Although shares of Children's Place (PLCE) have risen over 24% so far in 2013, the company's share performance has lagged behind the S&P's more than 26% rise in 2013, and far behind the retail sector's (XRT) rise of almost 42% year-to-date. While it is true that the company's 2013 operational performance (much more on this later) has not earned the company a place among the retail sector's leaders, Children's Place's financial results are far from the worst in the retail sector, and the company has shown meaningful cost discipline in an uncertain landscape. Children's Place reported its Q3 results on November 26, and although share rose by 5% on the back of the company's results, we see much more meaningful upside in 2014. Despite having the strongest balance sheet within its peer group, and a return to sales growth forecast for 2014, Children's Place trades at material discounts to its peer group on a variety of metrics, including price-to-sales, price-to-book, and price-to-earnings, both for 2013 and 2014. We see upside potential of 25% as Children's Place navigates successfully through an uncertain retail landscape, and the discount that shares trade at relative to its peer group begins to close, with more upside possible if the company utilizes its pristine balance sheet. Unless otherwise noted, financial statistics and managerial commentary used in this article will be sourced from the following documents: Children's Place's Q3 2013 earnings release, its Q3 2013 earnings call, or its 2012 10-K.
Q3 & YTD Performance: Navigating Through Uncertainty
Children's Place posted its Q3 results on November 26; revenues came in at $492.68 million, missing estimates by $9.35 million, while EPS of $1.89 (up 11.18% year-over-year) beat estimates by 5 cents. Revenues fell by $8.248 million year-over-year (or 1.65%) on a 0.7% decline in same-store sales. However, due to changes in the calendar, one week of back to school sales slipped into Q2 2013, trimming sales by $12 million. Year-over-year sales growth would have been positive excluding the shift, and foreign exchange headwinds trimmed sales by an additional $3 million. The table below provides a brief summary of Children's Place's results for Q3 and the first 3 quarters of 2013, and our discussion continues below.
Children's Place Q3 2013 & YTD Results (in Thousands of $)
Q3 2013 | Q3 2012 | Y/Y Change | Q1-Q3 2013 | Q1-Q3 2012 | Y/Y Change | |
Revenues | $492,680 | $500,928 | -1.65% | $1,298,292 | $1,300,262 | -0.15% |
Gross Profit | $202,865 | $209,533 | -3.18% | $492,315 | $502,883 | -2.1% |
Gross Margin | 41.18% | 41.83% | -65 bps | 37.92% | 38.68% | -76 bps |
Operating Income | $63,158 | $60,054 | +5.17% | $79,052 | $80,765 | -2.12% |
Operating Margin | 12.82% | 11.99% | +83 bps | 6.09% | 6.21% | -12 bps |
EPS | $1.89 | $1.70 | +11.18% | $2.30 | $2.23 | +3.14% |
As we noted earlier, Children's Place's revenue decline in Q3 was due to a shift in the timing of back-to-school sales; total revenues for the first three quarters of 2013 fell by just 15 basis points. Although gross margins fell by 65 basis points in the quarter (to 41.18%), CFO Michael Scarpa noted that this was not due to promotional issues; management stated on the company's earnings call that core merchandising margins rose 70 basis points year-over-year during the quarter, and that the decline was due to various supply chain investments being made by the company, as well as occupancy cost increases. In fairness to potential critics, Children's Place has not entirely escaped the promotional environment. CEO Jane Elfers admitted on the earnings call that the company has had to "intensify" its marketing and value offerings to attract and retain customers, which has put pressure on the company's AUR, offsetting higher conversion rates within the company's store base. Total comparable sales fell 60 basis points during the quarter, with the declines occurring in both the United States and Canada. In the U.S., total comparable sales fell 0.4% as a 30 basis point increase in transactions was negated by a 70 basis point decline in transaction values, while in Canada (the company's other major segment), comparable sales fell by 2.9% (but up 30 basis points sequentially), due entirely to a decline in the number of transactions. However, e-commerce sales were a bright spot for Children's Place, and now accounts for 14.8% of all sales, versus 12.6% a year ago.
