In our last update, we said that CENT had made one step forward and one step back. We think it is fair to say that after reviewing the company’s Q1 FY14 results, the company has finally taken one step forward. Our investment process is to look at the numbers first (SEC filings preferably) and listening to company management and analysts last when we form our opinion as to what the company is actually doing. We also place little faith in the “informational content” of short term stock price movements. Media outlets dutifully reported that CENT “beat” earnings estimates of a loss of $0.31 by $0.05 per share on “better than expected gross and operating margins.” The fact that the earnings estimate was comprised of only two analyst estimates seems less significant to the media or the fact that FY14 and FY15 estimates have been declining all year (down 25-30%). However, we do believe that the numbers do show that management is finally making progress in its multi-year turnaround effort after many fits and starts. [Read more…]
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.
|2 Yr Stack|
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.
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”:
- 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.
- 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.
- 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.
- 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.
- 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%.
As long-term investors, we normally do not pay much attention to any particular quarter’s results or investor reaction to them. However, since Central Garden & Pet’s (CENTA, CENT) stock price declined by almost 25% after investors reacted with vigor to “disappointing results”, we thought we would provide a brief overview of what we think were the important aspects of the company’s results.
We think that short term investors were hoping that CENT’s third quarter results would “beat expectations” due to the relatively good quarterly results posted by competitors Scotts Miracle-Gro (SMG) and Spectrum Brands (SPB). Alas, CENT reported results that missed on both the top and bottom lines and unlike SMG and SPB whose stocks trade near all-time highs, CENT’s stock price recently touched a five year low. Since investors have had ample time to react and overreact to the earnings release and conference call and have already decided what might happen in the next two quarters, we do not feel the need to repeat the numbers here. However, there were a couple of positive developments that we feel should be pointed out.
First of all, as we suggested in our original article, CENT has the ability to raise prices in the pet division due to the more fragmented marketplace. On the latest conference call, Mr. Ranelli reiterated that price increases were taking place in the pet division. We found it encouraging that Mr. Ranelli understands where to take price to attempt to improve margins and is implementing those price increases. We think that operating margins in the pet division can improve quicker and be more sustainable than the garden division. In fact, operating margins in the division declined only 100bps on a 13% decline in sales. It is important for investors to understand that last year the company sold $31 million in new flea and tick products at a very high 30% incremental operating margin. Those sales were $23 million lower in 2013. We also like the fact that the company is considering a low risk strategy of brand extensions in pet products. Numerous other brands from Kong to Martha Stewart have been successful extending their brands into pet supplies. Nylabone is one brand that seems capable of branching out.
The company continues to struggle with weather, competition, commodities prices and slow consumer acceptance to its new products in the garden division. These are all part of the game and tough to predict, but it would be nice to have a few things break their way next selling season. For the first nine months of the year, the garden segment operating profit has declined by $9 million (all occurring in Q3) versus flat operating profit for the pet segment.
Inventory levels continue to be higher than we would like to see and are also consuming more cash than we would like to see at this point in the selling season. So far this year, inventory has been a $78 million drag on cash flow and other negative changes to working capital of around $40 million have resulted in a $130 million negative swing in cash from operations to a drag of $65 million. Management offered several excuses for the increase in inventory including a “planned higher level of inventory this year to support our customer needs and ensure robust service levels in light of last year’s supply chain disruptions in both Pet and Garden”. Let’s hope that is not another way of saying “channel stuffing.” Short sellers, “forensic accountants” and others will duly point out this negative swing is a “red flag” in any business. Having written short selling research for over ten years, we are well aware that negative cash flow divergence is something to seriously consider and is at the top of the list of things that concern us. In fact, the weak results caused the company to amend their credit agreement in terms of interest and asset coverage.
Having acknowledged the higher net working capital situation (as illustrated in table 1), it should be noted that inventory should decline in the fourth quarter for seasonal reasons. This should give the company some time to get inventory lower before the big ramp up for the spring selling season. Inventory is up around $85 million YOY, but only about $20 million on a four quarter moving average. Management has acknowledged inventory is too high, so we are hopeful progress can be made on this front. In spite of the higher inventory, the company still has ample liquidity with only $60 million outstanding on its $375 million credit line (due in June 2016) with the option to increase that by another $200 million if a lender is willing to make it available.
|Jun 2012||Sept 2012||Dec 2012||Mar 2012||Jun 2013|
While there is no doubt that the top line and gross margins are still works in progress, it appears as though the numerous restructuring initiatives over the years are finally starting to flow through the income and cash flow statements. After increasing by almost $4 million YOY in the second quarter, total SG&A declined by $12 million as employee-related reductions and other cost cutting measures where implemented in the third quarter. This is the first tangible sign of significant cost improvements in YOY. The company also stated that these and other measures will result in $5 million in savings in the fourth quarter. As table 2 shows, costs in the third quarter were starting to approach 2011 levels, an encouraging sign. As the focus on cost cutting subsides, management can begin to refocus on the most important drivers of value creation, sales and gross margins.
