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Citi Trends (NASDAQ:CTRN) has been overly punished by the market over a sharp deterioration in apparel sales that began in 3Q18 amidst a large shakeup in upper management caused by activist investor Macellum Capital Management (“Macellum”). I believe the market is currently pricing in expectations of continued operational deterioration and obsolescence when, in reality, apparel sales have a history of being cyclical at CTRN and CTRN’s customer base expects merchandise selection to be hit-or-miss. Like how many customers shop at thrift stores, I believe CTRN’s customers shop by looking for deep bargains on apparel, and if they fail to find anything they like, they will return in a few months when inventory has been refreshed.
Even with the volatility in apparel, apparel sales have become an increasingly smaller portion of revenue mix, with non-apparel sales approaching 50% of total revenue, which should lead to more consistent profitability in the future. Furthermore, by being under the control of Macellum, CTRN now has ample opportunity to improve its weak operating margins through improved inventory management, supply chain, and merchandising efforts that have slowly deteriorated over the years due to inept management. CTRN has a loyal customer base that has been shopping at it and its predecessor for generations with a strong online following. With the right management in place, CTRN has much more potential than it is currently being given credit for.
Company Overview and History
Here is how CTRN describes itself in its most recent 10-K:
“Citi Trends (“CTRN”) is a value-priced retailer of urban fashion apparel and accessories for the entire family. CTRN’s merchandise offerings are designed to appeal to the fashion preferences of value-conscious customers, particularly African-Americans, who make up over 70% of the customer base. CTRN’s goal is to provide merchandise at discounts of 20-70% to department and specialty stores. CTRN’s stores average approximately 11,000 square feet of selling space and are typically located in neighborhood shopping centers that are convenient to low and moderate income customers. CTRN currently operates 562 stores in both urban and rural markets in 32 states.”
CTRN has a long history with its predecessor, Allied Department Stores, being founded in 1946. Allied Department Stores grew into a chain of 85 family apparel stores operating in the Southeast region of the United States before being acquired by the now defunct mid-market buyout firm Hampshire Equity Partners in 1999. Hampshire Equity Partners grew the business to 212 stores while posting double-digit average same-store sales (“SSS”) growth before taking the company public on May 18, 2005.
Why Discount Retailers Are A Strong Play
While many retailers have gotten crushed over the last decade with the rise of e-commerce and the “Amazon (NASDAQ:AMZN) effect”, discount retailers have been a notable exception. By offering name-brand apparel, accessories, and home furnishings at steep discounts to department and specialty store prices, they collectively tap into the rational consumers’ psyche across all demographics by offering bargains. Discount retailers have strong appeal regardless of income or age, with extensive consumer surveys showing that 75% of American adults shop for clothes at discount retailers. The proof is in the pudding, with leading clothing discount retailers such as T.J. Maxx (TJX), Ross Stores (ROST), and Burlington Stores (BURL), all outperforming the S&P 500 over the past five years as seen in Exhibit 1.
Discount retailers’ outperformance becomes significantly more amplified when taking into consideration recessions, where their operations have historically been very resilient. This is clearly demonstrated in Exhibit 2, which does not include BURL because it was not publicly traded for the duration of the time frame. Considering the late stage of our current bull market, having a portfolio with discount retail names would appear to be a conservative strategy for preserving capital. Unfortunately, valuations have become very stretched in the most well-known discount retail names.
Why Citi Trends Is So Cheap
While discount retailers have collectively been strong outperformers, CTRN has gotten left in the dust due to a number of mostly self-inflicted mishaps. In spite of strong growth trends in profitability and no debt except operating leases, the market has punished CTRN due to:
1) A recent C-suite/board of directors shake-up caused by activist investor Macellum
2) A recent downturn in same-store-sales (SSS) growth that accelerated in 1Q19
3) Seasonal earnings pattern wherein it has historically earned the majority of its annual profits during tax return season
4) Weak growth and operating metrics in comparison to peers
The most recent decline in SSS began 3Q18 following a difficult comparison period from an abnormally high 4.5% increase in SSS during 3Q17. CTRN’s fashion merchandising team didn’t adequately adjust inventory to changing fashion trends, which resulted in a bloated inventory of old clothes that had to be sold at clearance prices.