Notably, Children's Place was able to boost both operating income and operating margins year-over-year in Q3, as declines in sales and gross margins were more than offset by solid cost controls. Management continues to rebalance its store count, closing dozens of underperforming stores, all while continuing to invest in its burgeoning international business. Per its 2012 10-K, Children's Place ended 2012 with a total of 1,095 stores (966 in the United States, and 129 in Canada). The company plans to end 2013 with 1,105 stores, but with 1.1% less square footage than before. On its Q2 earnings call, Children's Place announced that through the end of 2016, it would be closing a total of 100 underperforming stores, a figure that has now been raised to 110. A total of 43 underperforming stores will be closed in 2013. Furthermore, the company is currently in the process of reviewing the performance of 25 additional stores to determine whether or not they should be closed. These figures do not include franchised locations in the Middle East, where the company now has a total of 32 stores, covering several countries, including Kuwait, the United Arab Emirates, Qatar, Bahrain, and Oman. 4 more stores are set to open in Q4, and the company announced that it would begin operations in Israel in 2014; guidance currently calls for 55-60 total Middle East stores (inclusive of Israel) by the end of 2014. In 2012, the company's franchise business generated $8.4 million in sales, representing less than 0.5% of total sales. However, the impact on operating income was likely greater, given that operating margins within Children's Place's international division are twice as high as its domestic operations (based on full-year 2012 results; the international division generated higher operating margins in 2011 and 2010 as well). As the company's franchise base grows, high-margin licensing income will continue to grow, providing Children's Place with another avenue to higher operating margins. The continued closure of underperforming stores, as well as disciplined supply chain management has allowed Children's Place to accelerate its SG&A cost reductions: total SG&A costs fell by 1.75% in the first three quarters of 2013, but fell by 6.56% in Q3 2013 alone. CFO Michael Scarpa noted that these store closures will boost operating margins by 30 basis points, and that if the company can meet its forecast of recapturing a fifth of the traffic lost by these store closures, margins can be raised by an additional 50 basis points. Children's Place will be utilizing both targeted digital and mail-based marketing strategies to attempt to meet this 20% goal. 2014 margins are also likely to see incremental benefit as the company moves to "improving the overall productivity of the store portfolio," with the pace of store openings to moderate in 2014 as Children's Place places more focus on expanding margins within its existing stores.
Preparations for 2014 are well underway, with the company's buys for the first half of the year nearly finalized, and Children's Place continues to invest in its loyalty program, known as MyPlace Rewards. On the company's earnings call, management disclosed that the program now covers 33% of its overall customer base, and that members spend two and a half times as much per year as non-members, with twice as many transactions per year. On its earnings call, Children's Place emphasized that MyPlace rewards will play a more prominent role this holiday season, with more capital allocated towards driving traffic within the membership base. In addition, the company expects to ramp up the presence of its e-commerce business in Q4 in relation to its traditional store portfolio. We note that Children's Place has grown its e-commerce business for 31 consecutive quarters, and it is a trend that is expected to continue in Q4 2013, as well as 2014. We turn now to forward guidance. Children's Place issued preliminary guidance for Q4 2013, calling for EPS of $0.94 at the midpoint (the guidance range is $0.90-$0.98), versus Q4 2012 EPS of $1.02, with the decline reflecting further increases in promotional activity. That being said, Children's Place did use its Q3 2013 earnings results to raise full-year EPS guidance; the company now expects EPS of $3.24 at the midpoint of a new range of $3.20-$3.28, versus a prior midpoint of $3.21 within a range of $3.15-$3.28. The increased guidance likely stems from the year-to-date results of the company's buyback program; so far this year, Children's Place has repurchased 1.1 million shares, or almost 5% of the shares it had outstanding at the beginning of 2013.
