Body Central: Thoughts After A Disappointing Quarter

Body Central: Update

Since we wrote our original article in March of this year, Body Central’s (BODY) stock price has experienced significant “volatility” (to use a popular term ) for “a big stock decline”. A 40% rise in the stock price, followed by a subsequent 50% decline in just six months is pretty surprising, even for the volatile teen retailer space. While we had no expectations of a significant improvement in BODY’s 2014 business (the new fashion merchandise is just hitting the stores now), we were surprised that the company hasn’t been able to show stabilization in its core business. After the latest quarterly report, the well documented list of excuses continued to get longer. Instead of simply repeating what was in the press release, conference call, and 10Q, and calling that analysis, we wanted to share our thoughts on the most important aspects of the company’s business.

Confluence of events conspires to negatively impact their business.

Outside of the possible destruction of the company’s new headquarters and distribution center, it is hard to believe anything could have gone wrong in the quarter. Any investor in retail stocks is well aware of the weak sales and earnings reports that a large number of retailers have reported in the last 30 days. Since BODY is in a major transition in terms of management (at least 4 major new hires), fashion (denim and shoes are completely new to their merchandise strategy), customer base (reduction in number of catalogs, focus on “social media” and new customers), store base (“stores are too black and tired”) and information/distribution systems, the company was ill-prepared to suffer a slowdown in general business conditions.

In our original article, we said we would have liked new management to have had more direct experience in teen girl retail turnarounds. The latest quarter illustrates how important that is. The company is changing its merchandise strategy and marketing plan in the middle of the back-to-school season using data it only collected in June and July. The company has also significantly reduced the number of catalogs it sends out to better align the catalog customer with this new merchandise mix and marketing message. While revenue per catalog has been declining for years, a 27% reduction in catalog distribution this quarter only exacerbated the sale decline. On the positive side, management attributed a significant portion of the margin contraction to the direct business and on a sales per catalog basis, the metric flattened after 5 years of declines.

We believe that looking at two or three year stacked same store sales figures give investors a better feel for a retailer’s sales trends than just looking at the current quarter’s numbers. While sequentially, same store sales declined 160bps to -13.2%, on a two-year basis they declined 780bps to -20.8%. This is a huge turnaround from the mid-teens positive comps of just two years ago. There is no other way to say that these numbers were terrible. However, management did attribute a significant part of the decline to fewer catalogs being distributed and on a sequential basis, the YOY change in catalogs more than doubled from -12% to -27%. So at least part of the “dog ate our homework” excuse can be validated.

SSS Mar Jun Sep Dec
2013 -11.6% -13.2%
2012 -1.4% -7.6% -11.9% -11.6%
2011 16.1% 14.7% 8.2% 7.0%
2010 17.6% 14.9%
2 Yr Stack
2013 -13.0% -20.8%
2012 14.7% 7.1% -3.7% -4.6%
2011 25.8% 21.9%

Lower than expected sales almost always lead to higher than expected inventory and this was certainly the case for BODY. While gross margins were only down 380bps, we feel that, based on historical trends, inventory is heavy by about $6-10M in terms of a normalized gross margin. Management stated that gross margin pressure would continue into the third quarter and frankly we think it could be worse than a 380bps decline if management really tries to clear the decks for 2014.

Guideposts

In or original article we said that BODY was “cheap for a reason”. Now the stock is even cheaper for similar reasons, especially on an EV/Sales basis (21% vs. about 38%). Admittedly it is more expensive on any earnings or EBITDA metric an investor would choose to use. Our basic earnings model appears to have been too optimistic on revenue growth in 2014 and SG&A costs. There is a tremendous amount of negativity towards teen retailers as illustrated by the large declines in stock prices and weak same store sales across numerous retailers. However, as is usually the case when that is the situation, valuations, especially on an EV/Sales basis, are near the low end of their historical range (while restaurants, another consumer oriented segment, are trading near the high end of their historical range). Recent 13D filings by Sycamore on Aeropostale (ARO) and Blue Harbour on Chico’s (CHS) and turnarounds at Christopher & Banks (CBK) and Cache (CACH) highlight the opportunity that longer term investors have in the space. To borrow a line from Monty Python and the Holy Grail, it appears as though specialty retailing is “not dead yet”.

With the company valued at only 21% of sales, a valuation typically reserved for low margin grocery store chains and office supply companies, we are not ready to give up quite yet on the long-term potential of BODY. The company has adequate liquidity at this point with a $20M undrawn revolver, $38M in cash (40% of its market value) and cash flow breakeven now. Once the distribution center is completed next year, $10M in cash flow will be freed up. However, we would like to see some progress on the following items as confirmation that we haven’t totally missed the boat and have found the dreaded “value trap”:

  1. Inventory has to come down $24-$26M (this would be better than $30-32M). The first step to margin recovery is always a reduction in inventories which will help reduce markdowns and restore gross margins. However, it is also true that it usually takes a rather large reduction in selling price to clear that inventory, which results in further degradation in gross margins in the short run. Management was clear on the earnings call that this is most likely going to happen in the next quarter or two.
  2. Slow/stop growth in new stores. A big pet peeve of ours is a management team that continues to rapidly grow its store base, while its core business is in disarray. The company is building a new distribution center, while growing its store base by 11% a year and needing to refresh its existing store base. Since rising inventory and lower gross margin and higher SG&A consumes precious cash, it is imperative for management to focus on liquidity and its merchandising and defer the ever popular “we are a growth company” mentality. Stopping store growth can help offset the cash burn from the new distribution center and operating losses. Inventory liquidation and lack of the necessity of purchasing inventory for new stores can also help liquidity. The company’s cash balance and $20M untouched revolver are a comfort at this point.
  3. Stabilize SG&A. SG&A as a percentage of sales has historically been in the low to mid 20s. With all the new hires and store growth, it has trended upwards of 30%. With a gross margin running 30-32%, it is difficult to make money. Management indicated that $23-$24M is a sustainable run rate. Considering it was around $80M just a few quarters ago, more clarity on this would be helpful.
  4. Better articulation of merchandise strategy. On the last conference call, management indicated that a lot of their consumer research was completed in July and that they were learning a great deal about how customers viewed their position in the market. Not only was it surprising to learn that they were that out of touch with their customer, it was also surprising that they set their new merchandise without this information.
  5. Two-year comps need to start improving from down 20%. Two years ago, BODY was showing 14% two-year comps, so the company had its merchandising strategy right in the past. If the new strategy is working, comps over the next three quarters should start coming in at less than minus 8 to 10%, which would move the two-year comp to better than -20%.
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About Tim Heitman