Description
Investment Summary
Yankee Candle is a very well positioned and well-managed company that dominates the premium scented candle industry with 42% market share. The company¡¦s stock has languished over the past several months due to a confluence of factors including general consumer weakness, sluggish retail sales, high gas prices, lackluster execution and poor investor communication. Although the company maintains industry leading operating margins of 25%, is growing sales in the mid to high single digits, generates returns on capital of 30%+ and is likely to grow earnings per share at rates in the mid-teens, its share price does not at all reflect such growth and does not account for the quality of the company¡¦s competitive position. At approximately 12X 2006 earnings, (net of the company¡¦s tax asset), an investment in Yankee at current prices represents an excellent risk/reward and is likely to generate annual returns in the high teens or low 20s over a 3-5 year time period with minimal risk of capital loss.
The Business
Yankee Candle is the leading designer, manufacturer, wholesaler and retailer of premium scented candles. The company has a 36-year history of offering distinctive jar candles, votive candles, wax potpourri and other candle products and marketing them as affordable luxuries and consumable gifts. Yankee is a uniquely positioned company not only in terms of its extensive product array, but also through its vertical integration. In addition to its 372 retail stores and approximately 16,300 wholesale locations in North America, the company also sells its products through direct mail catalogs, its website, www.yankeecandle.com, international distributors and its distribution center located in the United Kingdom. Yankee was acquired from its founder, Mike Kittredge, by Forstmann Little in 1998 and went public in July 1999.
Yankee has been proactive at managing and growing its business and has been pushing productivity and enhancing efforts at its retail locations through new product and scent offerings as well as by pursuing its unit growth strategy of 40-45 retail stores annually. Strong store-level economics and the low saturation level of the Yankee concept underpin confidence in the company achieving a 600-700 retail store network over time, which is consistent with management¡¦s goals. This rollout, together with nascent efforts to enter certain consumer products and home furnishing categories, as well as modest wholesale channel growth, should provide additional growth opportunities for the company for several years to come. Yankee¡¦s retail strategy has also helped build customer awareness and exceptionally strong brand loyalty.
The Yankee Candle brand is in some ways a cross between See¡¦s Candy and Starbucks though, of course, not nearly as successful to date. See¡¦s Candy is the dominant brand of high quality candy on the West coast and has built an incredibly loyal customer base that has a cult-like following. It is important to note that See¡¦s Candy has stayed focused on the West coast market and has not aggressively extended its brand nationwide. On the other hand, Starbucks has created the dominant, nationwide brand for coffee. Starbucks¡¦ roots are in Seattle, where it built a similar cult-like customer base for coffee before successfully expanding nationwide by filling a vacuum for branded high-end coffee. Yankee started off by building an exceptionally strong brand and loyal customer base for scented candles on the East coast similar to See¡¦s Candy. The company recently began expanding from its New England cult-like roots and has driven growth by migrating west and starting to build a national brand like Starbucks.
Yankee has reaped the benefits of a vertically integrated structure as it has generated mid-20% operating margins over the past several years ¡V the second highest of any specialty retailer. The strong economics of Yankee¡¦s business also allow it to earn superior returns on capital of 30%+ and generate substantial free cash flow (7%+ FCF yield). The latter should afford the company the flexibility to return cash to shareholders through its $150 MM share buyback program and 1% dividend yield, or redeploy cash into growth-generating areas including:
„X rollout of retail stores at 40-45 units per year, which is consistent with management¡¦s guidance;
„X rollout of its lower-end brand of candles, Plymouth Bay, to more Costco doors and other existing and potential mass channel retailers;
„X international expansion opportunities, which currently account for less than 3% of revenues but are growing at rates well into the double digits;
„X product line extensions and related development of new retail concepts;
„X consumer products (such as fragranced soaps, lotions and gels), diffusers and a housewares/furnishings initiative under the Yankee Home Store brand;
„X new wholesale outlets, similar to the lifestyle retailers Linens ¡¦n Things and Bed Bath & Beyond, as well as department stores similar to Dillard¡¦s and JC Penney; and
„X additional flagship stores in other parts of the country (the company recently opened its second flagship store in Williamsburg, VA in November of this year).
