- Cato has a 27 year record of continuous profitability, with remarkable 6%+ net profit margins, and 50%+ adjusted ROE the norm, including its best year ever in 2015.
- A risky and overly ambitious rejiggering of merchandising has resulted in dramatic comp sales and profit declines for 20 months now, causing the stock to swoon from $45 to $11.
- The company has been wrongly cast aside as "troubled retail," even though management is fixing the problem, and returning to its tried-and-true ways, with the new assortments currently flowing in.
- The company has $10 a share in cash and real estate held for investment and no debt, a huge margin-of-safety, making the stock way underpriced in any turnaround scenario.
- The CEO is seasoned, brilliant, has an exemplary record as a merchant, has been in charge for 20 years, and is fully aligned with shareholders.
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Source: Company website
The Cato Corporation (NYSE:CATO) was founded in Charlotte, North Carolina in 1946 by Wayland Cato, Sr., his son Wayland, Jr., and brother Edgar. The company's current business model has been in place for a few decades now, with third generation scion John Cato, 67 (son of Wayland Cato, Jr.) having been CEO for roughly 20 years now. (Company cofounder Wayland Cato, Jr., while no longer involved with the business, is a rather vigorous 95 years old, which may imply no immediate need for a succession plan at the company.) John Cato has a 9% economic interest in the company, but also controls super-voting shares, which give him 43% voting control. The company originally went public in 1968, then private in 1980, then public again in 1987.
Cato operates roughly 1350 stores (all leased) in 33 states, primarily in the Southeast, and primarily under the Cato, Cato Fashions, and Cato Plus names, but also under the It's Fashion, It’s Fashion Metro, and Versona names. The key to the business model is that the company offers on-trend ladies apparel and accessories at every day low prices ($29.95 dresses, $27.95 jeans, etc.) in a full service environment, where colors and styles are coordinated and presented for ease of selection. Cato locates its stores mainly in small town and secondary markets in strip centers that also include a Wal-Mart Supercenter and/or market dominant grocery store, which provides a steady stream of traffic, making the company highly resistant to the secular decline in shopping mall traffic. Unique to the company's business model, while it does have stores in medium cities, it purposefully avoids locating in the urban core, to avoid high rental costs, instead locating on the city outskirts.
Cato has emphasized broad and shallow assortments, in order to minimize markdowns, create a more dynamic and exciting retail environment, and to facilitate a more nimble-reacting buying operation. The company offers quality merchandise that is generally priced below comparable merchandise offered by department stores and mall specialty apparel chains, but is generally more fashionable than merchandise offered by discount stores. This creates a kind of value-added in store "treasure hunt" shopping experience for customers. The company seeks to be the leading retailer for fashion and value in its markets, and believes it is the every day low price leader in its market segment.
The Company Became A Financial Powerhouse Shortly After John D. Cato Took Over As CEO In 1999
Except for the last two years, 2016-2017, Cato has essentially been in a period of continuous improvement since 1990 (when the company was threatened with insolvency). Notably, this success ramped up considerably with John Cato's installation as COO in 1996, and then CEO in 1999. From 1996 through 2015, under John Cato's aegis, the company went from $492 million in sales and $7 million in net income to $1 billion in sales and a record $67 million in net income. Cato has evidenced himself to be a very shrewd merchant and buyer, surrounding himself with quality people, and, until very recently, possessing a consistent ability to execute, and provide shareholders with outstanding returns.
The company's business model has proven to be remarkably durable, with net profit margins consistently in an astonishing 6.0-6.7% range for each of the six years ended 2010-2015, which were, in fact, the best margins the company has recorded at any time in its modern history! Even in the recession years of 2008-2009, the company averaged between 4-5% net profit margins, and typically achieved 5-6% net margins from 2007 back to 1999, John Cato's first year as CEO. (The company has had NO loss years in the last 27 years.)
The company has had low turnover in management, with its four proxy statement listed executive officers (CEO, CFO, Director of Stores, and Chief of Real Estate/Store Development) each having been with the company for 30 or more years. This reflects the family atmosphere at the company, high morale of corporate employees, and healthy and stable corporate culture. It also should be emphasized how reassuring it is that the same core team remains in place that made this company such a resounding success over the last generation.
