First, there were a few mischaracterizations in Ms. Lomax's article. For example, she claims that TLB "has been struggling to pull off a turnaround for years." This is not quite the case. In fact, the first half of fiscal 2010 experienced positive same store sales, building off the momentum TLB experienced in 2009. At this point in 2010, TLB shares traded between $14-17 before the back half of 2010 where TLB's fashion missteps began to impact its operating results. So while TLB has been struggling for about a year, this is not "years."
Second, the current required turnaround is actually easier relative to what TLB experienced in 2008. Back then TLB still owned J. Jill, which it paid an expensive price for in 2006. TLB also had a children's, men's, and UK division. Last, TLB had a very challenging capital structure ending 2008 with about $460MM of net debt against 2008 EBITDA of just $19MM. More importantly, TLB had $219MM of debt coming due in 2009. Despite all of these obstacles, TLB was able to strip away non-core divisions and successfully address its liquidity concerns in 2009, cleaning up its balance sheet and paving the way for the stock to run up from the low $2s to mid teens over the course of the next year.
TLB shares are now back to where they were in early 2009 but TLB's current set of problems is actually less challenging relative to what its management team faced in 2009. The main problem facing TLB is that it tried to expand its core customer base from the traditional 55-65 y/o woman to the 45-65 y/o age range. As a result, its core customers felt TLB was too fashion-forward and felt alienated while the newly pursued younger customers were not purchasing enough to offset the decline from the core customer defections. This led to challenging performance over the past year. TLB management is aware of this and has been focused on shifting its fashion towards reinvigorating its core customer. This is clearly driving its decision to select a new Creative Director. However, investors should also note that core age segment has been up slightly based on comments in the most recent TLB conference call.
Ms. Lomax concludes her article stating that unless one enjoys "taking big, risky bets on wrecked companies" one should steer clear of TLB. One problem with this statement is that it takes no consideration for TLB's valuation and that appears to offer tremendous upside if the company can successfully execute on its plans. Table I first illustrates that on any measure, TLB is very, very cheap relative to its long term history. Its valuation levels are much lower than they have ever been, largely driven by the very real challenges TLB faces.
Click to enlarge tables
Note: Valuations based on Fiscal Year as opposed to calendar year. For example, TLB fiscal year ends at the end of January so therefore fiscal year 2011 actually corresponds to most of 2010.
However, as previously mentioned, management recognizes the problem and is addressing it. Second, the overall problem appears to be far more manageable than the numerous afflictions facing the company a few years ago. Table II can put TLB's problems in perspective relative to its recent history.
TLB's fashion missteps are represented by the company's poor gross margins as sales slow and merchandise must be sold at heavily reduced prices. In 2010, when TLB shares ranged from $10-18, gross margins were quite high. Gross margins were high enough to leverage its SG&A and drive operating income margins. Through two quarters in 2011 and company guidance for the following quarter and estimates for Q4, TLB appears to perform similarly to 2009, registering considerably lower operating income and margins. With an estimated $18MM in 2011 EBITDA, TLB is currently valued at 15.1x 2011E EBITDA.
Investors should note that this valuation is based on what should be abnormally low EBITDA levels. As Table II shows, gross margins are really what drives the company's operating income. When TLB has the right fashion in place, it can charge a fuller price and thus drive those margins over its SG&A. However, with wrong footed fashion, sales slow and gross margins take a hit as the company must cut prices to clear inventory. In Q2 2011, TLB management realized it needed to severely cut prices to move inventory, which resulted in very low gross margins. TLB is still in the process of clearing the poorly received merchandise which will result in depressed margins in Q3 2011. Q4 2011 should not deviate too much from Q4 2010, however, because by Q4 2010, TLB was already in the process of experiencing poor results due to its initial fashion missteps. What this means is that Q2 2011 results should be the worst of the storm TLB must endure.
One question investors may pose is how can one be certain that TLB can get the fashion correct? There are no guarantees but it's not uncommon for retailers to go through periods of both right/wrong fashion trends. The critical question is whether TLB has a legitimate brand value for its core customer group and by any measure TLB is a very well regarded brand. Second, a review of TLB's historical figures demonstrates that its gross margins can fluctuate considerably yet they tend to bounce back to the mid 30% range. TLB is on track to register gross margins close to what it notched in 2009. As a value investor I'd take my chances on the risk/reward at the current valuation level and performance based on the brand's history of sustaining itself and bouncing back from challenging periods.
Another net positive to TLB is that it is executing on a plan to close about 110 of its roughly 520 existing stores over the next two years with the bulk of closures occurring in 2011. These stores account for roughly $100MM in annual sales and $10MM in operating losses. If one were to strip out these stores on a pro forma basis, 2011 estimated figures would be slightly better. However, 2012 could likely have a nice rebound given the severity in sales declines in the current year. With a more streamlined store base, margins could improve considerably. As Tables III and IV show, it wouldn't take a lot to get the ship moving in the right direction. Even with a 34% gross margin in 2012, which is just 400 basis points above a close to record low gross margin 2011 and still off from recent high gross margin levels, TLB can generate strong operating income. With a range of $50MM-$80MM in EBITDA and better outlook, TLB could conservatively be worth $4-8 per share.
In 2010, TLB generated $140MM in EBITDA and its current LTM EBITDA is about $65MM, but because the trajectory is downwards for the balance of 2011, the market values TLB at just 4.0x LTM EBITDA. If the outlook can improve and TLB can generate levels of EBITDA close to its current LTM basis, that alone can result in valuation two times above current levels. If the operating results continue to improve, it's very possible for TLB to recapture previous valuation levels of 8-10x EBITDA and 0.5-1.0x sales. This would ultimately imply a valuation of $9-14/share.
Achieving that valuation is not solely tied to getting the fashion right. In fact, investors may be overlooking the impact of TLB's store expansion plans. On a net basis TLB is paring a significant number of underperforming stores but it is targeting expansion in upscale outlet malls with the projection that there is an 80-100 store opportunity in this segment. The reason this matters is that the sales per square foot at existing TLB outlet doors is $440 compared to $290 at normal retail stores. In addition, rent at outlet locations is generally lower than rents paid in traditional locations. This means that there is tremendous margin expansion opportunity simply by right-sizing TLB's store base between core retail and outlet locations.
The well regarded brand value and ability to impact margins through adjusting the store base are likely a few factors that have attracted smart investors such as David Gallo's Valinor and more recently, Sycamore Partners. Sycamore Partners traces its heritage back to GoldenGate Capital which is very familiar with TLB. GoldenGate purchased J. Jill from TLB, so the current ~10% stake held by Sycamore Partners ties to a firm that knows TLB very well. While TLB faces a number of challenges, it appears that current valuation discounts a large level of these negative potential outcomes and that an attractive risk/reward is available to investors that can get comfortable with the problems faced by TLB as well as the opportunities and likelihood of a turnaround.
Disclosure: Author manages a hedge fund and managed accounts long TLB.