Newsletter Value Investor Insight carried an interview May 26th with Springhouse Capital manager Brian Gaines (pictured left), whose fund focuses on undervalued small cap stocks. Springhouse Capital has generated an average net return of 29.6% per year since its launch, versus a 13.9% annual return for the S&P 500, according to Value Investor Insight. Here's the segment of the interview in which Mr Gaines discusses his position in Celebrate Express (BDAY), which was trading at $16.80 at the time of the interview (chart here):
Tell us about another of your Internet holdings, Celebrate Express [BDAY].
BG: The company’s main brand is Birthday Express, which sells party supplies for young children’s birthday parties through the web and catalogs. They also have a smaller costume business and they sell special-occasion clothes for children. About 70% of revenues come from the Internet, up from 50% three years ago.
We had never heard of it, but found that Birthday Express has very high brand awareness in the community of affluent mothers. They are the dominant online player and compete offline with chains like Party City and the discount retailers. The party-supply business actually works much better on the Internet. A retail store has trouble stocking enough themes with enough depth in those themes – Party City may have the SpongeBob plates, but not the cups or banners. With a centralized warehouse, Birthday Express can stock triple the number of themes of Party City and double the number of items within those themes.
The company has a lot going for it. It’s the online market leader, with high returns on capital and revenue growing 30% per year. People find out about it by word-of-mouth and repeat business is now 50% of the total, which should allow them to reduce marketing spending going forward. Given the fulfillment infrastructure needed with the average order having 20 different SKUs [stockkeeping units], it’s not easy for someone to step into the space – it would make a lot more sense for someone just to buy these guys out before doing something themselves.
So what’s the market missing in pricing the stock at a recent $13.17?
BG: Earlier this year the company ran into some operating problems, primarily as they started upgrading their fulfillment system to an automated pick process from the current manual process. This led to some inefficiency – which we think is temporary – but will result in pretax operating margins of 3-4% on $90 million in revenues for the fiscal year ending this month. On that, the stock looks pretty expensive, trading at more than 20x operating income.
As they grow and correct the system issues, fulfillment costs are going to go down. They should have lots of leverage in spreading selling, general and administrative costs over a larger base. They have gross-margin upside from selling a higher percentage of proprietary products.
In addition, they currently spend 25% of their revenues on marketing, which we think is much more than they’ll need as they move more of their business to the Internet and away from catalogs. Once you have a customer, you know when to market to them the next year and you can do it by e-mail, rather than a catalog. Management expects 10% margins over time. We think 8% should be fairly easy.
So looking at this a year from now, we think people will see $115-$120 million in revenues, with an 8% operating margin, resulting in around $9.4 million in operating income. If we get to that point, with the top-line growing at 20%-plus, that should warrant at least a 12x multiple on those operating earnings. If you add in the $35 million or so of cash they’ll have then, we get a target value of $19 per share.
What’s the downside protection here?
BG: One protection is from the takeout value if a big company like Amazon wanted to get into this space. An acquirer could immediately eliminate $2 million in public- company operating costs. Even if you assume Celebrate Express makes only 6% operating margins, someone would easily be willing to pay 8-9x that for a business growing like this. That comes out to around $15 per share.
A free option here is the database. Their customers are generally affluent mothers in their 20s and 30s, who are willing to pay a bit more for convenience and selection. It would not be a stretch to see them marketing related concepts to this valuable audience in the future.
The company named a new CEO last week. Has that affected your outlook?
BG: The founder took the company to this point and they decided it was best now to bring in more of an operating manager as CEO. As with Greenfield, we welcome the fresh set of eyes and think some of the things we’re looking for might happen faster.