The Company Has A Margin Of Safety Like You Have Never Seen Before, Attesting To The Underlying Value Proposition
First of all, the company is carrying $220 million in cash on its balance sheet, or $8.85 a share. Secondly, the company holds 350 acres of Charlotte-area real estate for speculative development, adjoining an interstate highway (I-77).
While this land is carried for only $11 million on the company's books, I estimate it to be worth $75,000 an acre, or roughly $25 million. Combined, the cash and land represent roughly $10 per share in "excess" asset value for the company. That means, at an $11 stock price, investors are essentially paying only $1 per share for a debt free business. At $1 per share, on 25 million shares out, one is paying $25 million for a business that is generating roughly $1 billion a year in sales and has earned, in the best of times, $67 million in net profit! Effectively, one is paying, adjusting out the cash and investments, LESS THAN ONE TIMES RECENT PEAK EARNINGS FOR CATO STOCK. That is virtually unheard of, in the annals of value investing, especially in times of fully-priced stock markets (as we are in now), and especially considering the fact that even AFTER we have seen 2 year "stacked" same store sales declines of over 20% (see below heading), Cato remains a materially profitable company.
A New Merchandising Strategy That Failed Has Caused A Harrowing Decline In The Company’s Fortunes...And Stock Price
Cato was at the very pinnacle of profitability in 2015. With the stock price peaking out at $45 early that year, as the company earned record high net margins of 6.7% and a ridiculous 56% adjusted ROE (backing out the cash position), management was concerned about customer surveys which revealed that the company was "unrecognized" by the younger generation. With that in mind, in order to expand the customer base, and appeal to that younger crowd, John Cato decided to go to 100% internally designed merchandise assortments, and stop buying "from the market." If executed correctly, the strategy would have allowed the company to offer desirable exclusive merchandise at lower production costs (which would earn the company higher profits), and result in the company being more vertically integrated. But the strategy was also dangerous, because buying from the market had long been a core competency of the company that produced growth and record results, results which stood on their own merits, even quite irrespective of the arrival of the internet era in retailing.
The company began implementing the new strategy in the summer of 2016...with the results being truly disastrous from day one. First of all, the company's designers were not familiar enough with the core customer and what she wanted. Secondly, the company's historic broad and shallow strategy was sacrificed, in order to minimize the burden (and cost) of having to come up with "too many" designs. In addition, a number of designs were look-alike in their styles, further alienating customers. Finally, and perhaps most significantly, the company SHRANK its clothing sizes, and changed overall fit, ostensibly to appeal to a younger crowd, but only serving to offend the core customer and make her feel like she had "gotten fat.” Adding insult to injury, the vaunted “youth customer” never showed up!
Consequently, the company's long term record of success was stopped in its tracks in 2016 and 2017, as the company suffered double digit comp declines, generally, from November 2016 all the way through September 2017, with only modest moderation since then. Similarly, the company's net profit dropped from $67 million, or $2.39 per share, in 2015, to an expected 70-90 cents per share in 2017 (excluding a one time tax effect for the Trump Tax Act).
Management was chastened by these "merchandising missteps" (as they referred to them), and has readily admitted that they may have become "too heady," and victims of their own success. They acknowledge that they should have tested the program more, or rolled it out gradually. Designers needed more time to study the company's customer base first, before pumping out product willy-nilly.
With The Company’s Historically Strong Positioning In Its Markets, Record Of Successful Merchandising, And Bedrock Balance Sheet, The Problems Are Eminently Fixable
Fortunately, the solution to the problem is almost as simple as the problem itself: Regain the loyalty of the customer base by going back to "buying from the market," and change back the sizing and fit of clothing to what the customer base has come to expect. It seems hard to believe that John Cato would take for granted his and his buying team's historical abilities to scour the marketplace and “buy right,” giving his customer base a dynamic and varied array of offerings that always pleases her, and has earned the company a loyal fandom. The notion that a skillset of surveying the landscape and cherry-picking the best of what the marketplace has to offer, reacting to hot trends, etc. would be interchangeable with the ability to become a full-fledged design house, overnight, seems rather hubristic to this author. But what is comforting about the situation is that this is not a management team that pulls its punches; it has taken full responsibility for the failure, and while it may have initially been fumbling around trying to make tweaks to the new system, when it found out that wasn't working, management was faster in "putting things back" than, say, J.C. Penney was, after the Ron Johnson fiasco (a situation that resulted in shocking 25% comp declines for JCP). Cato management has communicated to the Street that a return to "the old Cato," from a merchandising perspective, is being fully effected, and will be fully implemented, by the end of the current (first) quarter of this fiscal year. THEREFORE, SHAREHOLDERS WILL NOT HAVE TO WAIT LONG TO SEE IF THE REPOSITIONING OF THE COMPANY RESULTS IN THE HOPED FOR RETURN TO STABILIZED, AND EVENTUALLY INCREASING, COMP SALES.
