Retail turnarounds are never an easy sell, at least to me. The list of retailers that have gone under goes on and on, and fashion changes not even by the season, but sometimes by the week thanks to innovative retailers like h&m and Zara.
Citi Trends (CTRN) remains caught in the downward spiral that has captured bricks and mortar apparel retailers recently. High youth unemployment, changing consumer tastes, and weak employment figures amongst Citi Trends' core demographics have foiled recent performance, though the company reduced its growth strategy and has seen an overall improvement in margins and losses. Let's take a look at the velocity of recent performance and see what macro factors may or may not drive the stock higher.
A Quick Overview
Citi Trends is probably not a name on most investors' radar. The firm targets low-income areas that are predominantly African American. In reality, the company pursues a strategy that is much alike Wall Street darlings Ross Stores (ROST) and TJ Maxx/Marshalls (TJX). The firm buys brand name goods from a variety of vendors are incredibly low costs. This strategy certainly has its advantages. Lower cost of goods is one of them. Additionally, it allows the company to "load-up" when it finds a great deal on merchandise that it believes it can sell profitably. Further, diverse sourcing and brands creates a "treasure hunt" shopping environment that cannot be replicated outside of the stores. This strategy also allows Citi Trends to diversify away from any one brand. I have written before about how Foot Locker (FL) and Finish Line (FINL) are beholden to Nike-that is not the case for Citi Trends.
On the other hand, it gives Citi Trends less brand loyalty. When customers are looking for certain hot brands, whether it is Nike's Jordan (NKE) or Rocawear, they will not care if they get the item from Citi Trends or Ross. Some consumers will prefer the shopping environment at the smaller Citi Trends, but ultimately, the brands still hold the appeal and value. If Citi Trends does not get the right product in the store, then sales will be poor.
Another potential weakness in Citi Trends' business model is its concentration on a very specific demographic. 70% of the firm's business comes from African Americans of both genders with a median household income of $20,000-$40,000. The strategy will limit the potential reach of Citi Trends, but more importantly, I think it leaves the company highly dependent on an economically sensitive customer. There are a number of risks directly tied to this, which I shall address shortly.
Recent Weak Financial Performance
Citi Trends does not reveal detailed FY13 performance until March, but the initial read was pretty bad, in my view. Sales were down 5% for the year, but on a like for like basis, which excludes the impact of the extra week in FY12, sales were down 1.8%. Comparable store sales were down 1.6%. Neither of these figures is positive, but retail in general was fairly weak in CY13. Regardless, the company posted $622.2 million in total sales.
Source: Company filings
As we can see in the above chart, Citi Trends' financial performance over the last two years has been very inconsistent. However, the firm's two most important quarters-Q1 and Q4-have experienced the most downward pressure, revealing the hardships facing the business.
On the positive side, the company has seen a slight uptick in gross margins. During the third quarter, Citi Trends' gross margin jumped 231 basis points to 36.66%. Gross margins in FY11 and FY12 were in the 34.41% and 34.79%, respectively, which is down materially from the 38% range the company was accustomed to in the mid-2000's. Were Citi Trends able to resume its higher gross margin profile, the firm would be consistently profitable.
As for SG&A, the firm as seen its fixed costs move gradually higher as a percentage of sales thanks to a higher store count as well as the deleveraging effect of lower sales.
Let's take a look at some key factors to watch going forward.
Watch the Minimum Wage
In my view, SG&A is the key component to watch on the cost side going forward. With whispers of a higher Federal minimum wage, Citi Trends could really feel some pain on its bottom line. Most of its staff skews towards minimum wage labor, thus we could see a material increase in its fixed cost base. According to management on the third quarter conference call, the company has stripped costs down to the bare minimum, so I doubt there is more room to save with regards to labor costs.
Concurrently, a higher minimum wage should help bolster the store's core customer base. With a median income of $20,000-$40,000, Citi Trends' customers are low income, if not minimum wage employees. Higher wages should give them more discretionary income, and thus, more money to spend at Citi Trends stores.
African American Employment
The picture for unemployment in the African American population is pretty horrendous at the moment. According to the BLS, African Americans face 12.1% unemployment versus 5.7% for white Americans. Even worse, only 60.5% of the population is considered to be participating in the workforce, compared to 63.4% of whites. This translates to considerably worse economic performance for African Americans than the average US citizen. African Americans have underperformed the rest of the country since the Great Recession, and the trends have yet to converge with that of other races.
As I said before, 70% of Citi Trends' customers are African American. Unless there is a dramatic change, it appears the company's core customers could be challenged for the foreseeable future. Not only does this mean less discretionary income, but it also means the company's core demographic could opt to shop at less expensive places like Wal-Mart (WMT) and K-Mart (SHLD) in order to save money.
In my view, there is no short-term catalyst, particularly if we see an upward move in the minimum wage. Fast-food companies may look to technology to compensate for higher cost workers, meaning the unemployment rate could ultimately move higher. Additionally, the Agricultural Act of 2014 will likely reduce food stamp program subsidies to many of Citi Trends' core customers, putting even more pressure on spending. Overall, the economic reality for the firm's customer base looks weak at the moment.
Citi Trends' Female Strategy
Formerly a place for urban women to purchase urban brands, Citi Trends has had to respond to marketplace trends and move more towards unbranded, fashion-centric pieces. CEO R. Edward Anderson noted on the third quarter conference call:
"…we have pivoted to nonbranded fashion versus urban brands that no longer resonate with our ladies' customer. The nonbranded fashion has continued to increase as the urban brands continue to decrease. Importantly, nonbranded fashions now represents 85% of our ladies' business."
Kudos goes to management for recognizing the change and not continually sticking with dying urban brands. However, this changing trend in women's urban fashion opens the company up to competition from the likes of Forever XXI, h&m, and Zara. This is not a cohort I would want to compete against. Just ask Abercrombie & Fitch (ANF), American Eagle (AEO), and Aeropostale (ARO), which have all seen sales slump since fast fashion companies started to win over customers.
In recent years, the company has struggled to generate positive free cash flow due to its focus on opening stores and expanding. I think the company can generate around $10 million in free cash flow annually given current fundamentals, but I would wait to see how FY13 plays out to really make a decision.
As far as EPS goes, the company peaked at $1.44 in earnings in 2011, and it has not been profitable for the last couple of years. Analysts are expecting a loss of $0.02 per share in FY13, followed by EPS of $0.39 in FY14. In my view, the FY14 consensus forecast is too high given the headwinds for Citi Trends' core consumers and the potential for higher SG&A to impact the bottom line. I cannot envision the company earning more than $1 per share with its current business model, and even that figure seems optimistic, in my view. Realistically, I think shares should trade around $10-a generous PE multiple, but closer to 10x what I believe would be peak earnings.
Overall, this makes Citi Trends a compelling short. There does not appear to be much upside from current levels, and the firm is experiencing increased competition thanks to changing fashion tastes from its core female customer. Citi Trends may be debt free, but its business model is crumbling before our eyes.