The Children's Place: Bull Case Dented, But Not Yet Broken

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About: The Children's Place, Inc. (PLCE)
by: Vince Martin
Summary

A second straight disappointing quarter - and seemingly disastrous FY19 guidance - sent PLCE tumbling after earnings.

But investors actually have bid the stock up to pre-earnings levels - and there's an interesting underlying story here.

FY20 targets have been pushed back - but market share gains and operating margin expansion still seem on the table.

PLCE probably deserves the recent sell-off - but there's still a path out, even if it will require some patience.

From one standpoint, the story at retailer The Children's Place (PLCE) has simply collapsed. When I bought the stock last year, the case was reasonably simple. PLCE's earnings were being pressured by one-time investments in the omnichannel business. Those investments would roll off, boosting margins. Store closures added another boost. As a result, PLCE was targeting 12% operating margins by fiscal 2020 (ending January 2021) - and $12 per share in EPS. A mid-teen multiple - driven by strong e-commerce performance that was driving positive comps - suggested a path toward $200.

Though PLCE reaffirmed the long-term targets after the quarter, a disappointing Q3 dented that case, Q4 results earlier this month seem to obliterate it. Earnings missed guidance and consensus badly. Comps turned negative, and FY19 EPS guidance of $5.25-$5.75 makes the $12 target seem laughable.

PLCE unsurprisingly fell on the news - yet the stock has rallied in recent sessions. In fact, Wednesday's close is modestly above the pre-earnings level. Admittedly, that pre-earnings level is down sharply from late October highs - but the market seems reasonably accepting of the big Q4 miss.

That patience makes some sense. Recent performance is disappointing - but explainable. The long-term story here still holds. There's enough risk here that I'm not racing to double down, but I think PLCE still merits some patience.

Q4 Earnings and FY19 Guidance

Fundamentally, Q4 is an absolute disaster. Here's how the results compare to guidance given with Q3 results:

Metric Guidance Results
Same-Store Sales positive low single-digit -0.6%
Adjusted Operating Margin 7.7-7.8% 4.1%
Adjusted EPS $2.07-$2.17 $1.10

source: author from PLCE Q3 and Q4 releases

Taking a broader view, the news looks just as bad. Full-year operating margin went from 8.5% in FY16 to 9.6% the following year; it compressed 300 bps in FY18 and is guided ~flat in fiscal 2019. Adjusted EPS grew sharply in FY17 ($5.43 to $7.91); the figure declined 15% in FY18 and is guided down 15-22% this year.

And yet investors have bid PLCE up in recent sessions - to a valuation that suggests a 17x+ P/E multiple at the midpoint of that guidance. In the context of recent performance - and guidance for flat to negative comps in FY19 - that multiple seems far too high.

But there are some external factors here - most notably the bankruptcy of competitor Gymboree. Liquidation sales at Gymboree and its Crazy 8 brand (a more direct competitor to The Children's Place) had a significant impact on Q4 results: accelerated inventory liquidation (to avoid a bigger hit in Q1) cost $0.79 in EPS. And the company's decision to acquire the Gymboree and Crazy 8 IP out of bankruptcy is guided to have a $0.75 impact on FY19 EPS, as the company invests behind the brands.

In addition, the tax rate is expected to jump sharply to 25% (from near 10% in FY18, per the Q4 earnings slides). That move has a $1.15 impact on FY19 EPS, per the Q4 conference call, with most of it coming from share-based comp deductions.

Given all the moving parts, the news here is not nearly as bad as headline fundamentals suggest. That said, it's not as good as it was supposed to be, either.

How Bad Is The Underlying Business?

It's far too simplistic to say that everything is fine except for the Gymboree liquidation. As I pointed out after Q3, even that quarter's beat appeared to be a miss from an operational standpoint, as the omnichannel investments, the tax rate and the share count (owing to buybacks) all were lower than the company had forecast.

As far as Q4 results go, PLCE listed four key impacts that led earnings per share to decline year-over-year:

  • $0.79 from inventory liquidation ahead of Gymboree;
  • $0.30 from "store traffic declines and lower conversion rates" leading up to Christmas (it certainly seems like there was an "air pocket" in US consumer demand over that stretch; other retailers have called out similar trends at the same time);
  • $0.25 in fulfillment costs owing to higher ship-from-store costs (the company had guided for this pressure, as e-commerce sales were much higher than expected), plus higher distribution center wages;
  • $0.12 from the comparison to an extra week in the prior-year quarter.

Those four issues total a negative impact of $1.46 per share. Adjusted EPS declined $1.42 per share ($1.10 vs $2.52). In the context, the outside pressures seem to have driven the entirety of the year-over-year decline.

That's not quite the case, however. The $0.30 from traffic declines don't necessarily sound like a one-time factor, for one (even if Gymboree might have played a role). More importantly, shares outstanding dropped over 9% year-over-year - and the tax rate declined to 15.4% against 20.7%. Backing that out, it seems like the detailed compressed margins by 530 bps - with 110 bps of that coming from the weak pre-Christmas traffic.

In other words, there's an organic compression of at least 60 bps in Q4. Full-year figures of $6.75, adding back the $1.46 in Q4 items, still seems well below original guidance of $7.95-$8.20 given a greater contribution from share buybacks and a lower-than-expected tax rate. 300 bps in full-year margin compression similarly suggests a decline in the underlying business.

Disappointing comps in Q4 likely drove deleverage - and there's probably some effect from Gymboree in that figure. Freight and labor expense have risen as well, per recent commentary. But there also was supposed to be a benefit from closing weaker stores - the exact figure hasn't been disclosed, but PLCE had targeted ~100 bps over the three years from FY18 through FY20.