A Confluence Of Circumstances Has Knocked The Stock Down To Extraordinarily Depressed Levels
A combination of 1) 20 months of comp store declines that are running over 20% now, on a "stacked" basis, 2) the closely held nature of the company, with a perception of insularity and “mysteriousness” by some on the Street, 3) the fact that the company doesn't conduct earnings conference calls, and has little analyst coverage, 4) general fears around long term prospects for brick and mortar retail, combined with 5) the fact that Cato only has 2% of its sales coming from the online arena, as well as 6) short sellers sowing fear and doubt around the reliability and trustworthiness of Cato management, have all served to ramp up uncertainty and jitters here. In addition, 7) the extraordinarily high dividend yield (over 11% currently), and ultra high cash balance, cast a perverse pall on the stock, with some seeing the yield as "unsustainable," and the cash balance as representative of truly inexplicable and unjustifiable capital inefficiency on the part of management (or even perversely validating the notion that so much capital is "needed" because management may have little faith in its own future).
As Cato Only Realizes 2% Of Sales Through Digital Channels, Misperceptions That It Is “Behind The Curve” On Omnichannel May Be Just One More Reason The Stock Is So Irrationally Undervalued
While it seems clear to this author that the downturn in Cato's fortunes is the result of a discrete and sudden set of events that represent little more than the company shooting itself in the foot, there is no guarantee that returning merchandising back to "the way it was" is going to bring about the earnings recovery that would be fully expected. But, and it is important to note, since the Street has essentially priced in COMPLETE FAILURE as the most likely outcome (and a continued erosion of same store sales), there are asymmetric benefits to be had, should the company be able to turn itself around. And while it is certainly possible that some portion of the sales decline of the last 20 months may be due to fundamental changes in the marketplace, and the way the Cato customer buys her apparel (including increased internet purchasing), the FACT that Cato achieved 27 year RECORD HIGH net profit margins in 2015 compellingly argues that if the company's lack of omnichannel wasn't a problem in 2015, it certainly couldn't have become the lion's share of any problem, VIRTUALLY OVERNIGHT. Additionally, to its credit, Cato management has been making a conscious effort to ensure that it maintains appropriate margins with its omnichannel efforts, and not "give away the store." This is unlike other retailers, such as BBBY and PIR, that seem to be panicking like deer in the headlights, and undermining their business models by chasing unprofitable omnichannel sales just to "compete" with Amazon. (Just for example, Cato charges $6.95 shipping on all online orders shipped direct to the customer...but free if shipped to the store, avoiding the indiscriminate cannibalization we have seen at other retailers.) This author believes that the value-add of the Cato model is inherently tailored to bricks and mortar, considering the low price nature of its model, the appeal of the shopping experience to the customer, the fact that Cato matches up outfits on the sales floor for customers, the fact that sales associates often have personal relationships with the mainly small town customers, and the fact that she oftentimes wants the outfit NOW. (In addition, since Cato deals in FASHIONS, the model is one that stands apart from the flocking to digital purchasing that exists for commodity type items such as media, groceries, shoes, or even clothing basics that are more easy to buy online, sight unseen.)