Yankee¡¦s attractive returns on capital of 30%+ are a direct reflection of strong store-level returns and favorable economics with its wholesalers. On a total investment of about $265,000, an average retail store ramps up to approximately $750,000 in sales and generates an after tax return on capital of approximately 33%.
Just last year Yankee entered the diffuser market and added two significant product line extensions ¡V YC At Home and Stripes. YC At Home and Stripes are specifically targeted to appeal to a wider customer base and draw new people into the stores, particularly in the western U.S. Yankee has also recently been testing a lower-end brand, Plymouth Bay, at Costco. To date, there have been early signs of consumer acceptance for all four products, particularly Plymouth Bay which has been performing better than management¡¦s expectations.
Investment Considerations
Management: Yankee Candle¡¦s management team is experienced, smart and focused. As background, founder Mike Kittredge removed himself from day-to-day operations just prior to the sale of the company to Forstmann Little in 1998. Kittredge¡¦s team ran the company until a few years ago, when professional management was recruited by Forstmann to fill key positions. CEO Craig Rydin was recruited in 2001 from Campbell Soup, where he had enjoyed successive promotions from that company¡¦s Pepperidge Farm bakery division. He served as President of the Godiva Chocolates unit and advanced to President of the Campbell¡¦s away-from-home food business. Rydin is extremely focused on protecting the company¡¦s dominant brand and high returns on capital and he brings nearly 30 years of experience and a successful track record to Yankee.
Bruce Besanko recently joined the company in March 2005 as CFO. He was hired to replace the company¡¦s long-time CFO, Bob Spellman, who announced his plans to retire earlier this year. Besanko most recently served as VP of Finance for Best Buy from 2002-2005. Prior to joining Best Buy, Besanko held several financial leadership positions of increasing responsibility for Sears, Roebuck and Co. Besanko is insightful with respect to capital allocation and was instrumental in the company¡¦s recent $150 MM buyback announcement.
Other key management team members include Harlan Kent, President, who was formerly SVP and GM of the Wholesale Division of Totes Isotoner Corporation (and who is an excellent manager with a strong grasp of Yankee¡¦s business as well as the overall candle market); Stephen Farley, SVP of Retail, who was formerly EVP of Marketing and Merchandising for The Bombay Company; Lori Klimach, SVP of Wholesale, who was formerly VP of Sales for Worldwide Consumer Medicines at Bristol-Myers Squibb; Paul Hill, SVP of Supply Chain, who formerly held various supply chain and strategy positions for Kraft Foods; and Richard Ruffolo, SVP of Marketing and Innovation, who was formerly VP and Category Leader of Bath & Body Works¡¦ True Blue SPA and American Girl businesses.
Yankee¡¦s Board of Directors is remarkable, particularly for a company that is roughly $1 BN in total market capitalization. The board is comprised of the following individuals:
Board Member Company Title
Craig Rydin Yankee Candle Chairman and CEO
Michael Archbold Saks Fifth Avenue Ent EVP and CFO
Dale Frey GE Investment Corp Retired Chairman & Pres
Michael Hines Dick's Sporting Goods EVP and CFO
Sandra Horbach The Carlyle Group Global Partner
Carol Meyrowitz TJX / Marmaxx Group Former EVP / President
Michael Polk Unilever Foods President
Ronald Sargent Staples Chairman and CEO
Vijay Vishwanath Bain & Company Partner - Head of Retail
Doreen Wright Campbell Soup Company SVP and CIO
Industry: The total candle market grew at 12% per year between 1996 and 2000, while premium scented candles grew faster, at 15% per annum. Since that time, however, the candle business has slowed to a growth rate of approximately 2%, reaching a market size of $3.2 billion in 2004. This slowdown was largely due to decreased consumer spending and slowing mall traffic as a result of the consumer-led recession and an increase in online shopping. According to Kline & Company, the premier consulting firm covering the candle market, the long-term growth rate for the total candle market is projected to be slightly above inflationary growth, or approximately 2-3% annually.
