dividends. Their Executive Chairman (Hezy Shaked) is one of the co-founders. The founders’ shares are super-voting (10x) class B shares and they have a majority vote, thus I don’t expect the capital allocation policy to change. 
• Along with all brick-and-mortar, they will see an impact from people staying home due to virus concerns, which will be reflected, I believe, in weak guidance for Q1 (Apr quarter) when they report this week
  • I think this is more than reflected in shares, but below consensus guidance may cause further short-term weakness. I think it’s just as likely that there’s a relief rally once the bad news is out however. 
• Like essentially any brick-and-mortar retailer, they have significant operating lease obligations. As I don’t view this as anything resembling a terminally declining business, I don’t view these as a big concern, but it’s worth noting. Here they are as of the end of FY18:

Valuation

TLYS currently trades at 6.8x FY19 EPS and 2.5x ex-cash. Deciding what the right target multiple to use here is difficult when the market is currently valuing a solid business as if it’s in terminal decline. A few markers to consider though are:

• Mean P/E since 2012 IPO: 16.1x
• Mean P/E over the last 5 years: 16.7x
• P/E at the end of CY19: 13.1x

Note that none of these adjust for what has always been a healthy cash balance and are based on trailing EPS.

I’m using the lowest of these three, or 13.1x for a target multiple. This equates to less than 10x ex cash. On this basis, I arrive at a price target of $10.14, representing 91% upside from the last close. With 63% of the market cap in cash (a percentage that will go up to an estimated 69% once they report Q4 this week), I view downside as extremely limited with highly attractive upside, even when erring on the somewhat conservative side, I believe, in choosing a target multiple.

Catalyst

Return to positive comps at some point should allow the stock to re-rate closer to historical P/E multiple

Getting a likely soft guide for the April '20 out of the way this week