Description

Thesis

Vera Bradley (“VRA”) is a branded women’s bag maker best known for its cotton quilted bags, and sometimes compared to brands such as Michael Kors and Coach. VRA is the #2 women’s backpack maker in the US (behind JanSport) and #3 market share in women’s bags (behind Michael Kors and Coach). Its products are available through its 113 full-line stores and 49 outlets (Direct channel), as well as partner stores like Macy's and 2,400 independent retailers across the US. It trades for 4.1x EV/LTM EBITDA. We believe that if VRA decided to shift its focus from growing its brand beyond its core demographic to maximizing the profitability of its current customer base, its EBITDA would double to ~$90M. We think this is a turnaround story with a comfortable level of safety and downside, and can offer attractive risk/reward within a 2-3 year investment horizon. Our thesis:

1. VRA is cheap: it has limited downside given that tangible book value per share is $7.43. This is comprised of cash and short-term investments of $2.82 per share, net working capital of $2.50 per share and the balance being owned land and buildings and other fixed assets of $2.11 per share. VRA has historically been a 30%+ ROIC business and is generating ample free cash flow (a 10% forward UFCF yield on management’s guidance for FY18). We also believe there is significant value in VRA’s brand which resonates strongly with its core demographic. In fact, we think the brand alone could be worth well over $100M in a transaction (note that BEBE recently sold its brand which was an entirely specialty retail brand with less than $400M of revenues that was unprofitable and had limited “brand value” for $70M in December 2016 or ~.2x brand revenues)

2. Potential Catalysts:

1. Streamlining of corporate over-head and refocusing on profitability vs growing the brand: Our research suggests that (1) the company’s corporate overhead is geared for a $1B+ revenues business and (2) 60-65% of revenues are generated by the “core” consumer (girls below the age of 20 and women above age 45), while the balance is made up of the “non-core” consumer (women between ages 25-45); however, VRA spends 60%+ of their marketing and advertising dollars on the non-core consumer that only accounts for 35-40% of revenues. In other words, the company could cut 60% of its marketing and advertising expenditures and retain its most loyal, and profitable consumers.

2. Closure of unprofitable full-line stores: Possibly one of the most overlooked aspects of VRA is its ability to close down over half of its 162 store-base within the next 2-4 years due to the 5-year kick-out clauses in its 10-year leases. This means that VRA will readily be able to close down unprofitable stores as their leases come due or hit the 5-year mark within the next two to three years.  Management has also indicated that it is closing up to 15 underperforming full-line stores within the next 24 months, the first ever round of store closings for the company.

3. Manageable lease structure, clean balance sheet, and significant online presence: Annual rent expense of ~$30M on an annual gross profit base of $200M+, no debt, and 20-25% of sales online differentiate it from the slew of distressed retailers in the market [VRA has been direct to consumer via the web for quite some time and fulfills through an efficient centralized distribution model].

4. Solid capital allocation: VRA has been buying in ~5% of its shares annually for the last few years  

Business Description

• VRA has two channels through which it sells its products: Direct (73% of revenues) and Indirect (27% of revenues). These segments have very similar margin profiles, with gross margins around 56%. Within both segments, VRA sells:

• Bags (43%): totes, crossbodies, satchels, clutches, backpacks, baby bags, and lunch bags

• Travel products (25%): rolling luggage, cosmetics, travel and packing accessories, and travel bags which includes their iconic duffel and weekend bags

• Accessories (22%): fashion accessories such as wallets, wristlets, eyeglass cases, jewelry, and scarves and various technology accessories

• Home products (5%): textiles, including throw blankets, beach towels, and comforters, wellness and beauty, as well as items such as mugs and tumblers

• Other (5%): apparel/footwear, stationery, merchandising, freight, licensing revenue, and gift card breakage revenue

• Indirect channel (27% of revenues): VRA sells its products to approximately 2,400 specialty retail locations, as well as department stores (730 of them such as Macy’s), and third-party e-commerce sites. The Indirect channel has suffered over the past few years as seen below:

Management is guiding for another year of mid-teens declines in the segment. At its peak about 5 years ago, the Indirect business had roughly 4,000 specialty retail locations, but due to a channel conflict, many third party accounts decided to sell less of its products or drop them all together. In our research, we’ve found that the channel conflict stemmed from price competition with Vera Bradley full-line and outlet stores in the Direct business.  