Yankee¡¦s core market, the premium scented candle market, accounts for approximately 56% of the total candle market. Although this market is highly fragmented at the low end, the top 5 companies hold over 65% market share. Estimated market share for the top 5 players is as follows:
„X Yankee Candle 42%
„X Bath & Body Works 10%
„X Pier 1 9%
„X Village 4%
„X Blyth 4%
The premium candle market is expected to grow faster than the overall candle market, at a rate of approximately 3-5% per year. It is important to note that even though overall candle market growth has slowed, Yankee continues to gain market share at the expense of attrition among smaller players. Note that over the past 4 years, Yankee has grown its market share from 33% to 42%. This is primarily as a result of its strong brand proliferation and superior distribution capabilities. Yankee has also done an excellent job of stimulating demand for candle accessories and non-candle based fragrances, as candles currently represent approximately 72% of total company sales, down from approximately 90% in 1999.
Scented candles have today become the primary means of diffusing fragrance in the home, accounting for approximately 57% of the home fragrance market in 2002 versus just 32% in 1997. Reasons for this dramatic growth include faster growth in the 35-64 age demographic (prime consumers of candles), an increasing trend towards home entertaining and decorating, the affordable nature of scented candles as a gift item or for personal use and the consumable nature of candles. The last of these points is particularly important, as repeat customers will replace scented candles after they have burned them. Some candle lovers have a very strong bond with their candles since they turn to the candles for comfort. As such shoppers are loyal to the Yankee Candle brand, they represent an extremely valuable recurring revenue stream for the company. With such large share of premium candle sales, Yankee¡¦s own success in expanding its retail and wholesale footprint nationally helps drive the overall category growth. Although growth in Yankee¡¦s core market has slowed, the company is likely to continue to capture market share and enter into large and growing secondary markets.
It is worth noting that candles are frequently used as gifts. This helps in extending the brand to others that may not be already familiar with it. More importantly, however, the gift shopper does not want something that is too cheap, providing somewhat of a pricing umbrella for Yankee.
Competitive Position: Yankee Candle¡¦s competitive position is truly superb. Yankee enjoys approximately 42% share of the premium segment, versus roughly 10% for its closest competitor, Bath & Body Works. At the heart of this position is a unique breadth of established and evolving fragrance offerings, with more than 100 scents ranging from traditional floral scents (e.g., hydrangea, plumeria) to ¡§edibles¡¨ (chocolate chip cookie, pumpkin pie) to fresh fragrances (summer fresh, clean cotton). Coupled with a sophisticated and highly productive retail store format and an expanding wholesale base, the company¡¦s competitive advantages in the premium scented candle market are formidable and growing. Additionally, Yankee is the most professional and dependable manufacturer that big retailers (e.g., Bed Bath & Beyond, Linens ¡¦n Things, Dillard¡¦s and JC Penney) can trust if they want to sell premium scented candles.
There is extremely strong brand loyalty among Yankee¡¦s customers. Much of it is as a result of the superior quality of Yankee¡¦s products, such as burn-time and strength of fragrance. In fact, the company¡¦s customers shop at Yankee Candle three times more frequently than they do at the next leading premium scented candle manufacturer. The typical Yankee Candle customer purchases $100-$150 worth of Yankee products annually, twice the level of the average candle buyer. Three-quarters of customers will also purchase candles as gifts, which effectively serves as a marketing channel for the company.
Yankee currently does not spend on advertising. The company simply mails catalogs and emails direct-marketing promotions to its existing customer base. If Yankee were to increase its advertising spend, the impact on top-line growth could be significant, though there¡¦s of course the question of how much ROI they would get per dollar spent. The company generally targets an after-tax IRR of at least 15% on new investments. Although they don¡¦t advertise, Yankee Candle is still one of the top-rated gift giving brands. According to GIFTBEAT, a monthly gift industry newsletter, the company rates #1 in the candle category, #1 in the $10 or more category, #1 in the indoor season category, #1 in reorders and #1 in steady sellers.