Financials & Peer Valuation: Continued Strength, Continued Undervaluation
Children's Place continues to maintain a pristine capital structure, holding $194.246 million in cash & investments, and no debt on its balance sheet, and no debt (equivalent to $8.58 in net cash & investment per share). Although operating cash flow year-to-date has declined relative to 2012, there are several nuanced within Children's Place's financial statements that need to be addressed, and we discuss the company's cash flows below (note: because Children's Place has not yet released its Q3 2013 10-Q, no full cash flow statements are available, and the table below is based on a reconciliation of the condensed cash flow statement provided alongside Children's Place's Q3 2013 results and its Q2 2013 10-Q. Therefore, we will address the company's cash flows and balance sheet in general terms, with a specific focus on inventory to follow).
Children's Place Operating Cash Flow (in Thousands of $)
Q1-Q2 2013 | Q3 2013 | YTD 2013 | Q1-Q2 2012 | Q3 2012 | YTD 2012 | ||
Net Income (Loss) | ($4,364) | $41,739 | $37,375 | $6,810 | $37,301 | $44,111 | |
Adjustments | $51,447 | $20,208 | $71,655 | $42,107 | $21,143 | $63,250 | |
Operating Cash Flow ex-Changes in Working Capital | $47,083 | $61,947 | $109,030 | $48,917 | $58,444 | $107,361 | |
Changes in Working Capital | $17,073 | ($26,926) | ($9,853) | $11,641 | $24,472 | $36,113 | |
Operating Cash Flow | $64,156 | $35,021 | $99,177 | $60,558 | $82,916 | $143,474 |
Excluding changes in working capital, Children's Place has increased operating cash flow both in Q3 2013 (by 5.99%) and for the first three quarters of the year (by 1.55%). But, when changes in working capital are accounted for, year-over-year comparisons become less favorable, with Q3 cash flows falling by more than 57%, and year-to-date cash flows dropping by nearly 31%. The primary culprit is inventory, which rose 13.76% year-over-year to $337.172 million. However, the driver of this increase in inventory is not weak sales, but rather a series of conscious managerial decisions. Although holiday and prior season inventory fell by $24 million, Children's Place placed $65 million in spring and replenishment inventory onto its balance sheet earlier than normal, due to changing supply chain factors. In 2014, the Chinese New Year falls on January 31, 10 days earlier than in 2013, and given that there is a usual 2-week delay in shipping from Chinese ports associated with the holiday, Children's Place chose to accelerate delivery of millions in Chinese inventory to ensure that its stores remain stocked. In addition, instability in Bangladesh (another key country where Children's Place manufactures its inventory) has led the company to accelerate $50 million in shipments to ensure that new styles and goods are available for the spring selling season. We expect that year-over-year cash flow comparisons will become more favorable in Q4 2013 and Q1 2014 as the effects of these changes in inventory flow through the company's financial statements. In any case, Children's Place continues to have the strongest balance sheet within its peer group, despite trading at a discount to peers on a variety of metrics, which we discuss below.
Our peer group for Children's Place includes the companies that Children's Place names in its latest 10-K as competitors. Chief among these are Carter's (CRI), another pure-play children's clothing retailer, as well as Ascena Retail Group (ASNA) and Aéropostale (ARO), which compete with Children's Place via their Justice and P.S. divisions. Other competitors include Gap (GPS), Kohl's (KSS), Wal-Mart (WMT), Target (TGT), and J.C. Penney (JCP); key competitor Gymboree is excluded as it is owned by Bain Capital. The table below breaks down the valuation of Children's Place in relation to these peers, as well as its financial strength and forward growth rates (note: share prices and multiples are accurate as of the close of trading on November 29, and for the sake of comparability, and to account for different fiscal years, our comparisons will be based on each retailer's fiscal year).
