Market Cap: 171.07 million
Enterprise Value: $95.64 million
Stock Price: $6.01 per share
I am posting this today, but I purchased shares last week. The stock has gone substantially lower; I feel it's still undervalued. You can track my portfolio here, on marketwatch.
I dollar-cost average my purchases when buying falling knives and never buy all at once. This is the first of three or four equal buys for 8% of my portfolio. I will be buying at a trigger point of 80% of my original purchase price which is $5.44 per share.
Tilly’s is a destination specialty retailer of action sports-inspired apparel, footwear and accessories. On March 18, Tilly’s reported a 4.5% increase in sales year over year for FY '14 but then also reported that comparable store sales decreased 2.8%. The stock price is down 60% since that date.
On May 27, Tilly’s reported an 8.1% increase in revenues and same-store sales increase of 2% but then forecast a Q2 same-store sales decline of 2%. Former CEO Dan Griesemer and the CIO/COO stepped down. The board appointed a new CEO, Edmond Thomas, last month to turn this thing around. Thomas was CEO of Tilly’s from 2005 to 2007, and then left for WetSeal, stepped down from WetSeal in 2011 and has been rehired to turn the company around.
One can grow revenues to heaven, but if profits do not follow, then those revenues are soon lamented as a result of the inevitable store closures. Tilly’s faces the same problem WetSeal faced. Executives and directors of retail department stores generally prioritize rapid revenue growth –Â expansion in the sense of increasing the number of stores. This rapidly increases fixed costs, and if those stores do not work out as planned, the company is stuck with an operating or capital lease situation where the lessor has all the leverage. That is exactly what the WetSeal executives did; comparable store sales never recovered, and the fixed costs ate the company up.
Thomas knows that simply increasing the number of stores does not work, as he saw from his time at WetSeal. I am hoping that he applies that knowledge at Tilly’s.
I do not believe that any one person can consistently run one of these companies. JCPenney’s (JCP, Financial) has been having issues of its own, and it’s an established brand. Bill Ackman (Trades, Portfolio) tried to turn it around, took a large stake in the company and even hand-picked a CEO, Ron Johnson, from Apple (AAPL, Financial). It didn’t quite work out. He sold his Penney's stake at a $700 million loss.
Attempting to predict technological trends is simple, but not easy: Release a product that is more efficient and easier to use than your competitors. In the retail sector, however, you actually have to either figure out how to cut costs per square foot or predict what customers will want to wear next year. Oh, and the executive team also has to be able to predict what cities and states will prove to be gold mines for new stores while having fickle customers as well as tons of competitors selling identical goods.
As Warren Buffett says, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” The retail apparel department store business is what it is. Bad economics. That statement does not entirely apply to the high-end apparel retailers. Most apparel retail executives, teen retailers especially, attempt to predict general retail trends, which no one can consistently do. Sometimes being a profitable regional retailer with decent margins is superior to omnipresence with suppressed margins. During industry slowdowns, the retailer with the best margins and/or the most relative liquid assets less debt is best prepared for the storm.
Risks
Rising inventory
Inventories have risen faster than sales over the past few quarters. The CEO will most likely take a big bath to “turn around” what his contemporary did. I expect a large inventory write-down in the coming quarters. This should be a noncash expense; however, the stock might temporarily get punished for it.
Retail sector downturn
Virtually every retailer has been hammered year to date; this includes the high-end retailers as comparable store sales have been slowing and, in a lot of cases, declining. This should be only a temporary price risk for Tilly's, though, assuming that the new CEO makes the right moves, and curbs new store expansion to focus on the profitability of the others. Tilly's has $76 million cash on the balance sheet, which is sufficient cushion for the storm.
So why in the world am I buying Tilly’s?
Catalysts
Mean reversion
Operating and net margins have been beaten down over the past few years as a result of rapid expansion and underperforming stores. Inventory buildup has occurred as a result of the underperforming stores. I expect the new management to improve operating margins by 220 basis points back to Tilly's five-year average of 6.6%.
Slow down investments in new stores
Rapid expansion is eating up cash flows. Management has been opening up new stores across the country, and those stores have been performing poorly. Comparable store sales have declined over the past two years, and sales per square foot have been declining since 2008. The obstacle seems to be the rapid expansion. Management needs to cut off growth by stores and focus on the profitability of the current stores.
Substantial margin of safety/liquid assets
Tilly’s has no debt; it carries $76 million in cash with a $194 million market cap. Operating cash flows even with the low margins last year was $37 million, subtract maintenance CapEx of $16.3 million, and we have $20.7 million. With an enterprise value of $118 million, we have an EV/FCF multiple of 5.7. This is with the operating margins at 4.4%.
Effective management compensation
Tilly’s co-founders own 93% of the Class B shares, giving them 89% of the voting power. They don’t care about impressing Wall Street. I expect them to make smart long-term decisions for the company. The new CEO has been given the option to buy 500,000 shares at the Oct. 7 price of $7.79 per share; that will vest over four annual installments.
There is a 14% upside to that price. Management is also extremely strict about metrics. It is compensated on the basis of same-store sales growth and operating income, which are appropriate metrics. Last year, 75% of management's bonus was based on hitting the operating income metric, and 25% on the comparable store sales growth metrics. Operating income of $46 million and comparable store sales growth would have given the CEO 200% of his base salary as a bonus.
Management did not get a bonus last year, because it missed the comparable sales growth metric and only hit the minimum for operating income. Its options are also worth a lot less at this point as a result of the poor performance of the stock price. I suppose Thomas will be compensated in the same manner. He has every incentive to drive Tilly's to profitability; the stock price should follow.
Valuation
Operating margin
Tilly's, as of FY '14, had a 4.4% operating margin. The average operating margin of its fellow teen retailing competitors is 5.82%. We have an upside of 32% to that average.
EV/EBITDA
Tilly's has an EV/EBITDA ratio of 2.5; its competitors' average is 5.2. We have a 108% upside to that average.
DCF conservative
On a conservative Discounted Cash Flow basis, my assumptions were:
- -6% revenue growth next year and then trickles down to 0% over six years, and then grows at 1% terminally
- Operating margins revert to past five-year average of 6.6% from 4.4%.
- Tax rate of 39%
DCF aggressive
- Zero revenue growth next six years, and then 1% terminal growth
- Operating margins revert to the 2011 high of 8.7% from 4.4%.
- Tax rate of 39%
Price target
The average of all four estimates: $11.18, a 64% upside. I will also be willing to sell early, if one of Tilly's competitors becomes more attractive or if the CEO does not implement something along the lines of curbing the opening of new stores and focusing on profitability of the existing stores.
