Christopher & Banks (CBK) – Specialty Retail Turnaround

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Christopher & Banks (CBK) provides an opportunity to invest in an overlooked specialty apparel retailer with strong normalized earnings power and significant balance sheet strength at a rock bottom valuation. Recent earnings numbers have languished due to the general downturn in discretionary apparel spending as well as company merchandising missteps. A clearly defined turnaround is in progress with new management and a new design team. The company, which is debt free and has half of its market cap in cash, is cheap on an absolute basis and relative to sector peers. I think CBK can potentially generate $60 million in EBITDA with minimal ongoing capex needs while it is currently trading at a $105 million enterprise value. Additionally, a very safe 4% dividend will reward investors while the turnaround plays out.

Company Overview

Christopher & Banks (CBK) is a specialty mall based apparel retailer selling women’s clothing aimed at baby boomers (the industry dubs this the “missy” demographic). CBK has its roots in Braun’s Fashions, started in 1956 in Minneapolis. Braun’s went public in 1992 and changed its name to Christopher & Banks in 2000. CBK operates two retail concepts. The Christopher & Banks division offers misses and petite sizes, while CJ Banks sells plus sizes. The company currently operates 765 stores- 509 Christopher & Banks, 245 CJ Banks, 8 dual stores, and 3 outlet stores (the latter two concepts debuted in the past year)- and also sells its two brands online. CBK has stores in 46 states, but more than half are in the Midwest.

Industry Overview

Specialty Retail

Specialty apparel retail is a difficult business for a variety of reasons. Companies compete mainly on the basis of consumer perception of the fashion, quality, and value of their apparel offerings. Fashions change by the season and long product design cycles make it difficult for companies to quickly correct missteps in their product lines. It is hard to differentiate products and even if a company succeeds in doing so for a time the advantage is not typically sustainable. Fashion trends change or competitors copy styles. As discretionary purchases, sales are highly sensitive to the macroeconomic environment and levels of consumer discretionary spending.  Finally, customers have strong bargaining power (on a collective basis) as there are no switching costs to shopping at another store beyond the time spent walking in the mall or clicking over to a competitor’s website.

The only sustainable competitive advantage is in branding and creating an intangible sense of customer loyalty. But even brand equity is largely contingent on remaining ahead of fashion trends. Very few brands are inherently trend setters who can themselves dictate consumer fashion sentiment.

On the plus side, the business model is scalable- typically every store has the same format and sells the same products. So it is relatively easy to grow a successful specialty retail concept quickly just by rolling out more stores in new geographic areas. Additionally, as production is outsourced and most store space is leased the business does not require large amounts of up-front capex (mall operators often even pay for the initial store buildout in return for higher lease payments). Thus specialty retailers in growth mode can generate very impressive returns on equity.

Another noteworthy characteristic is the high degree of operating leverage. Store expenses (wages and rent) and corporate SG&A are mostly fixed so slight swings in sales levels can have a large impact on profitability.

These points- sensitivity to macroeconomic and fashion cycles, high operating leverage, and high growth companies that often quickly fizzle out- create a very volatile sector.

The “Missy” Segment

Missy retailers target the baby boomer demographic (defined by the Census Bureau as those born between 1946 and 1965, or between 47 and 65). CBK states that they target 40-60 year old women, although based on their marketing materials and online customer reviews my perception is that their customer base is skewed to the fifty plus range.

CBK competes with specialty retailers who target a similar demographic as well as with department stores and other apparel chains who sell clothes for the missy segment among their other offerings. The most direct publicly traded comps include Coldwater Creek (CWTR), Ann Taylor (ANN), Chico’s (CHS), Talbots (TLB), and Charming Shoppes (CHRS). CBK is mid-range in terms of price point, in between lower end department stores like J.C. Penney and higher end specialty retailers like Talbots. CBK is somewhat differentiated from their peers by a strong geographic focus on the Midwest and small markets (both represent about 50% of their stores), as well as the plus size CJ Banks line (although CHRS is a major competitor there).

After the market rally of the past two years, the missy segment remains a notable laggard. The Tiburon Research Specialty Apparel Index was up 31% in 2010, while among the missy retailers only ANN posted a positive gain (up 99%). In 2011 the index is up 9% YTD while only ANN, CHS, and CHRS have gained among the missy retailers.