Note: S&D= sales and distribution W&A= warehouse and administration
In addition, it also appears as though the company is finally approaching the end of a long and expensive information technology platform restructuring and upgrading program. The company has spent nearly $90M since 2005 (including $11M in fiscal 2013) upgrading its enterprise-wide information platform. In the company’s 10K, the company expected to spend around $40M in total cap ex, mostly related to the upgrade. This was on top of $39M spent on cap ex in 2012. In the latest 10Q, the company stated that it expects capital expenditures not to exceed $30M. We had mentioned in our original article that the wind down of the upgrade would boost free cash flow and it appears that at $10M a year in CFO will be freed up starting in 2014. That is a significant sum considering the $360M market cap of the company.
The company has authorization to repurchase $100 million in stock. However, only $50 million is available in fiscal 2013 and beyond. Historically, the company has been an aggressive purchaser of its stock, but so far in 2013 it has only purchased the token amount of $2.6 million. While we have no doubt that management recognizes the value that is presented in its shares today, we also believe that until the ballooning inventory situation is resolved, the company will place maintaining a high level of liquidity over stock repurchases. It should be noted that there are no new restrictions on share repurchases in the newly amended credit agreement. The credit agreement was amended to reduce the minimum interest coverage ratio to 2.25X from 2.5X and a 1.1X minimum asset coverage ratio was added. While we never like to see credit amendments due to underperformance, we believe that CENT’s recent improvements in costs and cash flow gave the company’s bankers confidence that the turnaround is beginning and were therefore willing to amend the credit agreement with no new onerous terms.
We believe that management has been able to show progress on several fronts (cost cutting, cap ex and price increases) which is encouraging. However, in order for the company’s valuation to improve on a sustained basis, the company must show progress on the other things it can control like working capital management, product innovation and gross margin improvement. Weather always plays an important role in the garden division, but is totally out of control of management or investors and is a risk that will always be present. We still think the company could be acquired at a substantially higher price (assuming no liquidity event is the motivating factor), but that is really in the hands of Bill Brown and his control position in the stock.
All value investors should pause for a moment and consider an investment in the airline industry. JetBlue Airways (JBLU) has done an outstanding job of building a niche franchise in a miserable industry. Very few investors seem to understand the unique franchise that JBLU has built. Selling for less than a pretty clean book value, and with a balance sheet that is better than it appears, I believe JBLU is a stock that value investors should own.
After a brief review of my sanity, I will explain some of JBLU’s unique characteristics, review its current valuation, and discuss a few miscellaneous topics.
THE WORLD’S WORST INDUSTRY
“It just might be a lunatic you’re looking for” – Billy Joel
Let’s answer the most important question first. Would any sane person invest in the airline industry?
-the big airlines have lost roughly $55 billion in the last ten years
-all the big airlines (except for Southwest Air (LUV)) have gone through bankruptcy
-Warren Buffett said, “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” – Warren Buffett, annual letter to Berkshire Hathaway shareholders, February 2008.
As a generalist value analyst for the last 30 years I must admit I seldom wasted a minute looking at this industry. Even though many of the stocks were often statistically very cheap, other than an occasional glance at LUV, I always had better things to do.
What changed? In a desperate search for new ideas, I reviewed the portfolios of professional investors who I have great respect for. One whom I particularly admire is Donald Smith & Co. This firm manages over $3 billion in institutional money using a strict discipline of investing in only the bottom 10% of price/book value stocks. Looking at their portfolio, I think they really understand this unique universe. Smith & Co. has owned JBLU since 2008, and they are now the largest shareholder with just over 10%.
It is also worth noting that the guys at PRIMECAP Management own 8% of JBLU and 11% of LUV. These guys are too growth oriented for me; they own things like Google and Amgen. Even the well respected John Hussman started a small position in the last quarter.
Have these apparently smart investors all gone mad? When I spent some time looking at JBLU, I must admit I was surprised by what I found.
The complete article can be found here on Seeking Alpha.
Please contact us for a copy of our report.
A few months ago, we looked at the merits of Rosetta Stone (RST), the investment idea presented by David Nierenberg of D3 funds at the Value Investor Congress in Las Vegas. In this article, we are going to examine, WPX Energy (WPX). The idea was presented by Guy Gottfried of Rational Investment Group. The presentation can be found here. Readers will have to scroll down the page to find it. What intrigued us about WPX initially was that at the time it was presented it was trading for 66% of TANGIBLE BOOK value. While that might be expected if the company was a bank or insurance company or had a huge debt maturity looming, it is rare for an E&P company to trade at less than even 1.5X book.