Short Sellers Have Been Tarring And Feathering The Company, Gleefully Sowing Fear, Doubt, And Insecurity, And Casting A Pall On The Company
Despite the fact that the company has otherwise been a reliably stellar performer (as indicated above) over many many years, and the nature of the company's merchandising missteps are rather straightforward (albeit seriously negative), the shorts have been "piling on” and shamelessly trumping up all manner of sensationalistic charges, red herrings, and innuendo. From allegations of accounting manipulations involving a change in estimate for gift card breakage, "running" sales through foreign subsidiaries, and "suspect" donations of inventory, to "artificially low" tax rates, and "desperate" and "impossible" cuts to SG&A, the list is a rather clever, but completely transparent, Pandora's box of motley and sundry charges. I investigated a few of the charges, just to assure myself that Cato management is on the up-and-up, and I have satisfied myself that such is the case. One example involves Cato's change in estimate for gift card breakage, which involves the accounting methodology for crediting back the income for expired gift cards. Cato was taking up to 5 years to bring the gain from expiration back into income, which is a very conservative practice. In this past fiscal year, their auditor told them the practice was TOO conservative, and asked them to do a catch-up, so that the income is taken in within a year of the expiration of the card. Since such change of accounting principle resulted in a one-time gain to Cato, one short seller presumed that this was an effort to game the system and essentially hide the decline in Cato's operating results using sleight-of-hand, by taking the offsetting one-time gain. But such was NOT the case, as the change was requested BY THE COMPANY'S AUDITOR. Similarly, the same short seller suggested that Cato's "artificially low" tax rate was suspect, and that donations of inventory to charity were highly suspicious. Yet, in my investigations of these matters, it became clear that the company was actually being incredibly SAVVY with regard to donations of inventory. Specifically, inventory that had been marked down to almost nothing, and still had not sold, is donated NOT to Goodwill or the Salvation Army, but to non-profits that help women apply and interview for jobs. In this way, the inventory can be deducted for an amount that is greater than its carrying value on the company's balance sheet (but less than retail), because the woman is using it for a higher purpose involving job-seeking, and not just as an "article of clothing." (Inventory donated to charities like the Salvation Army can only be deducted for its fair market value.) The explanations from the company on these, and other matters, are very clear and straightforward, but at least one short seller, who has made a litany of spurious allegations against the company, at the same time remarkably admits that he has NEVER spoken with management, which is a rather disturbing tell-tale.
The Company Has Bought Back Stock, And Insiders Have Bought Stock In The Open Market As Well, Signaling Confidence In The Company's Long Term Prospects
As a result of company stock buybacks, the share count has been reduced from 29.25 million shares in February 2014, to 26.6 million in February 2017, to 24.8 million at November 30, 2017, an overall reduction of 15%. Being that the company paid an average of $13.05 per share with its most recent November 2017 purchases, and there are over 600,000 shares remaining on the buyback, I believe that a turnaround in the company's fortunes would likely result in a rapid completion of the buyback, and there is a very good chance that management would increase the authorization, as well. Importantly, the company has executed on this buyback while paying a hefty dividend AND maintaining the bulk of its gargantuan cash hoard...a testament to the remarkable cash generating capacity of the business, over time. In addition, while the quantities are only modest, 3 different insiders bought stock in the June-Aug 2017 time frame at between $14-17 a share, a significant premium to the current price. And the CEO even exercised options on April 11, 2017 to buy shares at $23.56, which can only be interpreted as a clear "show of faith" in the stock (which was trading at six year lows, at that time), since the prior day close was $20.89.
The Company Has Historically Been A Generous Dividend Payor...And A Reliable Dividend Increaser
Since reinstituting a dividend in 1992, Cato’s dividend has been increased or left unchanged, every year, for 26 years. Moreover, to show how far the company has come under John Cato's management, the company paid a 19 cent dividend in 1998, one year prior to Cato becoming the CEO. The dividend is now $1.32 annually. (Hearteningly, the company just declared its regular 33 cent quarterly dividend on March 1st.) In my opinion, there's a very good chance the current dividend will be maintained, considering the strength of the balance sheet, and the short to intermediate term likelihood of a turnaround in the company's operations. (Even in the depressed 2017 year just ended, the lion's share of the dividend was funded with free cash flow generated from operations.) Of particular import is the fact that with the company being massively overcapitalized, I believe there is a high degree of assurance that any kind of material upturn in the company's sales and profits will secure the continuation of the $1.32 annual payout. And once the Street again believes that the dividend is safe, it could be a huge catapult for the stock price, as income investors decide that a 5-6% yield is more than adequate compensation for a Cato that is on the mend, versus the current 11%+ yield.
