Behind The Idea - Citi Trends: The Forgotten Discount Retailer

Sep. 03, 2019 9:00 AM ETCiti Trends, Inc. (CTRN)5 Comments
Travis Werling profile picture
Travis Werling
22 Followers

Summary

  • CTRN is an underperforming discount retailer with a loyal customer base that the market mistakenly believes is suffering from obsolescence. In reality, CTRN remains a popular family destination.
  • Discount retailers have heavily outperformed the broader market over the last 12 years and are resilient during recessions. CTRN similarly performed exceptionally well during The Great Recession.
  • CTRN has a large and engaged social media following that provides it with an effective platform for advertising new merchandise.
  • New changes being brought by activist fund Macellum offer ample room for growth and operational improvements.
  • CTRN's turnaround is already underway, and shares should be worth over $30.00 - 75%+ higher than the current share price.

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Seeking Alpha: Can you discuss the mispricing here or why does this opportunity exist?

Travis Werling: I believe the market has become jaded on CTRN’s prospects after a decade of tumultuous performance that includes a collapse in gross margins, constant turnover within key positions such as the Chief Executive Officer and Chief Merchandising Officer, and the inability to sustain momentum when previous operational turnarounds have been attempted. While the market has justification for being pessimistic on CTRN’s prospects, I think they have become irrationally bearish and have missed key signals that margin pressures are 1) at least partially self-inflicted and 2) have bottomed-out in recent years.

CTRN does not have the same long-term trend of diminishing returns on capital that we see in many other retailers. In fact, CTRN’s returns on capital have until recently shown signs of expansion and provided a glimpse into the possibilities the business has if placed into the hands of capable management. Amidst the retail apocalypse, CTRN appears to be mistakenly categorized as another casualty of e-commerce with dim prospects when in reality, CTRN has an incredible customer base that is actively engaged through social media and a great niche in the lucrative discount retailer space.

CTRN’s customers appear to shop at CTRN the same way many shop at thrift stores wherein they will hunt for bargains amidst the merchandise and if they don’t find any compelling products, they will return later when inventory has been refreshed. Consequently, I believe the market has missed the important point that CTRN has many more “second chances” to retain the loyalty of its customer base even when its merchandise selection is not on point.

The market has, in my opinion, confused this latest downturn beginning in 3Q18 as being a long-term trend when it is likely just a merchandising mishap - a point that appears to have gained some traction with the recent turnaround in same-store-sales (“SSS”) growth now that unfashionable inventory has been liquidated. Retail investors are justified in being pessimistic anytime a management team chalks up falling revenue to just a “fashion mishap,” however when viewed under a microscope it appears to be true in CTRN’s case.

I believe the market is also irrationally bearish on Macellum’s track record as an activist investor and have assigned little-to-no value in their operational capabilities. I have been impressed with the level of detail they have in their slideshow for operational change at CTRN and think they are very aware of the challenges facing the retail industry and CTRN specifically. Macellum has helped bring on board executives and directors with extensive backgrounds and track records in the retail space that CTRN was previously failing to attract. Macellum has also greatly increased the level of transparency between management and shareholders, which I think will pay dividends over the long run as investors can take comfort in knowing the strategic direction of CTRN. The hurdle rate is set very low for Macellum to impress and I think the market will reward CTRN shareholders when it becomes apparent that Macellum isn’t going to destroy the business.

The current valuation embedded in CTRN’s share price implies a continued collapse in margins that doesn’t seem supported by the trends we have seen within CTRN specifically or within the discount retail space at large. If CTRN returns to recent five-year averages for operating margins and SSS growth as I suspect they will, shares are intrinsically worth over $30.00 per share in my opinion. CTRN has a large margin of safety embedded in its current valuation which is further supported by the strength of its balance sheet, which has no debt outside of operating leases and over $80 million in cash while the company’s market cap is around $200 million.

The catalysts for improving CTRN’s share price will be:

1) Continued evidence that the sky isn’t falling and SSS growth is stable over the long run despite its short-term volatility.

2) Evidence that Macellum isn’t going to destroy the business and may have some important insights into critical and long-overdue operational improvements

3) Clarity around who will be the permanent executives in place to execute the long-term turnaround strategy amidst the recent resignation of current CEO Bruce Smith.

4) A recession, wherein CTRN has historically performed exceptionally well - potentially due to the “inferior” nature of its products that many customers flock to when their purchasing power is diminished.