Children's Place Peer Comparison
Company | PLCE | ARO | JCP | ASNA | TGT | WMT | KSS | GPS | CRI | Peer Average |
Share Price | $55.00 | $10.32 | $10.19 | $21.30 | $63.93 | $81.01 | $55.28 | $40.97 | $70.67 | |
Shares Outstanding | 22,628,000 | |||||||||
Market Capitalization | $1,244,540,000 | $809,984,942 | $3,103,874,000 | $3,399,233,431 | $40,409,366,597 | $263,849,570,000 | $11,940,480,000 | $18,969,110,000 | $3,853,344,929 | |
Cash & Investments | ||||||||||
Debt | ($2,792,000,000) | |||||||||
Net Cash | $194,246,000 | $100,291,000 | ($4,291,000,000) | $53,800,000 | ($14,081,000,000) | ($49,930,000,000) | ($251,000,000) | ($384,181,000) | ||
Net Cash (Debt) per Share | $8.58 | $1.28 | ($14.09) | $0.34 | ($22.28) | ($15.33) | ($9.89) | ($0.54) | ($7.05) | |
Net Cash (Debt) as a % of Market Cap | 15.61% | 12.38% | -138.25% | 1.58% | -34.85% | -18.92% | -17.90% | -1.32% | -9.97% | |
Stockholder's Equity | ||||||||||
Debt-to-Equity | 0.00% | 0.00% | 208.46% | 8.71% | 91.53% | 74.71% | 47.13% | 42.19% | 88.93% | 70.21% |
Net Debt-to-Equity | 0.00% | 0.00% | 162.11% | 0.00% | 87.16% | 63.59% | 36.07% | 8.49% | 58.30% | 51.97% |
Book Value per Share | $27.20 | $4.69 | $8.69 | $9.75 | $25.56 | $24.11 | $27.43 | $6.38 | $12.08 | |
Share Price, Adjusted for Net Cash (Debt) | $46.42 | $9.04 | $24.28 | $20.96 | $86.21 | $96.34 | $65.17 | $41.51 | $77.72 | |
Last FY Sales | ||||||||||
Current FY Sales | $1,800,000,000 | $2,170,000,000 | $12,380,000,000 | $4,930,000,000 | $73,290,000,000 | $471,130,000,000 | $19,060,000,000 | $16,200,000,000 | $2,630,000,000 | |
Next FY Sales | $1,840,000,000 | $2,220,000,000 | $13,240,000,000 | $5,180,000,000 | $77,290,000,000 | $492,980,000,000 | $19,380,000,000 | $16,970,000,000 | $2,900,000,000 | |
Last FY EPS | ||||||||||
Current FY EPS | $3.23 | ($0.82) | ($3.39) | $1.30 | $3.67 | $5.31 | $4.15 | $2.70 | $3.37 | |
Next FY EPS | $3.67 | ($0.17) | ($1.46) | $1.55 | $4.72 | $5.82 | $4.55 | $3.01 | $3.93 | |
Current FY Sales Growth | -0.52% | -9.06% | -4.66% | 4.56% | 1.85% | 0.42% | -1.14% | 3.51% | 10.42% | 0.74% |
Next FY Sales Growth | 2.22% | 2.30% | 6.95% | 5.07% | 5.46% | 4.64% | 1.68% | 4.75% | 10.27% | 5.14% |
2-Year Sales CAGR | 0.84% | -3.54% | 0.98% | 4.82% | 3.64% | 2.51% | 0.26% | 4.13% | 10.34% | 2.89% |
Current FY EPS Growth | 0.00% | 0.00% | 0.00% | 4.00% | -22.90% | 5.78% | -0.48% | 15.88% | 18.25% | 3.42% |
Next FY EPS Growth | 13.62% | 0.00% | 0.00% | 19.23% | 28.61% | 9.60% | 9.64% | 11.48% | 16.62% | 15.86% |
2-Year EPS CAGR | 6.59% | 0.00% | 0.00% | 11.36% | -0.42% | 7.67% | 4.46% | 13.66% | 17.43% | 9.03% |
Current FY P/S | 0.58 | 0.33 | 0.60 | 0.68 | 0.74 | 0.67 | 0.74 | 1.19 | 1.61 | 0.82 |
Next FY P/S | 0.57 | 0.32 | 0.56 | 0.65 | 0.71 | 0.64 | 0.73 | 1.13 | 1.46 | 0.77 |
Current FY P/E | 14.37 | 0.00 | 0.00 | 16.13 | 23.49 | 18.14 | 15.70 | 15.37 | 23.06 | 18.65 |
Next FY P/E | 12.65 | 0.00 | 0.00 | 13.52 | 18.26 | 16.55 | 14.32 | 13.79 | 19.78 | 16.04 |
Price-to-Book | 2.02 | 2.20 | 1.17 | 2.18 | 2.50 | 3.36 | 2.02 | 6.42 | 5.85 | 3.21 |
The table above contains several highlights we believe are worth noting (aside from the overall undervaluation of Children's Place). When adjusted for net cash and debt, Children's Place trades at virtually identical price-to-sales multiples as J.C. Penney, despite having a balance sheet that is far stronger than that of J.C. Penney. Although Children's Place is not the only company to have no debt on its balance sheet, we view its balance sheet as the strongest within its peer group, due to the fact that Aéropostale is burning cash, due to its ongoing losses. Although the company holds over $100 million in net cash as of the end of its most recent quarter, the company's cash balances have fallen by over $69 million over the past 12 months, and with losses forecast for both fiscal 2013 and 2014, we expect the company's cash balances to see further pressure.