Will John Cato Find It Irresistible To Make A "Low Ball" Bid For The Company, Especially If There Is A V-shaped Recovery?
Interestingly enough, the company had previously been taken private by John Cato's father in 1980, and there is no reason it couldn't happen again! While, certainly, no outside shareholder is interested in having the company "taken away" at a low-ball price (especially at the inflection point of a major turnaround), it is worth performing an analysis of how a management led buyout might look, just to reinforce how tempting it MUST BE for John Cato to consider, and revealing, in one more way, how dramatically undervalued the Cato franchise is. So, just for example, to buy out the 22.3 million shares owned by outside shareholders at a low-ball price of $18, Cato would have to come up with about $400 million. $220 million could come from the company's cash hoard, and the other $180 million financed with debt. Considering the company consistently achieved EBITDA of well over $100 million annually for six years running from 2010-2015, the ratio of debt to historical EBITDA would be very manageable indeed, at under 1.75x. Even at the currently depressed level of EBITDA, the leverage it would require to "take out" the company, at $18 a share, would be just under 5.0x EBITDA, a still reasonable number. Tantalizingly, any sudden "inflection" in comp sales results to the positive, without a rapid snap-back in the common stock price, could markedly increase the potential of a buyout, as the confidence of potential lenders would climb rapidly, and set us up for exactly the scenario in which management might not be able to resist pouncing on the opportunity.
Valuation And Price Targets
It is my belief that a combination of 1) a return to the old "buy from the market" merchandising strategy (with a return to INCREASING comp sales), 2) the 15% reduction in the share count we have seen (including the high likelihood of additional stock buybacks as any turnaround takes hold), 3) the reduced SG&A we have seen, 4) reduced store openings along with a focus on driving profitability at existing stores, and 5) a lowered federal tax rate under the Trump Tax Act (the company has historically paid between 33-35% of its income in taxes, in good years...a figure that should come down in any earnings recovery), should all serve to return the company to record EPS within a few years. In such a longer term scenario, if the company returns to $2.00-2.50 in EPS, a conservative 10-14 multiple on that number seems appropriate, considering the out of favor nature of retail right now. Taking such a multiple, and adding in HALF of the previously noted cash and investments per share, would yield a stock price target of $25-40. This, indeed, is my 2-3 year target for Cato stock. In the intermediate term, it is my belief that same store sales declines will begin to moderate, based upon the new merchandising, and return to positive growth by summer. Under such a scenario, I would expect the stock to return to its historically "depressed" trading range of $20-25, within 6-18 months. Moreover, in any turnaround scenario, I believe it is highly likely that the company will continue to pay its $1.32 per share annual dividend. If such is the case, I believe another way to value Cato is to set its valuation at a 5-6% dividend yield, which would imply a 6-18 month target price of $22-26. Finally, I believe that in a shorter term 3-6 month scenario, that involves simply a flattening in comp sales results, the effect of investors suddenly believing that the sky is no longer falling would be a huge collective sigh of relief, and that such an occurrence would be likely to return the stock to its recent highs in the $16-17 range.
Concerns/Risks To The Upside Scenario
After 20 months of same store sales declines that were caused by a compromise of Cato's "treasure hunt" experience, and the insult of ill-fitting product, some customers may view the company's actions as a slap in the face. Such customers may never come back and, in this sense, the damage may be done. On the other hand, one only need look to J.C. Penney for an example of how even a catastrophic collapse in same store sales can be slowly recovered from. In addition, Cato is still profitable, as we speak, so it doesn't need to recover all of the sales it lost. Even recovering 1/3 of the sales lost would cause a significant "bounce" in the stock...and recovering 2/3 would be a stupendous outcome, for restoring shareholder value.
Management's merchandising miscalculation, and maintenance of a ridiculously overcapitalized balance sheet, is evidence of the need for more independent thinking and oversight on the board, including one or more new independent directors. But concentration of 43% voting control in the Cato family creates the risk that such changes may never be made, or even considered. (The announced expansion of the Cato board, on March 1st, from seven to eight members, and appointment of a Charlotte area university president...who already serves on three other boards...appears to be more of the same.)
