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The apparel industry is known for its intense competition. However, the babies and young children segment is the niche market of which the competition is more benign and the fashion is more predictable. Here I'll explore the investment thesis of a forgotten small-cap growth stock in the segment, Carter's (CRI).

1. The leading apparel player in the babies and young children segment.

Carter's is the largest branded marketer in the U.S. of apparel exclusively for babies and young children. Essentially, Carter's owns two well-established brands, i.e. Carter's and OshKosh. Carter's brand is known for high-quality apparel for children sizes newborn to seven whereas OshKosh is positioned for children sizes newborn to 12. The US children's apparel market is estimated to be worth $21 billion. Carter's brand commands the top position with a 13.9% market share whereas OshKosh brand has a smaller market share of 2.6%. Both brands are positioned to offer high quality apparel at attractive prices, in other words, value for money.

2. Steady expansion of Carter's brand in the US.

The largest segment is the Carter's brand in the US, contributing 75% and 90% of revenue and earnings, respectively. The growth is driven by 10-15% increase in store count per annum and mid-single digit comparable store sales growth.

Table: Steady store count expansion of Carter's brand in the US.

Year

2012

2011

2010

2009

Carter's retail stores

413

359

306

276

% change y-o-y

15%

17%

11%

Table: Steady comp of Carter's brand in the US.

Quarter

4Q2012

3Q2012

2Q2012

1Q2012

Carter's Retail

5.2%

2.7%

1.0%

6.7%

Quarter

4Q2011

3Q2011

2Q2011

1Q2011

Carter's Retail

7.2%

5.5%

8.1%

1.2%

The latest comp has been temporarily less encouraging, turning negative for February 2013. The management attributed this trend to the snowstorms in February. Looking back at the historical comps, another reason could be the high base last year. Nevertheless, the management is expecting a positive trend in March because the stores typically sell more in March than January and February combined. Furthermore, the comp for Carter's online is up more than 50% in the first two months.

3. OshKosh turnaround.

Acquired in 2005, OshKosh's performance has been volatile, dragging down Carter's profitability. Currently, OshKosh is making a loss, which is far and apart from the 17% margin of the Carter's brand. The company has taken steps to improve OshKosh, including strengthening its product offering and marketing, reducing unprofitable sales, testing a new store format and building direct sourcing capabilities. We are starting to see better numbers from OshKosh. Despite a declining number of retail stores, revenue is maintained and loss is shrinking. Store count has been declining due to the closure of unprofitable stores. The management is expecting total sales from OshKosh from all segments to grow to at least $600 million by 2017 with an operating margin of 10% to 12%. Not to discount the ambition but to be conservative, we can take OshKosh's turnaround as an added bonus.

Table: OshKosh's performance.

Year

2012

2011

2010

Revenue ($ million)

363

363

340

Margin

-1.0%

-2.4%

6.8%

No. retail stores

168

170

180

4. International segment: the new growth driver.

Another growth driver is the international segment. The revenue contribution from international segment exploded from 2% in 2010 to 9% in 2011.

Table: Fast growing international revenue contribution.

Year

2012

2011

2010

International

9.2%

6.5%

2.0%

The jump in revenue was primarily driven by the expansion into Canada via the acquisition of Bonnie Togs in June 2011. Bonnie Togs is a Canadian specialty retailer focused exclusively on the children's apparel and accessories marketplace. Over the next five years, the sales from Canada are expected to grow at a respectable 15% per annum. The growth will be driven by increasing store count by 15-20% per annum and by extending the partnership with the global wholesale partners to Canada. Carter's has begun shipping to Target Canada. Another partnership will be with Wal-Mart Canada in 2014.

The next country targeted is Japan, which is the third largest children's apparel market in the world with $8 billion market size. Carter's recently acquired its licensee in Japan, assuming the control over nearly 100 points of distribution in Japan. Given the small revenue size of $20 million per annum, the impact on the overall picture will be not be meaningful but it is a first step to expand its direct-to-consumer retail footprint beyond North America.

5. Distribution model is shifting from wholesale to direct-to-consumer.

Over the years, Carter's has been focusing on retail expansion and online commerce, shifting the revenue contribution from wholesale to direct-to-consumer.

Table: Wholesale revenue contribution is declining.

Year

2012

2011

2010

US wholesale

45%

48%

52%

While offering a low gross margin wholesale model requires a lower SG&A fixed cost and enables a young company to focus on product development. However, as the brand awareness of a company grows stronger, the natural development is to shift from wholesale to direct-to-consumer. Carter's is currently going through this new phase of development.

Direct access to customers will provide Carter's a better position to further strengthen its product development, marketing and branding. The direct-to-consumer model requires a higher SG&A fixed cost but it will be offset by a higher gross margin. In addition, as the revenue per store rises, the operating margin will expand via operating leverage. The company is targeting to improve operating margin by a fifty basis points.

Table: Rising SG&A will be offset by rising gross margin. Over time, operating margin will improve due to operating leverage.

Year

2012

2011

2010

2009

Gross margin

39.4%

32.8%

38.6%

38.0%

SG&A as % revenue

29.9%

25.7%

26.8%

27.0%

6. Cotton price has stabilized.

The biggest risk to the business is cotton price. The gross margin is highly sensitive to cotton price. In 2011, cotton price surged by more than 150% to $2 per pound, resulting in six percentage point decline in gross margin and 22% decline in operating income in spite of 20% revenue growth in the year. Subsequently, cotton price declined steadily into 2012 back to the normal level, leading to a staggering 40% increase in operating income. Cotton price, like any commodity, will always be volatile. With a steady topline growth and the prospect of expanding operating margin, any decline in share price led by rising cotton prices in future should be seen as an opportunity to buy.

Table: Margin and earnings growth in 2011 was severely hit by the surging cotton price.

Year

2012

2011

2010

2009

Revenue growth

12.9%

20.6%

10.0%

6.4%

Gross margin

39.4%

32.8%

38.6%

38.0%

Operating income growth

41.6%

-22.8%

17.2%

53.6%

7. Reasonable valuation.

Over the past few years, the stock has been re-rating upward. The valuation has been rising every year. At $58 share price, Carter's is currently trading at 18x PE for 2013, expecting 20% earning growth. The Children's Place Retail Stores (PLCE), which has a lower operating margin than Carter's, is trading at 15x PE for 2013. Relative to its peer and its own historical valuation, Carter's valuation seems reasonable. Furthermore, the cotton price has stabilized, removing the biggest concern to Carter's.

Table: Historical PE.

Year

2012

2011

2010

2009

52-week high PE

20.0

19.5

13.6

13.7

52-week low PE

14.9

13.5

9.5

8.0

Conclusion

Carter's offers a steady growth prospect from both topline and margin. First, the topline growth is driven by the expansion in both the US and international segments. Second, the operating margin will be gradually increased due to the shift of distribution model from wholesale to direct-to-consumer. At the current valuation 18x PE for 20% growth, it is a good candidate for a long position.

Disclaimer: Third Mile is not a registered investment advisor or broker/dealer. All information contained herein is for general information purposes only and does not constitute any investment advice. Third Mile does not guarantee the accuracy or completeness of the information contained herein. Readers are solely responsible for their own investment decisions.

Source: Carter's: A Forgotten Small-Cap Growth Stock