Children's Place trades at a discount to its peer group on a price-to-earnings, price-to-sales, and price-to-book basis, and while a slight discount may be warranted, given below-average compound annual growth rates, we feel that the size of the discount that Children's Place currently trades at is unwarranted, particularly in light of the fact that the company has ample room to leverage its balance sheet. With cash comprising almost 16% of its market capitalization, Children's Place has room to issue debt to allow for either further investments in store optimization or further share buybacks. The company has $25.7 million remaining on its current buyback program (begun in November 2012), equivalent to over 467,000 shares at current prices, or more than 2% of all outstanding shares. With nearly $200 million in net cash & investments (a level that will be boosted by double-digit EPS growth in 2014), Children's Place has the ability to increase buybacks further, thereby continuing a tradition of share repurchases. Over the past several years, the company has repurchases huge swathes of its stock, and the company's outstanding share count is now at its lowest level since going public in September 1997, as the chart below illustrates.
With an average debt-to-equity ratio of over 70% (and a median of over 60%), Children's Place could issue over $369 million in debt and raise its leverage ratio (as measured by median debt-to-equity) to levels that are merely in line with its peer group. Were that $369 million in debt to be issued and used to fund an aggressive buyback program, Children's Place could repurchase around 6.15 million shares (based on a price of $60, to account for a theoretical rally on the back of such an announcement), or more than a quarter of all outstanding shares. We believe that shares of Children's Place are undervalued at present levels, with upside potential of at least 20%, based on a blend of several multiples, with a 10% discount to peer averages to account for below-average growth in 2013 and 2014.
Children's Place Valuation Matrix
Metric | Peer Average | Discount Factor | ex-Cash Multiple | ex-Cash Share Price |
Current FY P/S | 0.82 | 10% | 0.74 | $58.60 |
Next FY P/S | 0.77 | 10% | 0.70 | $56.59 |
Current FY P/E | 18.65 | 10% | 16.78 | $54.21 |
Next FY P/E | 16.04 | 10% | 14.43 | $52.98 |
Price-to-Book | 3.21 | 10% | 2.89 | $78.64 |
The average results of these 5 multiples yields an adjusted share price of $60.20, to which we add back $8.58 in net cash to arrive at a pro forma price target of $68.78, representing upside of over 25.05% relative to the company's November 29 closing price.
Conclusions
Children's Place is navigating through an uncertain retail environment, and despite having the industry's strongest balance sheet, and the ability to dramatically boost share repurchases, the company's shares trade at multiples associated with J.C. Penney, not a company set to grow EPS by double digits in 2014 and having almost 16% of its market capitalization in cash. The opportunity for more aggressive capital deployment serves as a further source of potential upside, as does further clarity on the financial impact of its growing Middle East franchise business. Children's Place is optimizing its store base to boost profitability, and management has laid out a path to improving operating margins in 2014, and as the company executes on its strategy, we expect that the discount it trades at relative to its peer group will begin to close, thereby providing investors with solid returns in 2014.
Disclosure: I am long PLCE, GPS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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