• Direct Channel (73% of revenues): The Direct business consists of sales through its 113 full-line and 49 factory outlet stores in the US, verabradley.com, direct-to-consumer eBay sales, and the Company's annual outlet sale in Fort Wayne, Indiana. Management started opening stores in 2006 with 10 year lease-terms and has aggressively added over half its current store-base count since 2013. VRA used to be run under the Indirect business model prior to adding any stores, and had built out it’s e-commerce platform starting over a decade ago (which is why online sales are now 20-25% of total sales). Same-store sales turned negative in 2014, and management is guiding towards another year of single digit comparable store sales decrease:

We can also back into the breakout of retail vs online revenues as seen below [note that e-commerce revenues are stable at $120M per annum]:

The current store count is 162 stores and management has indicated that under the current strategy, it envisions seeing 100 full-line and 50-60 factory outlet stores in the near future (including the 15 planned closures). Stores are mostly outfitted in A, A-, B+ malls, with some sort of J.Crew adjacency. Rent expense is currently ~ $30M, which is roughly 15% of the SG&A, spend:

Despite spiraling revenues and ugly comps, this part-retailer has been run fairly well. As seen , most other retailers are highly leveraged compared to VRA on a Net Debt/EBITDAR basis:  

• Demographics: Vera Bradley and its products have historically generated interest among older (women age 45 and older) and younger consumers (girls below ages of 20). This core customer base is higher in income ($100k+ household income level) and appreciates both form and function. This core customer tends to shop in-store and online for multiple purchases for herself and others. Over the last few years, VRA has been targeting consumers that are not core to the brand in the age range 25-45, which is where a substantial amount of marketing dollars goes toward (more on this later). The idea is clearly to grow the brand’s appeal.

Valuation

• At its current price, VRA, a recognized mid-tier brand with a loyal core customer base, trades for an EV/LTM EBITDA multiple of 4.1x and an UFCF Yield of 27% ([LTM EBITDA-Capex-Taxes]/EV, with Capex at ~$10M which is at the lower end of next year’s guidance). This is based on the dismal forward guidance management has given.

• VRA trades at a significant discount to its peers:

Even with depressed EBITDA levels, VRA is cheaper than its peers on a relative basis as seen by its LTM EV/EBITDA of 4.1x and EV/Sales of .46x. It’s worth noting that Kate Spade (KATE) was acquired by Coach (COH) for roughly 9x LTM EBITDA and 1.7x LTM Sales in May 2017. Although we wouldn’t argue the VRA brand is as strong as the KATE brand, we certainly believe VRA—a solid mid-tier brand with a loyal customer base according to our research—is worth more than its current valuation. More importantly, VRA is cheap on a hard asset basis which should help provide downside protection in the event of greater-than-expected headwinds for the broader retail industry.

• VRA can essentially be liquidated for approximately the current purchase price today: Assume the VRA brand is worth 25% of the annual LTM revenues (the Bebe Brand (NASDAQ: BEBE) recently commanded a 20% valuation for its brand, NWC (current assets ex-cash less total liabilities) is readily liquidated, the land and property is sold (more on this below), and the cash (cash and short+long term investments) is collected. Next assume VRA is able to come off its lease obligations (~$30M annually) by paying 1.5x the annual amount.  

The Land and Building consists of the property (90 acres) and buildings located in Roanoke, Indiana. The property was also expanded and renovated a couple of years ago for $28M. According the property records, the main property is assessed at $17M while the other is at $11.9M. The property is worth roughly ~$29M, or $.81/share. This real estate is unencumbered and well situated for any e-commerce or direct to consumer business. The land value assessment can be found here: http://www.lowtaxinfo.com/allencounty/#/Results

Catalyst

• At one point in time not too long ago, VRA used to be a $100M+ EBITDA business with half of its current 162-count store base. When same-store sales turned negative in 2014, management decided to pursue the a non-core consumer demographic and build unproductive retail stores in an attempt to maximize the brand’s sales. The results, as seen below, are ugly: EBITDA margins and sales both have fallen dramatically from prior year peaks.

