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I want to begin with my two cents on the fashion retail sector.

Fashion retail is a challenging business model. Essentially, you rent a box (real estate) at $x per sq. ft., and try to sell $y per sq. ft. It is a highly competitive business with relatively low barrier to entry for many retailers. It is hard for a company to control its destiny when macro spending slows or peers engage in heavy discounting and markdowns.

There is very little brand loyalty, except for iconic brands such as Coach (NYSE:COH), Michael Kors (NYSE:KORS) or Kate Spade (owned by FNP). You have to earn the loyalty and relevance every season. Getting the merchandise mix, price points, location and shopping experience right is essential. Targeting a niche segment improves the odds of success. Ability to generate traffic is not enough unless it can be converted into profitable sales. The risk of fashion miss is more pronounced for specialty (brand) retailers such as Abercrombie & Fitch (NYSE:ANF) and Urban Outfitter (NASDAQ:URBN) compared to that of the multi-brand retailers such as Tilly's (NYSE:TLYS) and Zumiez (NASDAQ:ZUMZ).

In the midst of the difficult model also lies a big opportunity. If you get the concept right and execute it well, the unit growth opportunity can be huge. Once in a while, you get a compelling multi-bagger opportunity in retail. Think ZUMZ in 2005 or A&F in the early 2000s. TLYS is one of those multi-bagger opportunities, I believe.

It pays to understand the typical cycle of a retail franchise. Most of the fashion retailers go through the hype cycle.

  • Early cycle growth - If the concept is right, you can ride it through the unit growth phase. Retailer tends to pick best locations and opportunities during the early phase.
  • Mid cycle - The early growth generates overexuberance on the street. Management typically does over-expansion and even takes on financial leverage.
  • Store closings and turnaround - Retail stocks crater when the reality hits. Store closures and de-leveraging follow.

Owning a stock in early cycle or betting in on a successful turnaround could be very rewarding. I believe, TLYS is an early growth cycle opportunity.

Investment Thesis

Tilly's is a multi-brand, action sports specialty retailer targeted at teens. By deploying a larger store format, TLYS has positioned itself to be the fashion retail destination for teens. TLYS is in its early innings. Its transition from regional to national chain presents a rare multi-bagger opportunity. At the current valuation, you are buying a 15-20% grower at ~10.8x (ex-cash) LTM earnings or 6.25x LTM EBITDA.

The recent pull-back (~25% down in past three months) presents an attractive entry point for long-term investors. It is time to load up.

Key highlights

  • Multi-year growth potential - TLYS currently owns ~168 stores. Half of its stores are in California, while 2/3rd are in three states i.e. California, Arizona and Florida. TLYS is targeting to grow its store base to 500 stores at the rate of 15% per annum. This represents a growth runway for 7-8 years.
  • Compelling valuation - TLYS trades at 10.8x (ex-cash) LTM earnings, 6.25x LTM EBITDA.
  • Adequate margin of safety - With strong cash flow, ~50M cash on balance sheet and 18 month cash on cash return on new stores, TLYS provides an adequate margin of safety.

Key to understanding the story:

  1. How large and convincing is the unit growth opportunity?
  2. Will the concept work in new markets?
  3. How does it differentiate from ZUMZ? Can they co-exist?
  4. New store economics
  5. Valuation
  6. How do you explain recent sell-off? What might the market be missing?

How large and convincing is the unit growth opportunity?

TLYS has 161 stores as of Oct 2012, with 1.27M square feet of store space. The company does ~ $350 per sq. ft. in sales. Almost half of the stores are in California, while 2/3rd of them are in three states i.e. California, Arizona and Florida. TLYS has 3 or less stores in 45 states of US. There is an opportunity to put many more dots on the map here. During the early unit growth cycle, the company also has the ability to pick the best locations.

Source - Company Presentation

ZUMZ is the direct competitor and operates ~470 stores in United States. Just for comparison purposes, ZUMZ has grown from 176 stores in 2005 to 470 stores today. To me, the following chart puts the growth opportunity in perspective.

State

TLYS

# of Stores

ZUMZ

# of stores

Difference

Colorado

3

16

13

Pennsylvania

2

15

13

Illinois

2

15

13

New York

3

27

24

Washington (ZUMZ HQ is here)

2

23

21

New Jersey

7

16

9

Texas

1

31

30

Wisconsin

1

12

11

Oregon

1

12

11

Source - SEC filings for TLYS & ZUMZ

Source - MapMuse*

* Blue dots on the map are ZUMZ stores. MapMuse information is bit dated, but it is primarily used to visually represent the gap between TLYS and ZUMZ.

Will the concept work in new markets?

Trends in eCommerce sales for TLYS confirm the opportunity in new markets.

According to the management, ~ 1/3rd of eCommerce sales are coming from customers who do not have access to brick-and-mortar locations (within 50 miles). This trend reinforces the confidence in the unit growth opportunity. The eCommerce sales for TLYS are ~11% of total sales vs ~7% for ZUMZ. The large difference in the share of eCommerce sales further confirms the opportunity.