A similar shadow gets cast over FY19 guidance. On the call, the company cited $30 million in gross profit hit from Gymboree - 150 bps-plus of pressure to gross and operating margins. But investments were supposed to pull back by about $15 million, offsetting half that pressure - and there should be incremental benefit from continuing closures.

Given operating margins near 10% in FY17, the 6.3-6.8% guidance for FY19 is a notable disappointment, even given the upheaval caused by the Gymboree bankruptcy. It calls into question the still-intact (at least per management) 12% target, and it raises worries about whether continuing inflation in labor and freight, plus the often margin-dilutive effect of e-commerce growth, might cause further pressure even once PLCE works through the Gymboree effect.

Stepping Back

Even considering those worries, however, there's a perhaps more intriguing long-term story here in the wake of Gymboree's bankruptcy. The near-term disruption is obvious: PLCE is guiding for a -10 to -12 comp in Q1, and Q2 might be worse. The company is comparing against a 13.2% print, and management said on the call that it expected the liquidation to pull demand out of the quarter into Q1.

Looking beyond the first half, however, there's an enormous opportunity here. CEO Jane Elfers estimated the bankruptcies opened up about $600 million in market share - nearly one-third of guided FY19 revenue. Gymboree does have dedicated customers - and PLCE plans to re-open the Gymboree website to target them, while also adding Gymboree-branded product to its stores.

The acquisition of the assets also gives PLCE insight into Gymboree's real estate strategy and store-level performance - valuable data as it continues to shrink its own footprint. And in some cases, PLCE can enter new markets, with the company planning to add 25 new locations (while, as CFO Mike Scarpa emphasized, remaining a net closer of stores).

The Gymboree opportunity is part of what Elfers again called an "annuity" of market share gains from competitor weakness. On the Q3 call, she pointed out that Sears (OTCPK:SHLDQ), Kmart, and Bon-Ton had generated another $425-$475 million in children's sales in the preceding twelve months.

There's at least $1 billion in market share opening up - over half of FY19 revenue - and more on the way as other competitors shrink footprints and/or go out of business. (An analyst on the Q4 call even cited the liquidation of Payless as a potential benefit to PLCE footwear sales.) And PLCE is well-positioned to capitalize profitably, given that e-commerce is headed toward 30%+ of total revenue.

Even with the near-term disruption and disappointment, the qualitative aspects of the bull case haven't completely eroded. Spend still should pull back another $15 million post-FY19, a ~$0.70 benefit to EPS at the higher FY19 tax rate. Store closures are going to continue going forward: PLCE has said it had 1,000 lease events over the next three years (more than the current number of stores), and its focus on managing the footprint likely means the company is maintaining similar flexibility with lease renewals. PLCE still is the lowest-cost producer, and e-commerce sales still rose 20% in the chaotic Q4.

On top of that, Gymboree should be accretive in FY20, per commentary - and the expenses of FY19 will roll off. The case here last year was based on the idea that even a stable underlying business could drive upside thanks to a few key catalysts. Even at a lower price, and with recent results, that broad case still holds.

Valuation

As noted, at the midpoint of FY19 EPS guidance, PLCE trades at 17x earnings. But the underlying business still seems rather cheap. Add back the $0.70 from investments that fade by FY21, and $0.75 from the FY19 effect of Gymboree, and EPS gets just shy of $7. That suggests a much more reasonable 13x+ multiple. Free cash flow figures should be modestly better, given contributions from working capital (notably inventory) over time.

That aside, there should be some benefit simply from a more normalized business in FY20. As Elfers put it in the Q4 release, "We have never experienced a total liquidation of a direct competitor of the size and proximity of Gymboree." PLCE locations overlap with 61% of Gymboree stores - and 80% of Crazy 8 outlets. And if the Gymboree buy truly is accretive, that provides another tailwind to growth.

There's still a path here toward the $12 in EPS figure - even if does look more complicated, longer, and even less likely than it did a year ago. Of course, PLCE also is 30%+ cheaper - which more than accounts for those issues. It will take some time to work through this disruption - but the bull case here isn't gone. Even falling short of targets, EPS should be able to get back to the high single-digits (with some help from more buybacks), and a mid-teen multiple still suggests a path to $130-$150 in that scenario.

There are risks, admittedly. Near-term trading might be choppy. FY19 results are going to look weak, particularly in the first half, which raises catalyst issues. Investors have to trust management - and that trust probably has taken a bit of a dent given the massive Q4 miss. That performance, too, colors guidance - if the Gymboree liquidation is as unprecedented as Elfers argues (and it is), PLCE by definition is guessing to at least some extent. A miss in Q1 or Q2 wouldn't be surprising - and particularly with the current bounce, wouldn't be received well. It's worth remembering that skeptics (here and here) have raised worries that recent growth has been driven largely by higher credit card penetration which isn't sustainable.

Longer-term, there's still the standard retail worries about e-commerce competition, margin pressure, and foot traffic. PLCE still plans to end fiscal 2020 with almost 900 stores. The business probably is less susceptible to a cyclical downturn - as Elfers pointed out, comps stayed positive through the financial crisis - but there could be a 'knock-on' effect if a recession pushes regional mall traffic down even further.

Still, I think those risks are worth taking. The long-term outlook for the business, particularly after FY19, still seems reasonably bright. The Children's Place should be able to take market share. The Gymboree buy should provide some benefits. Spend is going to roll off, and the business will continue to shift online. At ~13x underlying earnings, that case is still good enough - even if it's not quite as good as the case PLCE offered a year ago.

Disclosure: I am/we are long PLCE. 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.