Because of the company¡¦s strong brand and vertical integration, Yankee enjoys operating margins that far exceed any of its competitors in the candle market. The following is a list of the top 10 specialty retailers and their respective operating margins and valuation multiples:
Company Operating Margin 2006 P/E
Coach 36% 26X
Yankee Candle 25% 12
Chico's 21% 33
Bebe 20% 18
Urban Outfitters 19% 29
Abercrombie & Fitch 17% 15
Claire's Stores 17% 15
Tiffany 15% 22
Pacific Sunwear 14% 13
Limited Brands 12% 15
Note that Yankee trades at a substantial discount to the specialty retailer group. The group, on average, trades at approximately 21X 2006 earnings, whereas Yankee is trading at approximately 12X earnings, despite the fact that it is growing earnings as fast or faster than most in this group.
Yankee¡¦s major candle competitors include Bath & Body Works, Pier 1 Imports, Village and Blyth. The company has been outperforming its competition, especially on the East coast, and is continuing to take market share from its remaining competitors. Competitors such as Blyth have faced difficulties in recent years associated with more commodity-type candle products and have chosen to no longer compete with Yankee in the premium scented candle market. Illuminations, the company¡¦s largest west-coast based competitor, recently filed for Chapter 11 bankruptcy protection and closed 45 of its 90 stores, as competing with Yankee¡¦s brand, vertical integration and superior distribution capabilities proved too difficult.
Overall, Yankee appears to be benefiting significantly from its dominant brand, wide breadth of selection and unique store merchandising approach, as demonstrated by its consistent growth and market share gains.
Price: Yankee¡¦s shares currently trade at roughly 12X 2006 EPS, reflecting concerns around slower industry growth, competition, channel conflict and comp store sales. Despite slower industry growth, Yankee is extremely well positioned to outpace the industry by continuing to garner share from its competition. Yankee¡¦s focus on maintaining its brand strength and loyalty, along with streamlining its retail operations and minimizing cannibalization, has already paid dividends as seen by its steady increase in market share from 33% in 2001 to 42% today. Note that management believes it can increase premium scented candle market share to above 50% over the next 5 years. Furthermore, despite negative retail comps (which the company is focused on improving, and notably, achieved positive retail comps in Q4 2004), Yankee is still generating returns on capital of 30%+.
Many of the above concerns have weighed on the stock for some time now, such that the stock has been essentially flat since June of 2000. In the meantime, and notwithstanding a difficult retailing environment, EPS from continuing operations has grown approximately 125% between 2000 and 2005E (from $0.80 to $1.80) and operating cash flow has grown from $57.3 MM to $113.0 MM. During the same time period, shares outstanding have decreased from 54.7 million to 45.3 million as a result of share buybacks. On a prospective EPS view, Yankee¡¦s shares trade at approximately 12X earnings, a price that undervalues Yankee¡¦s myriad growth opportunities. (Note that Yankee¡¦s multiple of 12X is adjusted for the present value of the company¡¦s deferred tax asset of approximately $80.0 MM, which arose at the time of Yankee¡¦s recapitalization in 1998 and is a future tax deduction that should be fully realized by 2012.)
RISKS
Slowing Industry Demand: After several years of double-digit growth, growth projections for the premium scented candle industry have decelerated to the low single digits. This phenomenon has been worsened by lethargic mall traffic trends, which have been negative for much of the past 3 years. However, it is worth noting that over this same time period Yankee has continued to grow and gain market share and has consistently and materially outperformed its peers. Although I do not expect candle market growth to return to the low double-digits or even high single digits, at current multiples you are not paying for growth anyway.
Brand Dilution: As with the apparel and personal care industries, brand dilution remains a risk for the candle industry. With over 300 different brands, candles can be found in essentially every retail channel from supermarkets and drug stores, to department stores and other mass merchants (e.g. Wal-Mart and Target). CEO Craig Rydin is extremely focused on, and dedicated to, keeping Yankee¡¦s brand dominant and will not risk brand dilution by trading the company¡¦s superior margins for additional sales into the mass merchant channel. Most important, Rydin has stated publicly that the Yankee Candle brand will not enter the mass merchant channel during his tenure. (Note that the company¡¦s Plymouth Bay brand extension will have no association with the Yankee Candle brand, hence it is not likely to cause any brand dilution.)
