The initial reasons for my purchase are as follows:
- Annuity type business, coupled with less consumer sensitivity to children's clothing vs. other non-children focused apparel businesses
- Potential catalyst in that two activist investors have recently won seats on the board. See link to the following bloomberg article describing the circumstances
- Recent initiatives taken by management to make transformative changes to the business, including growing ecommerce channels, closing underperforming stores, and purchase and implementation of a new ERP / inventory management system, which could translate into better inventory management and (hopefully) improved future free cash flows
- The possibility of private equity interest/involvement at some point in the future. Bain Capital purchased Gymboree back in 2010 in an LBO, see link to the following bloomberg article describing the deal. Bain paid 7.7x EBITDA and 13x free cash flow. A similar deal would value Children's Place at an EV of around $1.1B, approximately 35% more than current
- Market wide pressure on "anything" retail, especially as of late, resulting in a compelling valuation (which could become even more compelling :( :( :( )
From the above noted bloomberg article re: appointment of activist investors, my takeaways are as follows:
- Current CEO's compensation cited as "egregious" <translation, get rid of problem CEO, increase free cash flow>
- Merchandising and inventory problems need to be rectified <translation, new ERP systems should "theoretically result in improved free cash flow>
- Possibility of an eventual sale evident
I modelled free cash flow to the firm, and came up with the following free cash matrix, using the following assumptions:
- Base year free cash flow of $108M, plus an adjustment for cost of debt service in lieu of capitalizing operating leases of 5% x $877M, resulting in adjusted FCFF of $151M
- Net debt of $673M (capitalizing 100% of operating leases), deducted from FCF's
- Expected future growth in free cash flow of between 0% yrs 1-5, 0% yrs 6-10, and 0% terminally, up to 4% yrs 1-5, 2% yrs 6-10, and 2% terminally
I note that actual free cash flow growth over the last 14 years has averaged 9% since 2002, and has exceeded $90M per year (excluding 2012) since 2009 (before adjusting for capitalized leases).
|Sum of DFC's||Re =|
|G =||8%||9%||10%||12%||15%||Average, growth, blended Re|
|Average, Re, blended growth||102.71||82.65||67.84||47.37||28.66|
I also modelled theoretical EPV in order to determine a potential margin of safety at different WACC's. I note that at WACC's in excess of 10% up to 11.5%, a potential margin of safety exists:
|Cost of capital rates:||EPV||Adj for Debt & Excess Cash||Adj EPV||O/S shares||EPV / share||BVPS / share||Excess EPV||Current price||Price / EPV||Prem/Discount vs EPV|
|LT equity return; 2014 - 1928||11.53%||2,167.62||-673.00||1,494.62||20.6||72.55||25.9||2.80||48.7||0.67||-32.88%|
- Retail is super-competitive. Children's Place Inc.'s gross and EBIT margins have dropped from around 40% and 8% back in 2006 to 35% and 5% respectively currently. There's no reason why margins can't continue to drop.
- New ERP/inventory management systems could take longer to implement, or prove more costly than initially expected
- Activist's on the board may not result in discernible operational improvements or an eventual sale.
- I'm likely early in my purchase based on the above DCF analysis. If the market continues to punish retailers, there's no reason why the Children's Place, on any hint of performance less than current expectations, can't get down to the low $40's or even mid $30's.
Certainly this purchase is not without risk, but my thoughts are that the presence of the activist investors on the board coupled with the relative stability of the children's clothing business could make Children's Place a possible acquisition target. <PS, my analysis should not be construed as a buy recommendation whatsoever.>