Gymboree: At 10x EPS, You Get Future Growth for Free

 |  About: Gymboree Corp. (GYMB)
by: SkepticLLC

I'm not usually a huge fan of investing in apparel retail (discretionary spending and fad risk), but I have two kids and therefore know Gymboree (NASDAQ:GYMB) well as a consumer. When the stock showed up on my screens that look for a combination of high EBIT/EV yield and high return on invested capital, I decided to take a closer look.

Business overview

Gymboree is a specialty retailer focused on children's clothing (newborns up to ~10 years old depending on the brand). The company was founded in San Francisco in 1976 as a provider of play programs for kids and parents - which is still provided through over 600 non-retail locations (primarily franchised and only a small portion of revenue/profits). As of 10/31/09, the company operated 951 stores: 630 Gymboree, 139 Gymboree Outlet, 120 Janie and Jack and 62 Crazy 8. The company's investor relations website is here.

The Gymboree brand is a middle price point, while Janie and Jack is the high end and Crazy 8 is the low end (very analogous to Gap (NYSE:GPS), Banana Republic and Old Navy, respectively). In my opinion, children's clothing has two notable advantages over other specialty apparel retail: (1) kids grow, so new clothes are required and purchases are less discretionary; and (2) there is less of a focus on trends/fashion in the newborn-elementary school set than among teens, adult, etc.

I won't reproduce the recent financial history here, but the young management team seems to have done a capable job during both the strong years of 2006-2007 and the dismal years of 2008-2009. They have managed gross margins and operating costs (including their own bonuses) proactively, and have a very strong balance sheet with no debt and over $180 million in excess cash. A share repurchase program has been authorized.

Net asset value

Based on the balance sheet analysis shown below, I peg the reproduction value of Gymboree's assets at approximately $23 per share as of its 10/31/09 financial statement. The major estimated adjustments were the 25% haircut I placed on the net PP&E of the business and the addition of one year's SG&A spending to intangibles. Almost all of the company's operations are in leased, mall-based locations, so there is no real estate play here.

Earnings power value

The calculation of the earnings power value adds in approximately $182 million in excess cash on the books at present. I used a WACC of 10%/multiple of 10.0x, which I believe is relatively conservative based on their financial position and track record of steady cash flow generation. This WACC would imply a return on equity of 12% - 14% if you allow for a reasonable amount of leverage (in the range of 35%) for an EPV of approximately $39 per share.

Growth value

Over the past decade, Gymboree has grown its revenue base at a compound annual rate of approximately 8%. Revenue held steady during the severe consumer economic decline in 2009, but I think it's reasonable to assume that growth should resume as the economy recovers. The company has continued to invest in growth and is opening new Crazy 8 stores at a fast pace. Most importantly, the company produces a very high return on invested capital, allowing it to create substantial additional shareholder value through growth. I calculate a conservative return on capital of 19% based on the adjusted NAV calculated above. On a GAAP basis, the after-tax return on both invested capital (NI/[working capital + PP&E]) and incremental capital invested have been well over 30% for the past several years (adjust out the excess cash when doing those calculations). Using 6% as a conservative estimate of long-term growth, I arrive at a GV of $64 per share.

Valuation continuum and margin of safety assessment

The chart below summarizes the valuation work above compared to the current trading price and targeted entry level:

Summary and conclusions

Based on the current trading level of approximately $39, Gymboree is trading below where I calculate the margin-of-safety buy point at $42 (33% discount to the GV of $63). At the current market valuation, you are essentially paying EPV and getting any growth of the company for free. I have tried to be conservative in my estimate of a long-term growth rate and in the return on capital calculation, given that the return on cash invested in the business has been over 30% for the past several years. If growth is disappointing due to continued economic weakness or other factors, the EPV should provide a reasonable support for the company (which currently trades at ~10x EPS, adjusting for cash).

Disclosure: Author is recently long GYMB