SA: One of the catalysts for your thesis is the activist involvement – how do you determine if an activist is more or less likely to be successful? How do you monitor their progress after they become involved to see if the thesis is playing out?

TW: I think more about what expectations the market baked into the share price regarding future company performance and how likely the activist is to beat that implied hurdle rate. In CTRN’s case, I believe that even if Macellum does a mediocre job running the business, the share price is low enough that investors will be rewarded. I tie in the odds of activist success with the margin of safety present in the current valuation.

In Macellum's case, monitoring its progress is easy because one of its priorities is to boost transparency between upper management and shareholders. I have a good idea of what operational improvements it is trying to implement, such as reduced supply-chain costs through new packaging techniques, re-bidding of carrier contracts, upgrades to IT infrastructure, automated inventory management, etc. Ultimately, if Macellum is doing what it is supposed to be doing, the result will be reflected in the numbers through stabilizing/improving margins, a reduction in working capital on a per store basis, and a healthy rate of new store expansion. The opposite also holds true, although I believe continued operational deterioration is already reflected to an extent in the current valuation.

SA: If you had a nickel for every time you heard “retail apocalypse,” you’d probably be managing $10B right now – to what extent are these fears legitimate and more importantly priced into retail stocks already?

TW: I think the fears of a retail apocalypse are legitimate in a lot of instances. We can see large sub-sectors of our retail base suffering from a persistent downtrend in return on capital (“ROC”) that send a strong signal of obsolescence. Many D and C class malls are seeing continued downtrends in foot traffic and e-commerce continues to come up with new ways to enhance the online shopping experience that makes the environment very difficult for traditional brick-and-mortar retailers to survive in.

I think in a lot of cases, retail stocks are priced to reflect the strength of the ongoing downtrend in ROC, which makes them collectively more-or-less accurately valued. Having said that, I believe there are a handful of retail companies with more resilient business models than the market is currently giving them credit for that are being unjustly punished.

A silver lining to the “retail apocalypse” is the lowered cost of operating leases for the survivors. In CTRN’s case, it is primarily operating its stores in strip malls in low to moderate income communities that are struggling to retain reliable tenants. Consequently, CTRN can control the cost of its operating leases and maintain profitability even in a challenging environment.

SA: You did a great job identifying one of CTRN’s overlooked strengths (its loyal customer base) – are there any other retailers in a similar situation on the long side or even the short side (e.g. they have ignored their core customer)?

TW: In my analysis, I looked at the strength of a retailer's social media base as a proxy for the dedication of its customer base. While many of us shop at stores we don’t follow on social media, I believe that following a company on social media signifies having at least some part of your personal identity invested in the brand. I think that is precisely what retailers aspire to have - a customer base that embraces the idolized image their brands are trying to portray.

With that in mind, I think Lululemon (LULU) has done a phenomenal job of building a feverishly loyal customer base. While I think LULU is too expensively priced for my personal investing style, I can see the business performing exceptionally well for a long time to come due to the intangible brand premium LULU continues to build.

J.C. Penney (JCP) is a good example of a retailer that failed to navigate the shifting habits of its customer base. By trying to appeal to everyone, JCP ended up appealing to no one. I think one of the biggest mistakes a retailer can make is pricing inventory like a discount retailer to win back business. First off, it muddies the brand reputation by confusing customers on whether they are shopping for luxury goods or inferior goods. Secondly, many retailers don’t have the correct merchandising team in place for such a strategy and are not positioned in the right real estate. Consequently, they end up with expensive operating leases and piling inventory that crushes margins and a permanently devalued brand premium. The discount retail strategy is not easily emulated, which provides a moat to the businesses who have already succeeded in using such a strategy.

***

Thanks to Travis for the interview. If you'd like to check out or follow his work, you can find the profile here.

This article was written by

Travis Werling profile picture
22 Followers
I am a long-term investor who believes that for most stocks (with certain exceptions), prices eventually converge on value. As a long-term investor, I place higher weight on intrinsic valuations over relative valuations in most situations. I prefer to keep my firm valuations and my macroeconomic views separate, however macroeconomic trends certainly inform which companies I choose to research. I generally avoid companies entering fragile markets where product obsolescence occurs rapidly and paradigms change on a dime. I also avoid companies that are heavily tied to commodities that make forecasting future cash flows an exercise in futility. My inclination is to focus on thesis falsification, and all assumptions included in my valuations are supported by a constant weighing of potential outcomes. Beware of fat tails.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: Travis Werling is long CTRN.

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