Over-Extension of Yankee¡¦s Brand: Yankee has a cult-like following on the East coast, particularly in New England. However, it is unclear how Yankee will be able to extend this cult-like mentality and demand for its products as the company expands outside of its home market and across the nation. That said, as stated above, Yankee Candle now rates #1 in the ¡§Gifts Over $10¡¨ category in all four regions of the United States. This gives some reassurance that Yankee has started to achieve strong brand loyalty outside of its home market.
Cannibalization: Yankee must constantly balance its wholesale mix and assess the quality of doors to which it sells its Yankee Candle branded products. For example, the company¡¦s agreements with Bed Bath & Beyond and Linens n Things, while generating strong top-line growth, have probably taken some share out of its traditional retail business as customers may no longer perceive the stores as a destination. That said, approximately 71% of Yankee Candle stores are currently in malls, likely limiting extensive cross-channel competition given that most of its wholesalers are generally located outside of malls.
Negative Comps: Yankee has generated negative retail comp store sales in six of the past nine quarters. However, the company¡¦s total comp store sales have remained solidly positive, averaging 3% over the same time period. Despite negative retail comps, the company is still generating extremely high returns on capital at the store level. The negative retail comps primarily stem from weak traffic trends at malls and conscious cannibalization. As of this past quarter, the company strengthened its core retail team and is now intensely focused on new CRM initiatives, which should theoretically yield improving same store sales trends over time.
Investor Communication / Execution: The company has recently done a poor job of communicating with investors and managing expectations around quarterly earnings guidance. Furthermore, they have been hurt in 2005 by the extension of a semi-annual sale which hit gross margins, lackluster inventory management, sky-high commodity prices for paraffin wax and a sluggish overall consumer. On the execution front, they seem to have learned their lessons with respect to the semi-annual sale and inventory stocking issues, and with respect to commodity prices and the consumer, I don¡¦t have a view as to what the short-term (or long-term) trajectory is likely to be. At current share prices, I am not forced to take a view on such macro-economic factors. Management has recently communicated to investors that it will provide conservative sales and earnings guidance going forward and has stated that its number one goal is to regain investor confidence. Time will tell if they are able to succeed in doing so.
Squeezed by Big Retailers: Although Yankee currently enjoys favorable wholesale economics with big retailers such as Bed Bath & Beyond, Linens ¡¥n Things, Dillard¡¦s and JC Penney, these large retailers could potentially try to squeeze Yankee¡¦s margins. While this would undoubtedly affect Yankee¡¦s profitability, Yankee is not without pricing power. The strength of Yankee¡¦s brand is likely to protect its margins over time with large retailers as the company¡¦s candles are consistently among the #1 or #2 best selling items in its retail partners¡¦ stores.
Market Shift Towards Diffusers: While a potentially significant revenue generating opportunity for Yankee, diffusers could also represent a long-term threat to scented candles altogether. In the future, trends may change and consumers may prefer a diffuser to a scented candle as their primary home fragrance product. That said, this scenario is highly unlikely given the very different ambiance and aesthetic natures of the two products.
Conclusion
Yankee Candle has a striking collection of factors that make it a great company. It has an extremely strong competitive position in an attractive industry that is growing, is run by a focused and smart management team, and is currently trading at a price which represents a significant discount to intrinsic value.
Catalyst
Although this investment is not ¡§catalyst¡¨ based, and is more representative of a Buffet/Munger See¡¦s Candy type purchase of buy and hold, there are a number of catalysts which may pop the stock. Among them are:
1. the successful launch of Plymouth Bay candles;
2. a return to positive comp store sales in the company¡¦s retail segment;
3. an increase in the company¡¦s share buyback plan for 2006 (note that the company recently increased authorization from $100 MM in 2004 to $250 MM in 2005, comprised of a completed $100 MM plan in the first half of ¡¦05 and a $150 MM authorization this past July);
4. successful new product launches in household and accessory segments that augment the candle business; or
5. the rollout of Yankee¡¦s new retail store format which has been generating greater than 50% returns on capital in 3 test stores.