By Zoe Tan
In our view, Carter's (CRI) second-quarter miss, which was weighed down by several one-time factors, has provided investors with an attractive entry point. While we agree that rising input costs in the apparel industry will have a negative impact on near-term results, we believe Carter's should be able to weather these headwinds better than its peers, given its market-leading position in the space. Additionally, we are optimistic about Carter's long-term prospects, given its well-established relationship with retailers in the wholesale channel, a growing presence of its retail stores, and improving trends in the OshKosh brand. Therefore, we think an attractive buying opportunity will arise if Carter's stock falls below our Consider Buy price of $23.80, which implies forward fiscal-year price/earnings of 10 times, enterprise value/EBITDA of 5.2 times, and a free cash flow yield of 8.6%.
We view weakness in Carter's second-quarter results as a one-time phenomenon.
At the end of July, Carter's announced second-quarter results that appeared to be loaded with bad news, including a deceleration in wholesale revenue growth, negative retail same-store sales and reduced floor space at Wal-Mart (WMT). As a result, the stock has declined by about 10% since then (or about 26% since its peak in May this year). However, we believe the numbers are not as bad as they seem. Firstly, second-quarter sales were negatively impacted by the Easter holiday timing shift and earlier-than-expected merchandise shipments to Wal-Mart in the prior quarter, which accounted for almost half of the 14.5% growth posted in the first quarter (see chart below). Additionally, weaker retail store traffic was largely driven by the lack of clearance inventories in the second quarter (total inventories were down 7% at the end of the first quarter), a period where retailers traditionally clear excess spring merchandise, given strong sell-through trends earlier this year. This is also evidenced by the healthy 160 basis-point gross margin expansion during the quarter. Further supporting our view that weakness in Carter's second-quarter sales is more of a one-time phenomenon, the firm has already secured incremental orders for both Carter's and OshKosh in the wholesale channel for the rest of the year and into spring 2011, which will likely translate to high-single-digit revenue growth over the next few quarters. (Click to enlarge)
Higher sourcing costs are a real near-term threat, but we expect that Carter's will hold up better relative to its peers.
The price of cotton, which is a primary component of kids' apparel (80% of Carter's merchandise is cotton-based), has increased by 40%-50% in recent months to $0.90 per pound in July 2010. Furthermore, the price of shipping a 40-foot dry container from China to the U.S. has increased substantially to $2,800 in August 2010, representing a 94% increase from the $1,400 paid in August 2009. Therefore, we project that higher sourcing costs will weigh on Carter's margins in the near term. However, we believe Carter's leadership in the children's apparel space will allow it to pass on a fraction of these price increases on staple items such as baby and sleepwear products. In our view, private-label brands, which face similar cost pressure, will likely follow suit, maintaining a 10% pricing gap to branded products. Therefore, we remain confident that Carter's can maintain a low-double-digit operating margin in 2011, with margins recovering to the 12% range over the next few years as consumer spending improves.
Carter's well-established brand name in the kids' apparel space should drive long-term growth.
The namesake Carter's concept has become one of the major brands in the kids' apparel space, as its value-priced positioning and quality merchandise resonated well with consumers. Over the past decade, Carter's market share grew to 10% in 2009, up from 6% in 1998, which is an incredible feat, in our view, given the emergence of many private label names over the past decade (private label sales in the children's apparel market more than doubled over the past 10 years to 42% in 2009). Additionally, Carter’s has made itself a preferred partner of large national retailers such as J.C. Penney's (JCP), Kohl's (KSS), and Macy's (M), by being a store traffic driver through consistent ad-spending and attractive in-store displays. In fact, J.C. Penney's CEO Mike Ullmen, specifically pointed out that "increasing sales of select national brands with great brand loyalty like Carter's have really moved the needle in establishing J.C. Penney's as a destination for mums" during the firm's second-quarter conference call. Therefore, we remain confident that Carter's wholesale business will continue to be a steady revenue generator for the firm.
In the mass channel, however, Carter's was faced with floor space reductions at Wal-Mart over the past two years, following the mass merchant's decision to downsize its branded apparel offerings. Nonetheless, this strategy seemed to have back-fired, and Wal-Mart has decided to bring back higher-quality brands into its stores. With a new apparel team at Wal-Mart, Carter's management forecasts that future orders will probably be more predictable and projects incremental orders following the successful door test earlier this year. Carter's expects to ship approximately $8 million to $10 million of incremental volume to the mass merchant in the back half of the year, and another 10% increase in mass channel sales in 2011, based on current orders.
We see potential upside in the OshKosh segment.
After acquiring the struggling OshKosh chain in 2005, the firm repositioned the concept into a more upscale and sophisticated children's apparel brand. However, this change did not resonate well with consumers, as not many are willing to pay a hefty premium for branded children's clothing, especially since kids outgrow them pretty quickly. Moreover, as the economy weakened in 2007, management swiftly adjusted OshKosh's brand positioning and lowered its average pricing as much as 20% in the wholesale channel and about 5% in its retail stores. In our view, this is similar to what the firm has done with the namesake Carter's chain in the earlier part of this decade, where prices are adjusted to just 10% above private-label products. During our call with CFO Richard Westenberger, he explained that this strategy has worked well, as consumers are willing to pay a buck or two more for better quality merchandise. Additionally, the sales volume increase has more than offset lower mark-ups, enabling the firm to grow operating margins to the low double digit range in recent years, up from the high single digits in the late 90s (see chart below). Therefore, we have reason to believe that OshKosh will follow a similar path, albeit at a slower pace, as it is faced with a more competitive market for slightly older kids. In fact, we believe the change has already started to resonate with consumers, as OshKosh's wholesale orders and same-store sales at retail stores has turned positive over the past two years.
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