Using reasonable estimates for the value of the company’s oil and gas reserves, WPX appears to be even more undervalued. In this article, we will expand on Mr. Gottfried’s analysis to show that WPX appears to have considerable upside with a reasonable margin of safety for investors. We also like it when other value investors whom we respect come to similar conclusions on valuations and investment thesis. In addition to reading company annual reports, we read the reports and commentaries of mutual fund companies such as FPA, Third Avenue Value, GMO and Aegis. Many times these funds go into detail on an idea and the methodology used to analyze a company. In the first quarter Aegis Fund quarterly commentary, the portfolio manager Scott Barbee makes his case for WPX in the following excerpt. Mr. Barbee also expands on the thesis a bit more in the latest Value Investor Insight publication.
Source: Aegis Fund Q1 Shareholder Letter.
Here is a summary table of his valuation metrics. Please do not let the precision of the numbers give you a false sense of certainty in them.
|Aegis Value Fund Valuation||Price per Unit||Value ($M)|
|Nat Gas Proved Reserves (TCF)||4.1||$1.25||$5,130|
|Bakken Oil (MBBL)||68||$20.00||$1,360|
|NAV per share||$31.16|
This was the starting point for our analysis. Our entire report can be found on Seeking Alpha, here. Please email us if you want a copy of the report.
We are posting a report by Shaun Currie, a former co-worker. Shaun’s work has been featured before and believe he is a good example of how a young analyst can improve his skills over time with a modest amount of mentoring. We encourage other young analysts to read his reports and follow his progress. He has started a research firm that you can find with this link. Young investors should develop their own process and analytical style by exposing themselves to a multitude of investors and deciding what fits their personality and mental make up. Value investing takes a certain type of personality and mental outlook and isn’t something that everyone can succeed at. The wide variance in styles of successful value investors (Schloss, Gabelli, Tweedy Browne, Buffett, Whitman, etc.) shows that there is a place for many types of personalities. At Investing 501 we try to encourage individuals to think for themselves, but try to focus that effort with examples and concepts we have found personally helpful.
Dick’s Sporting Goods: The Catalysts are Here – Take a Position before Analyst Day
Dick’s Sporting Goods recently presented at the Goldman Sachs (GS) retail conference, and the stock responded quite positively (up 10% since the presentation). But, with an investor day only a week away, there are plenty of catalysts to take the stock 20% higher. Catalysts Include:
- The new Field and Stream concept
- 2014 guidance is possible at the analyst day, and the company has a low bar to beat
- Increased guidance on store expansion makes the original 900 store goal more feasible
- The company is testing smaller store concepts, which has been something investors have been hoping for
- The company has a plan in place to reach double-digit margins
- The company is growing their e-commence and omni-channel platform, while increasing margins in the business at the same time
- The company is investing in more employees, which investors have been hoping for
- The company is taking share through their store-inside-a-store concepts with the major apparel companies
In the past few years, investors have come to understand the investment opportunities that corporate spin-offs can provide. The successful five-year track record of the Guggenheim Spin-Off ETF (CSD) has highlighted this opportunity. This article is going to examine the investment merits of Crimson Wine Group (CWGL), which was spun out of Leucadia National (LUK) earlier this year at around $7.30 per share. The company is not followed by Wall Street and keeps its conversations with investors to a minimum. Company does not issue earnings press releases, doesn’t hold conference call and doesn’t give guidance or much detail about the operations of its business. Most of the information about the company has to be gleaned from SEC filings and outside sources. Information voids such as this can lead to opportunity for diligent investors.
Before going any further we think it is important to repeat what Ian Cummings wrote about the wine industry in a past LUK annual report:
“We repeat our mantra on the wine industry: Even in good times, it is difﬁcult to make estate wineries proﬁtable, though as real estate investments they are good inflation hedges. The entire industry suffers from oversupply and intense competition from home and abroad. The sheer number of brands, combined with owners having to sell out last year’s vintage at (or below) cost, is a constant anchor on price. Estate wineries have high ﬁxed costs and require large marketing dollars, making volume the key proﬁt driver. We need more volume to make our goal of consistent, yearly cash flows a reality.”
There seem to be two basic investment angles that investors are considering when evaluating CWGL. The first is that the current book value of the assets on the balance sheet understates their current value and the second is the potential for the company to expand its current operations and to roll-up wineries to boost case sales, leverage costs and produce free cash flow. Even though there is much to like about CWGL, we find it hard to make a case that it offers a compelling valuation with a sufficient margin of safety at its current valuation.