CTRN has historically experienced similar periods where its merchandising team purchased large amounts of discounted inventory designated for future seasons (such as winter clothes for women) too far in advance and consequently suffered from low inventory turnover and high markdowns when fashion trends suddenly shifted. For years, buying seasonal apparel in bulk far in advance of the season has been the strategy of CTRN’s merchandising team to reduce inventory costs. Unsurprisingly, this has led to large inventory impairments in the years this strategy failed.
Annual inventory turnover is an important benchmark for analyzing how quickly a merchandiser can adapt to rapidly changing consumer preferences. If fur boots are all the fashion rage in October and suddenly Kim Kardashian announces in November a boycott of fur boots, stores that can quickly clear fur boot inventory and replace it with the newest trend will typically have stronger sales and margins. A comparison between CTRN’s annual inventory turnover in comparison to its peers can be seen in Exhibit 3.
The financial underperformance from the misread in changing fashion trends was amplified by a disastrous tax return season during 1Q19. CTRN traditionally generates the bulk of its annual profitability during the fourth and first quarters from holiday sales and increased discretionary spending among its customers during tax return season as seen in Exhibit 4.
On the 1Q19 conference call, management tried to blame the deterioration of apparel sales and resulting deterioration of operating margins on delayed tax return refunds. Historically, delayed tax returns simply moved sales into the next quarter. However, CTRN never recovered lost sales this time. SSS fell 10% YOY during the busiest four-week refund period while remaining flat for the remainder of the quarter. Investors fear that customers are permanently abandoning CTRN, and the depressed share price reflects expectations of a continued collapse in average sales per store.
Why Headwinds Appear To Be Temporary
While apparel sales have been declining as a percentage of revenues for the last five years, they have still collectively been growing albeit at a slower pace relative to the rest of CTRN’s business. As CTRN continues to expand store count, average apparel sales per store continue trending down. Both trends can be observed in Exhibit 5. Apparel sales by category shows that the recent deterioration in ladies apparel is driving the current downturn as seen in Exhibit 6 and Exhibit 7.
There is obviously reason for concern over falling apparel sales, especially within the ladies clothing category, but overall, I view the product mix shift out of apparel sales and into accessories and home decoration sales as largely a positive for the company. Accessories and home decorations are not subject to the same whims of fashion trends and provide a more stabilized revenue stream. While apparel sales at CTRN are highly seasonal with a large portion of annual profits being earned during tax return season, accessories and home sales have been consistent profit generators with strong annual sales improvements over the past decade. The shifting mix of CTRN’s revenue stream can be observed in Exhibit 8.
Accessories primarily include purses, shoes, perfume, jewelry and cosmetics whereas home sales include items such as rugs, bathroom sets, bed comforters, suitcases and car mats. From my visit to a couple CTRN locations, I liked the fact that many of the home decorations could be hung on racks. Hanging home decorations such as rugs and car mats on racks increases visibility to the customer while minimizing retail space. While home sales only contribute 6% of revenues, they take up an even smaller percentage of the stores’ retail space.
The shift out of apparel sales and into accessories and home sales has been universal among discount retailers as demonstrated in Exhibit 9. All (besides CTRN) have performed very strongly amidst the changes in revenue stream. While CTRN’s performance is disappointing and may reflect a failure on its part to adapt to the trend earlier, I believe CTRN’s competitive strategy of appealing to a specific customer base has remained intact through the transition as it offers a unique selection of home and accessory merchandise that match its urban image.
CTRN is an institution in the communities in which it operates with a very loyal customer base. Few if any other clothing stores have successfully operated in primarily low to moderate income African American communities for as long as CTRN has, which has resulted in it becoming a generational destination with widespread awareness among the community in primarily Southeastern states.
I attempted to quantify the awareness and strength of the CTRN name among its target customer base by considering:
1) Advertising expense as a percentage of revenue, with a lower proportion of advertising expenses to generate revenue giving an indication of intangible brand strength and awareness (Exhibit 10).
2) Revenue-to-Facebook-likes ratio (Net sales/Facebook likes), with a higher proportion of Facebook likes relative to revenue (and consequently a lower ratio) indicating a larger portion of the company’s revenue base following them on social media (Exhibit 11). I believe a low ratio number is especially powerful due to the advantages a large social media following gives a company in both advertising and customer feedback.