Past track record confirms the demand for the TLYS offering & the management's ability to execute - During 2007 to 2011, TLYS has successfully doubled the store count and grown from 5 states to 14 states. This track record confirms the unit growth opportunity as well as management's ability to execute.

Source - Company Presentation

Nationwide presence of target customer - TLYS caters to the teen lifestyle and positions itself as a retail destination. The action sports, teen retailer category has matured from the niche fashion to the mainstream, everyday lifestyle. The action sports lifestyle is relevant in all pockets of the county from urban, suburban, to rural.

The successful expansion of ZUMZ from 176 stores in 2005 to 470 stores in 2012 is another proof point in support of growth potential for the category.

How does TLYS differentiate from ZUMZ? Can they co-exist?

To me, this was one of the most important research questions. It is important to understand who the TLYS customer is.

The biggest differentiation between these two retailers relates to the box size. Tilly's average store size is 7,900 sq. ft. Vs. 2,900 sq. feet for ZUMZ. How many multi-brand retailers you can name with a 3000 sq. ft. box?

For a multi-brand retailer, the floor space size determines the ability to display and carry merchandise mix. With a larger store format, TLYS can target more niche segments and broader merchandise offering and truely distinguish itself as a teen retail destination.

During my store checks, I have noticed that the many of the hot selling/trending items in the Tilly's stores are also the ones that are not carried by ZUMZ. Note - this is an anecdotal observation and not hard evidence.

Some more important differences:

  • ZUMZ has a much narrow focus on action sports lifestyles such as skateboarding, snowboarding and surfing, while TLYS targets these categories as well as the niche action sports such as Motocross and NASCAR. TLYS also targets music, art and fashion.
  • ZUMZ targets the hardcore action sport participants, while TLYS targets the action sport enthusiast. TLYS targets the customer base who aspire to or casually participates in the action sports.
  • ZUMZ dedicates a lot of floor space for the skateboard counter as compared to TLYS. ZUMZ also offers skateboard accessories and repairs. The hard goods sales make up a meaningful of ~11% of total sales for ZUMZ.
  • ZUMZ is mostly mall-based stores. TLYS has 50/50 split between mall and off-mall.

Both the chains have co-existed in California very successfully. There is no reason why they both cannot grow and co-exist in the rest of the country. ZUMZ has 77 stores in California, while TLYS has 78 stores. Many of their stores are located in the same mall.

What are the new store economics?

If you believe the unit growth thesis, you would want to know the new store economics next.

Opening a new stores requires ~500K-550K in capex and generates $2.2M in sales during the first year. The cash on cash payback period for a new store is 18 months. The compelling new store economics and the inherent operating leverage in the model will bring strong earnings growth even without the help of SSS comp improvement.

Source - Company presentation

TLYS is a cash-generating machine. Its future growth can be funded through operating cash flows.

The cash on hand and the ongoing operations are more than sufficient to fund it's future growth. TLYS has a strong balance sheet with ~$50M cash on hand.

TLYS is also a cash-generating machine. During 2010 and 2011, company generated ~$94M in operating cash flow. Even after spending $36M in cap-ex and opening 29 new stores, TLYS generated free cash flows of ~$57M during that two year period.

Past investments have positioned the company for growth and a strong execution

During past five years, company has invested over $20M in infrastructure and systems. The company has made significant investments in its IT systems and distribution infrastructure. I had an opportunity to visit company's distribution center in Irvine. The distribution center is highly automated. The shipments are created in the floor-ready format, making it easier to deploy the merchandise at the store. The entire distribution infrastructure is built around being agile and making frequent deliveries. Currently, the average utilization of the distribution center is a single eight hour shift. The distribution center is built to support the 500 store growth objective. Given the back-end readiness, expect further improvement in the operating leverage via reduction in G&A.

The company typically delivers the shipments to stores 5x a week. The company uses its own fleet to ship merchandise to the local (Southern California) stores and third-party distributors for the remaining stores. As the store density improves, there is further leverage in reducing the logistics costs by bringing the distribution in-house.

TLYS will also benefit from the tremendous operating leverage inherent in the unit growth phase of the retail business. G&A leverage will kick in with the increasing scale. The distribution and selling cost leverage will kick-in as the store density in the region improves. The occupancy leverage will kick-in as the new store base matures.

Expect the operating leverage to further augment the earning growth coming from the opening of new units.

Why recent sell-off?

TLYS is down in sympathy with ZUMZ. ZUMZ is down because of softer comps over the past three quarters. Remember that the ZUMZ is coming off a very strong comp base of 2011. ZUMZ is also coming off a much higher valuation than TLYS.

Note - ZUMZ is also a terrific franchise run by a top-notch management team. However, I like TLYS more because of better visibility, longer growth runway and more favorable valuation.

Is market mis-reading SSS comps?