The recent increases in the wages paid by stores like Walmart, Target, etc., may pressure Cato from the cost side. Yet, management has voiced an opinion that increases in the low end of the wage scale are a wash for the company, at worst, and may actually be a benefit. (In effect, the upshot of increased wages on the low end of the socioeconomic scale is that Cato's customer base is more flush with money to spend...at Cato.)
The company has been depending on John Cato for its success for a generation now. The lack of a succession plan could lead to the risk of the company not being nearly as profitable as it once was, if it loses its chief merchant. (On the other hand, John Cato is only 67 years old and quite vigorous, and his father is doing well at 95 years old, so there may be a number of years to go for John Cato to run this show.)
In the end, the company's lack of omnichannel penetration could mean that the times are leaving them behind, and an “insular” management is “in denial,” or simply doesn't have the right skillset to move the needle (a belief I obviously disagree with).
Catalysts And Upside To Outlook
This is the same team running the company that has been wildly successful for a generation. It is really about merchandising, and buying right, when you come right down to it. These are not talents that are typically "lost." For John Cato and his team, that part is like riding a bicycle. And my sense is that John Cato does not like to lose.
This is not a model that is really suited to the web. It is about needing/wanting an everyday low-priced fashion forward outfit now, wanting to shop in person to discover what is available, and receiving help from the sales floor.
When same store sales start to turn flat to positive, that is likely to be a rather rapid catalyst for the stock price to recover. Similarly, the dividend becomes a catalyst when the sales turnaround happens, because faith in the dividend's sustainability will be almost instantly restored, as it will be fairly rapidly seen as "safe" again, especially keeping in mind the company's fortress-like balance sheet.
Management is a conservative bunch and appears to have cut back on the stock buyback, with the intent to continue funding the dividend, until they see the "whites of the eyes" of a turnaround. But that means they may very well resume the buyback, as a turnaround gains traction, which would only help provide more support, and ultimately momentum, for the stock. Similarly, management could create a huge amount of value by pouncing with a Dutch Tender for several million shares, at the inflection point for same store sales, which would significantly increase EPS in the recovery, and likely create a virtuous cycle for a very favorable stock price move.
By any and all valuation metrics (especially after adjusting one's purchase price by backing out the cash per share), Cato Corp. is remarkably undervalued. Whether looking at its price/book, price/sales, price-to-historical-earnings, historical ROE, EV/EBITDA, or the fact that the company pays an 11%+ dividend that is likely sustainable, the Cato valuation story truly stands out, in the annals of deep value stock selection. The story is a relatively simple one of an overly ambitious management team that, like Icarus, got too close to the sun, with its waxed wings. But unlike Icarus, the situation for the company is NOT fatal, and management is in the final stages of "putting things back to where they were,” so that most or all of the lost sales and profits can be restored. Cost cutting and a 15% share count reduction, over the last few years, along with a reduced federal income tax rate, make it more likely than not that the company can and will return to historical profit levels of $2.00-2.50 in EPS, over the next few years, which would result in a stock price that could be expected to roughly triple from the current price. This is a fantastic business that has historically thrown off huge amounts of cash, and the current cash balance masks the inherent capital efficiency of the business itself. The model works and even has a "moat" of sorts around it, with roughly 2/3 of stores located in towns of 50,000 people or less. (In many locations, Cato may be the only nearby place to purchase everyday low-priced, fashion forward women's apparel.)
Third generation scion John Cato is a seasoned merchant, who can readily pick himself up off the floor, dust himself off, and go back to buying right, buying smart, and being the great merchandiser that he has PROVEN himself to be. He is vested for the long term, with 9% economic ownership of the company, and will not "blow up" the company. The Cato family has been operating this company for over 70 years. This is a family name where retail courses through its blood... lower profile, to be sure... but clearly deserving the recognition accorded to more well-known and storied retail names such as the Leslie Wexners, Nordstroms, Dillards, and Waltons of the world. Cato stock is drastically undervalued and completely misunderstood. Most importantly, I believe it is highly likely that the turnaround at Cato Corp. is HERE and NOW.
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This article was written by
Analyst’s Disclosure: I am/we are long CATO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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