Citi Trends: Value in US Retail Apparel?

The news in retail apparel seems to be getting worse and worse. Whilst I still think ARO is generally cheap I am attempting to cut up the position into a more diversified retailer position of roughly the same size. There are a few companies comparable to ARO that are kind of cheap like American Eagle Outfitters (NYSE:AEO) but there are some opportunities to take a slightly more diversified approach. Three companies that I have highlighted and will look at the next month or so are Citi Trends (NASDAQ:CTRN), hhgregg, Big Lots and Big 5 Sporting Goods. These are companies that have just come on up on my screens so I haven’t done any extensive research yet although I am somewhat familiar with Big 5 and Big Lots.

The first company I will look at is Citi Trends, a value-priced retailer of both branded and private label urban apparel with around 460 stores in 27 states. CTRN is most comparable to companies like TJX Companies (NYSE:TJX, runs TkMaxx stores) and Ross Stores (NASDAQ:ROST) in that it takes an opportunistic approach to buying often purchasing for the current season or, to a lesser extent, buying to hold for a later seasons. However, besides being far smaller it operates within a niche, of sorts, focusing on African-American consumers and offering womens, mens and kids clothes. A more subtle difference, but one I believe is important, is that the products are displayed by brand rather than size, the focus for CTRN is on providing branded goods at cheap prices. CTRN aims to sell these brands at prices 60% below comparable apparel available in department stores or elsewhere. We can see from the above table that given past results CTRN looks a bit, but not massively, cheap. The share price has been in freefall roughly since April 2010 losing 50% of its value, driven by declining same store sales. I will look at three main factors:

1. Operating metrics
2. Financial position
3. Recent trends/Economics of the business
4. Competitive Position
5. Valuation/Conclusions

Looking to the usual metrics, we see that margins have been steady whilst it has been turns in net operating assets that have led to declines in return on operating assets. Inventory turns are obviously a big part of the retail apparel business and this has been leading the decline in turns. In 2006, it took around 99 days for inventory to be converted to cash whilst in the last fiscal year this was closer to 106 days. Changes in payables mean the effect on the cash cycle wasn’t as noticeable. Another factor is the recent investment in a third distribution centre which increased capex/net operating assets significantly but will pay off over the next five years. So operations have clearly been worsening however, it isn’t clear if this is due to less profitable growth or worsening financial condition for CTRN’s customers.

Whilst operating results have declined, leverage has increased modestly which offsets some of the effect of poor operations and means shareholder returns are still just above 10%. The company has an unused credit facility for $20m and runs large cash balances so the origin of debt is operating leases. Interestingly, CTRN has a mix of contingent and flat rate rent which is unusual as, in my experience, flat rate rents are very rare in apparel retail. Another unusual factor is that rental expenses are 29% of total operating leases. If  we refer to my previous post here we see this is very unusual and suggests that the average operating lease for CTRN is around 3 years. This is probably something to do with CTRN’s business model and it mainly operating in strip malls. Either way, it introduces a fairly significant of leverage into operations. As we can see from the EBIT/Interest expense multiple in the first table the company’s financial position has got much worse recently, now just under 3. The company has a significant cash balance of $95m but this is probably something to keep an eye on.

Looking at same store sales, we can see that for the last four quarters the trend has been negative. The interesting point here is that there was a decent recovery from the “recession” but sometime in mid-2010 CTRN started struggling again. Looking at the reasons behind these poor same store sales, in Q4/10, the company highlights:

the lapse in extended unemployment benefits in December, the delay in our customers receiving their income tax refunds in January, and a very significant comp miss in branded denim that occurred throughout the quarter.

In the last quarter, the company highlights increasing food and fuel prices and, in particular, the underperformance of its branded apparel line. The first point to highlight is that CTRN really is going after a niche customer. Second, the poor performance of the branded line is worrying as this suggest something wrong with the business rather than a cyclical factor like commodity prices. The company explains the poor performance of branded apparel as predominantly a problem with buying but highlights that the customers are also trading down CTRN’s private label goods or buying accessories. The company appears to have responded quite fast and has already instituted a review of its buying practices and its performance over Christmas. The company expects 1-2% increase in comps over the next three quarters highlighting Q4 as the quarter where most improvement will be made. It is obviously difficult to split out secular and cyclical factors but as I try to focus on the long-term I would say this issue with branded goods is what is important going forward. The company appears responsive and aware of where it needs to improve and how but I don’t think we can really consider this a catalyst for revaluation.

Discussing CTRN’s competitive position a bit, we know that it relies on suppliers having excess inventory and CTRN opportunistically buying this inventory.Changes in the dynamics of this relationship might play out through sales growth if CTRN wasn’t getting the right products but it would also play out through margins. In the most recent conference call, the company mentions that it has good access to inventory. In addition, it is worth mentioning some of CTRN’s competitors have been going out of business. However, we should recognize that CTRN is operating in something of a niche so the effect of this is somewhat difficult to make out. Another factor is that CTRN operates out of strip malls. With higher gas prices, consumers are choosing to go to one place with everything and smaller retailers like CTRN suffer. This may prove to be cyclical but we should bear in mind the type of locations it is selling from. Overall, what we see here is what we expect. CTRN seems to have a fairly good competitive position but it is has struggled recently with poor execution and its customers appear to be still struggling.

Putting this altogether is quite difficult. The company’s growth strategy is quite typical, keep growing stores and some refits. I think same store sales have gone through the worst but the worsening financial position suggests that increasing investment isn’t paying off. However, the company operates within a clear niche for consumers and its relations with suppliers appear sustainable. Over the long-term, CTRN will, probablly, make money. Book value is $15 which is 8% below the current price of $16.35 giving a P/B of 1.09x. At this price, we don’t have a great deal of margin of safety considering the dangers that recent poor performance has raised. Fair value is around book so I would look to buy around $13, at the most.

Disclosure of interest: No positions