TLYS sold off recently on de-accelerating comps in Q3. However, consider the following:

  • Very high base - The comps are coming of a very high base of 2011.
  • California exposure - SSS comps include 130 comparable brick-and-mortar stores. Approximately 60% of these stores are situated in California. The California exposure will continue to decline as the franchise expands in new markets. For the most recent quarter (Q3 12), sales in California came in softer. The potential cause for the pullback is the temporary spike in gas prices (as high as $6 a gallon) due to refinery issues on the west coast. Footwear also came in softer which was evident across the category. These are temporary issues and do not suggest any change in the long term thesis for the franchise.

Reminder - 31 stores are not included in the comparables because these have not completed 12 months since opening at the time of reporting.

Source - Company SEC filings

The Street tends to worry too much about the SSS comps from quarter to quarter. SSS comps are important because they indicate the incremental growth & the category growth. It is important to understand that the primary source of growth for TLYS is the new units. The operating leverage and new store economics could pick up the slack from softer SSS comps.

Given the long term opportunity, I would not worry too much about slight de-acceleration in the SSS comps.

Is the category growing? Or are the players stealing share from each other?

The actions sports multi-brand retailer category has been clearly growing. Consider the combined store base and net sales for ZUMZ, TLYS and PSUN. This is not a complete list but these are the main multi-brand retailers in teen fashion retail (destination retailers). I wanted to use these three franchises to illustrate the trend.

Interpretation - What is happening here is that TLYS and ZUMZ are creating a one-stop destination for the teen fashion category. They are stealing a little share from many (branded) specialty retailers. TLYS and ZUMZ carry over one hundred third party brands. The single brand speciality retailer cannot provide a full range of offering. The expansion into new market is the major source of growth for ZUMZ and TLYS. Under-penetrated markets and the maturity of existing store base should continue to support the category growth for a significant period.

Financial Overview

Here is the historical overview of the company. Few things worth noting regarding the financial performance:

  • Strong positive comps. FY10 comps of 6.7%, FY11 comps of 10.7% and LTM comps of 3.6%
  • Strong EBITDA trends. FY10 $39M, FY11 $50M and LTM $48M
  • High quality growth. Net sales as well as EPS growth.
    • Net sales growth FY10 17.6%, FY11 20.5%, and LTM 12.2%.
    • EPS growth FY10 17.5%, FY11 10.8%, LTM 22%
  • Strong free cash flow (ex-distributions). FY10 $25.8M, FY11 $31.7M

Source - Company filing.

Trading psychology

TLYS has a limited history as a publicly run company. Its market cap is near the lower end of the small cap range. As the company establishes its track record as a public company, its stock will extract premium multiple. Consider how the ZUMZ stock traded for the first two years as a public company.

Management team

TLYS is run by very competent and experienced management team.

Mr. Hezy Shaked is the Chairman and Chief Strategy Officer. He is a co-founder and has been with the firm since 1982.

Mr. Daniel Griesemer is the President and Chief Executive Officer. He joined TLYS in February 2011. He has been in retail over 28 years. He served in various roles with Coldwater Creek, Inc. from 2001 to 2009 including most recently as Chief Executive Officer. During his tenure, Coldwater Creek increased the store base from 13 to approximately 400 and increased revenues from approximately $340 million to approximately $1.1 billion. Mr. Griesemer also served in leadership positions at Gap, Inc. and Macy's, Inc.

Mr. Bill Langsdorf has served as Senior Vice President and Chief Financial Officer since February 2007. Prior to which, he has served in CFO position with many firms including Anchor Blue, Wet Seal and House2Home, Inc. (formerly Home Base, Inc.). Prior to joining Home Base in 1986, Mr. Langsdorf was a Manager in the consulting practice of Ernst & Young LLP (formerly Arthur Young & Co.).

Valuation

I am aware of the inherent bias involved in creating detailed projections because you are more likely to believe in the preciseness of your own model. However, they do help put the potential upside in perspective.

The 15% unit growth can contribute to 15% earnings growth, if the comps are operating margins remain at the current levels. The operating leverage or SSS comp improvement can contribute to another 500 bps.

The company earned $1 in LTM. For FY 12, company has guided for 89c-91c earnings. For the projection, I will take mid-point of 90cents earnings in FY 12.

Earnings estimates scenarios

Potential valuation scenarios

The company holds ~$2 per share cash. Valuation assumes a $3 in cash by the end of FY 14. In the base scenario, TLYS could be worth $27-32 over next two years.

Conclusion

Tilly's transition from a regional to national chain represents a very compelling multi-bagger opportunity. TLYS is positioned to grow at 15% per annum with the target footprint of 500 stores, representing a growth runway for 7-8 years. By deploying a larger store format and offering a broad selection of merchandise, TLYS has positioned itself to be the fashion retail destination for teens. TLYS is in its early innings. At the current valuation, you are buying 15-20% grower at ~10.8x (ex-cash) LTM earnings and 6.25x LTM EBITDA.

It is time to load up..

Note - Email me to receive the financial model in Excel.

Source: Tilly's: Retailer With A Broken IPO Is A Double

Additional disclosure: Email me to receive the Excel model.I have spent significant time following the company since its IPO. I have met the CFO, visited the company’s head quarters, distribution center, number of company stores and competition’s stores. The article is more focused on the analysis of the opportunity than the stating the facts about the company’s current operations.