I included Lululemon (NASDAQ:LULU) in the revenue-to-Facebook-likes analysis because Lululemon is famous for successfully developing a rabid customer base. I similarly believe these data points indicate that CTRN’s core customer base is very sticky, which provides a foundation whenever CTRN’s merchandise flounders. Through Facebook, they have a cheap, highly targeted method of advertising when staging a turnaround. CTRN has almost 600,000 Facebook likes, which it has leveraged to stay in close contact with its customer base. What I find particularly interesting about CTRN’s Facebook page is that it has become a platform for aspiring models with an interest in urban fashion to showcase themselves. While customers frequently inquire about online sales on CTRN’s Facebook page, it does not have an online store and has minimally experimented in the e-commerce area in the past.
The resilience of CTRN’s intangible customer dedication has allowed it to survive despite mismanagement throughout much of its history, and there is no reason to believe its core customer base won’t continue supporting the business into the future. Unlike many other retailers who have faced obsolescence as their name brand apparel lost its appeal, CTRN carries a wide range of both branded apparel and non-branded apparel that makes its inventory unique at any given point in time. I believe CTRN’s customer base is well aware of this unique characteristic and consequently shop at CTRN in a similar manner to how many shop at Goodwill or thrift stores. Customers go in to CTRN hoping to find bargain priced treasures, and if they don’t find anything they like, they go again a few months later once inventory has been refreshed.
The Activist – Macellum Capital Management
Positive operational change is being brought to the company by activist fund Macellum, who recently gained two seats on the board of directors (which is composed of seven directors total) with a guarantee of gaining an additional board seat next year. Macellum has uprooted practically all of CTRN’s legacy directors and executives culminating in the recent resignation plans of current CEO Bruce Smith, who has been a powerful figure at CTRN since he joined in 2005.
CTRN and Macellum became involved in a contentious proxy contest in 2017 after Macellum established a 3.9% position in CTRN and attempted to take over the board. After thoroughly reviewing the letters sent out by both parties involved in the proxy contest, I have come to agree with Macellum’s perspective that previous management was too content in their mediocre operational performance and that a shake-up was overdue.
Macellum has identified low-hanging fruit to improve operating margins at CTRN, which includes:
– Significant capital investment in IT infrastructure to optimize store planning and inventory markdown. CTRN’s current systems are outdated and have been highly underinvested in despite the massive cash flows CTRN has been bringing in to support this necessary capital investment. Bringing system infrastructure in line with the rest of its peer group should increase inventory turnover, which should in turn drive higher sales by keeping inventory fresher (previous inventory was being bought a year early, and frequent fashion misses would consequently force the company to sell this product at clearance) and improve margins by reducing markdowns.
– Improvements to warehousing, distribution, and supply chain. Since Macellum’s presence on the board, CTRN has begun critical investments, including a new warehouse packing system that should generate $500k in annual savings and a rebidding of freight contracts. Outside consultants have been hired to assist with these efforts and will also help implement a transportation management system by 4Q19.
CTRN’s operating margins have averaged only 2.7% over the last 5 years while competitors such as T.J. Maxx and Ross Stores average 10%+. CTRN previously used to have operating margins around 10% up through 2010 with a slow and steady erosion since that time frame.
Margins have eroded over the years in part due to a shift in consumer tastes from higher margin branded apparel to unbranded apparel but also in part due to inefficiencies within its merchandising department, store planning, warehousing, distribution, and supply chain. I believe the disruption caused by Macellum is precisely what CTRN has needed as it has become a clear example of a poorly run company in a great niche that has grown complacent.
Bad Company, Great Industry
After reading through every earnings press release CTRN has issued since its IPO in 2005, the company never made any mention about addressing its glaring issues with inventory management and never made any admission of operational shortcomings. Communication about growth strategy (or much of anything) with shareholders was virtually nonexistent. CEO and CMO (Chief Merchandising Officer) positions remained in a state of constant turnover. CTRN’s board of directors had very little independence, very little retail experience, a classified and staggered re-election term structure, weak performance targets that were constantly sandbagged to ensure excessive payouts, and long tenures with no plans to bring any fresh perspectives on board. Additionally, for a company which generates most of its business from primarily an African-American customer base, there was no racial diversity on the board. It is not surprising in the slightest that highly qualified CEOs and CMOs avoided the company.
Founder and CEO of Macellum, Jonathan Duskin, has a mixed track record in turning around retail businesses that has increased skepticism about his ability to turn CTRN around. Duskin is serving or has previously served as a director at Christopher & Banks, The Wet Seal, and Whitehall Jewelers – all of which have either gone bankrupt or are in the process of going bankrupt.
