Describe the investment thesis for children’s apparel company Carter’s [CRI].
KO: The company has two main brands, Carter’s, which is #1 in baby apparel in the U.S. and OshKosh B'Gosh, one of the most recognized clothing brands for children between 2 to 7. Total revenues are around $1.4 billion, nearly 80% from Carter’s and the rest from OshKosh. Two primary things attracted our attention here. First, the company badlybotched the 2005 acquisition of OshKosh, from start to finish. Second, its own branded retail stores started experiencing problems at the beginning of last year. The resulting impact on earnings, plus overall concerns about consumer spending, took the share price below $20 recently, from around $35 early last year.
How are they addressing the problems?
KO: After buying OshKosh, Carter’s replaced management and decided to focus the brand more on fashion, at higher price points. They took a recognized existing brand and changed the whole goto-market strategy, which was a disaster – sales plummeted and profits evaporated. They’ve since put the company president in charge of fixing the OshKosh business and he’s basically returning to the original positioning: traditional styling, lower prices, lower product costs and broader distribution. Customer acceptance for the new product line appears to be good, although the proof won’t really show up until the spring of next year. What happened on the retail side was an ill-advised strategy to accelerate Carter’s store growth while changing instore merchandising and certain operational processes. Comps stopped growing and store operating margins declined from a peak of 20% to around 16%. The company has since hired a much more experienced head of the retail business, who in just a few months has already instituted badly needed operating discipline around inventory management, product flow, promotions and in-store merchandising. It’s still early, but the situation appears to have stabilized and is moving in the right direction.
Is the overall business growing?
KO: The company is targeting 8-10% organic sales growth per year, a rate it’s exceeded, on average, over the past 15 years. The end markets are fairly mature, but right now there’s a demographic tailwind as the “echo” boom – children of baby boomers – enter parenting age. The other key growth driver will be increased penetration of the mass-market retail channel, selling to stores like Wal-Mart and Target, where Carter’s market share is only in the high single-digits. You might imagine that business having lower gross and operating margins, but the margins are comparable with other channels because the products sold at lower prices are similarly cheaper to produce.
What upside do you see for the shares, now around $20.50?
KO: The company expects to earn about $1.40 per share this year. That includes a loss of 20-25 cents per share on OshKosh, so that means the Carter’s business in a difficult year is earning around $1.65. If we assume they can get OshKosh to breakeven, Carter’s revenue grows 7-8% per year, and – due to better retail margins – its operating income grows 10% per year, the company would earn $2.25 by 2010. A company with that type of growth should command at least a 16-17x multiple. Adding on the cash earnings they’ll earn between now and then – which they could use to buy back shares or pay down debt – we’d expect the share price to be closer to $40 within three years. The option on the upside is the OshKosh business. When it was bought, management thought it could become a $1 billion business [three times today’s level], through better penetration of OshKosh products in existing Carter’s wholesale accounts. Once they get the OshKosh product offer right, there’s still a lot of potential growth from that.
How susceptible is the company to a consumer-spending downturn?
KO: Carter’s baby products, in particular, are not completely discretionary and are also heavily given by grandparents as gifts. Given the brand strength and the nature of who buys it and why, I’d expect the business to hold up well in a weaker consumer environment. It’s not at all like the buy decision for something like a flatpanel TV.