Fortunately, things are now headed in the right direction. A small number of profitable factory-outlet store openings and 15 cash-flow negative store closures are planned in the next 24 months. We believe that there are as many as 15 more cash-flow negative stores beyond the original 15 that are planned to close. It’s not entirely implausible to believe that half of the 75+ stores added in the last 1-4 years could be cash-flow negative. Management also indicated interest in closing cash-flow negative stores on our call and the latest earnings call. We believe that most store leases have kick-out clauses at year five, allowing management to significantly reduce store count.

The second part of our catalyst is related to the unallocated corporate expenses. As one can see, these corporate expenses have ballooned over the past few years, rising from just over $50M to $85M today:

Management indicated that the $85M unallocated corporate expenses included back-office functions (IT, HR, finance), as well as corporate marketing expenses (which were ~$40M of the $85M). The company has also indicated that the overwhelming majority of funds in corporate marketing expenses is geared towards acquiring non-core customers (i.e. women in the age group 25-45) and that these non-core customers made up roughly 35% of its sales. If we break apart the core and non-core customers (assuming $35M of the total $40 corporate marketing expenses is associated with non-core customers, 35% of revenues are non-core customers, and allocating remaining expenses equally), we can model out a simple income statement:

This shows us that VRA could shift its focus to its core customers and generate $80M+ EBITDA business today by simply refocusing its strategy away from acquiring non-core customers. While management indicated it was still concentrating its efforts on non-core customers, it can easily pull this lever and can become a smaller, yet highly-profitable, brand focused on its repeatable, core customer.

Upside: Close 15 stores in the next 24 months (add in 3 productive stores this year), shut 5 stores (net) every year after that (store count becomes 125 by year 2023), and make same store sales flat by 2019. Overall sales per square foot falls to $583 by 2023. VRA also makes the rational choice of reducing corporate expenses from $85M today to $50M in 2019 by gutting non-core corporate marketing spend. This eventually falls to $40M by 2023. EBITDA of ~$70M with an exit multiple of 4x. Maintenance capex of $10M. This yields a per share price of $17.47, a 2x upside, or a ~19% unlevered IRR.

Base case: Close 15 stores in the next 24 months (add in 3 productive stores this year), shut 2 stores every year after that (store count becomes 140 by year 2023), but FY2017 declines continue until 2021 (same store decline 7% and in-direct decline 10%). Sales per square foot falls to a dismal $396 by 2023. VRA also makes the rational choice of reducing corporate expenses from $85M today to $50M in 2019 by gutting non-core marketing spend.  This eventually falls to $40M by 2023. . EBITDA of ~$40M with an exit multiple of 4x. Maintenance capex of $10M. This yields an $11 share price, a ~10% unlevered IRR.

Downside case: Keep store count at 150 from 2018 and onwards, every single segment declines by 10% every year, EBITDA becomes negative in 2020. Corporate expenses are not gutted. Sales per square foot falls by half to $322 by 2023. Maintenance capex of $10M. At the end of 2023, one can liquidate VRA for $4.94/share (remaining cash and NWC after cash burn), or a 40% discount to current price.

Management

• The 2 founders, both close to 80 years old, own almost 40% of the stock, and one of them is active in design and strategy

• The previous CFO joined in 2013 and left in March 2017 for unknown reasons, and we think the Interim CFO John Enwright is competent and recognizes what levers to pull in order for VRA to become the highly profitable brand it once was

• CEO Robert Wallstrom also joined in 2013 and is the reason for the downturn of VRA. We wouldn’t be surprised if he is let go some time in the next 1-2 years after the permanent CFO replacement is found. It seems like he is bent on continuing the same strategy of trying to appeal to the non-core customer base.

Risks

• Retail is exposed to general economic conditions and consumer confidence/spending

• The Vera Bradley brand could be in perpetual decline or permanently impaired

• Management continues value-destructive path of focusing on non-core base of customers at the expense of profits/cash flow

• Management doesn’t decide to take advantage of 5-year lease kickbacks in order to close a meaningful amount of cash-flow negative stores

Catalyst

Catalysts (note that ~30% of the shares are shorted, so any hint of good/in-line news will be beneficial for longs):

• Board decides to refocus on core consumer and cuts overhead and restructures stores portfolio

• Comps stabilize

• Old owners decide to sell company either to private equity firm who could realize major expense synergies or another company interested in owning the brand