What critics fail to account for in Duskin’s track record is the fact that he has historically been elected to the board in companies that were already suffering from obsolescence and impending bankruptcy. Shareholders in many retail companies will not capitulate and vote for new directors until the damage is irreversible, and by the time Duskin got on board, he had a limited ability to implement meaningful change. Duskin has intentionally targeted distressed retailers fully knowing that outcomes for equity holders are binary events while making returns across the capital structure through vulture financing. I don’t see how one can draw a parallel between those sickly companies and CTRN, which has no debt besides its operating leases, $80m in cash, and has grown EBITDA by an average of 10% a year over the past five years.
Macellum demonstrated it has the ability to deliver shareholder value in financially secure/operationally weak retail companies with its turnarounds at both The Children’s Place and Perry Ellis. Macellum gained two board seats at The Children’s Place in March 2015 after publicly releasing an explicit strategy for turning the company around. Share prices for The Children’s Place increased nearly 300% within three years before recently declining again. At Perry Ellis, Macellum consulted behind the scenes with its board of directors from the period of May 2014 to December 2014 during which time frame the share price increased 65%, and it received multiple acquisition offers for $30+ (Perry Ellis was eventually sold for $27.50 per share in June 2018 to founder George Feldenkreis).
In conclusion, I believe we can expect Macellum to swing for the fences with CTRN, which may be why many shareholders have been scared off. Fortunately, CTRN has a very strong balance sheet and customer base which allows for a large margin of error. Macellum has explicitly laid out its game plan for turning around CTRN in its deck “Citi Trends: The Case for Change”, and I believe that at this valuation, shareholders will be strongly rewarded if they have even a modicum of success in implementing change.
Despite being in a near constant state of executive turmoil with outdated IT infrastructure, CTRN has managed to remain profitable by filling in a vital niche within discount retailers that is unlikely to disappear anytime soon. Since 80% of CTRN’s customers do not own a credit card (see slide 62), they are likely to remain loyal customers because they are limited in their ability to purchase apparel online. Store expansion efforts have been largely successful with all but six of CTRN’s 562 stores being profitable on a four-wall basis.
CTRN has generated excess returns on capital throughout its store expansion without assuming any debt, and this trend was strengthening over the past few years due in part to the Tax Cuts and Jobs Act of 2017 before the recent downturn. By reinvesting heavily in store expansion while earning excess returns on capital, CTRN has been able to organically grow adjusted EBIT at a 5.8% compounded annual growth rate (CAGR) over the last five years. CTRN’s historical returns on capital (ROC), returns on incremental invested capital (ROIIC), and reinvestment rate can be seen in Exhibits 12 and 13.
Under Macellum’s guidance, CTRN recently outlined a detailed plan to steadily grow store count to 800 from the current store count of 562 by expanding net stores at a pace of 2-3% per year. CTRN has already been growing at this pace for the last several years and has generated a five-year average ROC of over 9%, while its cost of capital is estimated to be only 6.5%, which provides me with confidence that they can profitably continue expanding into the future even with year-to-year volatility in ROIIC. I used this expansion plan as guidance for my intrinsic valuation. My assumptions are outlined in Exhibits 14 and 15.
Under these operating assumptions, I project that CTRN has an intrinsic value of $22.76/share (as seen in Exhibits 16,17 and 18), which is 34% higher than the share price of $16.94 as of writing. I believe these assumptions provide a base value in the event Macellum is unable to improve the business and operational deterioration gradually continues. CTRN has experienced fluctuations within apparel sales in the past (the years 2011-2013 were particularly difficult) but has always managed to rebound. There is undoubtedly a component of luck involved with apparel merchandising, and it is incorrect in my opinion to believe that CTRN’s current apparel woes will last forever. Considering the historical fluctuations in apparel merchandising success and low-hanging fruit available for increasing operating margins through IT infrastructure upgrades, better freight contracts among suppliers and automated inventory, I view this scenario as highly conservative.
CTRN is currently priced such that its ROC would have to deteriorate from its five-year average of 9.1% down to 4.75% for the next 15 years to justify in addition to having zero growth in its terminal stage. I think it is highly unlikely that there will be a scenario where that much value destruction would take place – not even in a recession where CTRN has historically performed strongly as seen in Exhibit 19.
CTRN’s business model is much more durable than the market is currently giving it credit for. If CTRN can return to operating margins and SSS growth that is similar to its peer group, its shares could be worth as much as $70.00. Considering CTRN was generating numbers in line with its broader industry as recently as 2010, this is not out of the realm of possibility.
My comps analysis shows a truly massive disparity between CTRN’s EV/EBITDA multiple and its competitors with CTRN having an EV/EBITDA of 3.1x and its competitors having an average EV/EBITDA of 10.8x as seen in Exhibit 20. While CTRN ought to trade at a discount on the merits of its thinner margins and slow growth rate, in my opinion, the disparity is simply too large to justify. At an EV/EBITDA of 10.8, CTRN would be worth $73 per share. A 70% discount due to weaker margins and growth rates values shares at $21.90 – nearly 30% higher than the share price as of writing.
Putting all the pieces together, I believe that CTRN shares are worth over $30 per share as demonstrated in Exhibit 21. This assumes an 80% chance of continued underperformance by Macellum and a 20% chance of an ultra-bullish complete turnaround. CTRN was trading over $35 per share last August before the collapse, and I think it is reasonable to believe that with modest operational improvements CTRN can return to this level in short order.
I believe we are currently in the midst of a catalyst as Macellum orchestrates its turnaround plan now that it has successfully taken control of the company. Macellum has deep connections with executives throughout the retail space and has the capability to attract strong talent into key positions. With the recent announcement of acting CEO Bruce Smith’s transition out of the role, Macellum director nominee Peter Sachse is now in a Co-CEO position. Peter Sachse brings far more experience to this position than any recent CTRN CEO, and I am optimistic that, with the right leadership in place, operational performance will gradually improve. Furthermore, Macellum has indicated that they are interested in selling CTRN if they cannot find a highly experienced CEO to run it. CTRN seems like a strong candidate for an LBO fund due to its low debt levels, relatively steady earnings and opportunity for margin improvement.
The largest risk facing CTRN is that its core customer base does not return and that the decline in sales is a long-term trend. I believe this risk was partially mitigated after 2Q19 earnings showed a stabilization in SSS deterioration and promising signs of improvement for 3Q19. Additional risk is added by recent store expansions into predominantly Hispanic markets, which necessitates merchandising and marketing expertise in this area that CTRN may be lacking since this is a new customer base. Because this is a key area for future store expansion, failure to appeal to a Hispanic customer base could produce a subpar return on capital.
There is also the risk that as an increasing portion of CTRN’s customer base obtains credit cards, they will migrate to online sales and abandon CTRN. I believe that if a substantial change in the number of customers with credit cards took place, CTRN would be in a strong position to launch its own ecommerce store based off its large social media following and frequent requests from customers to purchase items online. Furthermore, CTRN’s discount retailer peers who have a higher proportion of their customer base owning credit cards have demonstrated resilience against rising ecommerce sales. If there were a substantial threat from the Amazon effect, we would likely have already seen it among discount retailers.
A final and important risk is the dramatic change brought on by Macellum that could disillusion CTRN’s customer base. Macellum is the driving force behind the expansion into new markets and has ambitious plans for improving merchandise that could fall flat and jeopardize the brand CTRN has established for itself as a discount retailer specializing in urban apparel. Macellum, and more specifically, Jonathan Duskin, has a hit-or-miss track record at turning around retailers and could de-rail decades worth of progress CTRN has made at establishing itself within its core customer bases communities.
I believe CTRN is a compelling business that has retained a loyal customer base by staying true to its roots of providing urban apparel at a discounted price. Other discount retailers abandoned urban apparel when famous urban brands such as Roccawear and Southpole lost popularity at the beginning of the decade. While preferences for branded clothing have changed, there is still a thriving and dedicated customer base for urban apparel that has been shopping at CTRN and its predecessor Allied Department Stores for over 70 years, and I don’t see any indication they will abandon CTRN anytime soon.
Despite the resilience CTRN has demonstrated in many difficult environments, the market is currently forecasting a continued path of value destruction that seems unjustified. There are many exciting developments on the horizon for CTRN being brought by Macellum that are being completely discounted. I view an investment in CTRN as a highly asymmetrical bet that the headwinds it has experienced for the last year will not last, and that once management stabilizes, company performance will at the very least regress to its mean. I rate CTRN a conviction buy with a price target of $32.00, which implies an 89% increase from its current $16.94 share level as of writing.
Disclosure: I am/we are long CTRN. 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.