The decline of the missy segment has been compounded by several factors. The general pullback in discretionary spending hit specialty retailers harshly. Additionally, older women tend to be more frugal than younger women and teens. They are purported to be the first to cut back on discretionary spending and the last to return. And the top line decline has weighed heavily on profitability due to the high degree of operational leverage inherent in the specialty retail business model.

Investment Thesis

I have seen a turnaround investment thesis floated for all of the missy retailers with the exception of CBK (and so far only ANN and CHS have played out well). I think CBK is a compelling opportunity on an absolute basis and the most compelling of the missy retailers on a relative basis.

The current thesis for investing in a missy retailer combines two major elements. One is a more macro reversion to the mean play. Consumer spending will eventually return to the sector as it has to a large degree in other retail segments. It seems reasonable to assume there is some pent up demand among the target demographic that will eventually be released. It is clear the rate of decline has slowed in the segment, but most companies are still not seeing positive SSS growth. Of course, how fast consumer spending returns to the sector cannot be predicted with any degree of certainty. I won’t dwell much on trying to predict broader levels of consumer spending going forward other than to analyze whether CBK can survive a protracted downturn.

The second element is a combination of company specific factors that leaves the right specialty retailers poised for relatively quick turnarounds (12-18 months), assuming the macro environment is somewhat cooperative. Specialty retail tends to be cyclical regardless of the macro environment due to the long lead times for product design and ordering combined with the need to be on-trend to drive sales. A quarter with a merchandising miss can take several quarters to correct as excess inventories need to cleared out. Additionally, the lessons learned regarding consumer preference will only show up in stores several quarters later.

The positive side of this cyclicality is that the restructuring process is clear and many factors driving profitability are within management control irrespective of the macro environment. Specialty retail turnarounds are more straightforward and easier to predict than turnarounds in other industries as they do not typically require drastic changes to the business model. Rather, the turnaround is driven by improved execution. Management must get inventories realigned with the temporarily lower sales to avoid excessive markdowns or writeoffs. They should use the down cycle to implement rationalization in store count, product sourcing, SG&A, and capex spend. Management then needs to be bring their merchandising back on fashion point and reconnect with their customers, while ramping inventories as appropriate. With a large fixed cost base specialty retailers possess a great deal of operating leverage, so these various moves can have an outsized impact on the bottom line.

Christopher and Banks (CBK) possesses a compelling valuation and all of the elements necessary for a sharp operational turnaround combined with a solid balance sheet to protect against a prolonged trough period.

Background and Current Situation

The story of CBK over the past decade is similar to that of many mall based specialty retailers- rapid store count and revenue growth combined with declining profit margins as their markets become fully penetrated. CBK grew revenues of $209.2 million in 2000 (their fiscal year ends in February so I will be referring to the fiscal year by the previous calender year for clarity) to a peak of $575.8 million in 2007 as their store count grew from 310 to 848 (including results from the Acorn chain, which was closed at the end of 2008 and reclassified as discontinued operations). CBK was a growth angel, going from a little over $3 a share in 2000 to almost $30 a share in 2006. Yet earnings growth was masking a decline in margins and ROE. Same store sales growth slowed and sales per square foot dropped. EBIT margins went from 19.7% in 2000 to 3.8% in 2007. ROE declined from 37.1% in 2000 to 7.8% in 2007. Both EBIT margins and ROE declined every year along the way.

Lorna Nagler came from plus size competitor Lane Bryant (a division of CHRS) to become CEO of the company in August 2007. While she implemented several positive initiatives including overhauling ERP and CRM systems and rationalizing cost structures, core merchandising began to deteriorate just as the recession hit. SSS have declined 12%, 15%, and 1% in 08, 09, and 10 respectively. Q4 of 2007 started a run of nine straight quarters of flat or negative SSS comps. There was a brief respite in Q1 and Q2 of 2010, but SSS growth in Q3 and Q4 was once again negative. Yet despite the decline in revenues, they have remained EBITDA and cash flow positive throughout this down period.

In October 2010 Nagler left the company along with the Chief Merchandising Officer she had appointed after CBK delivered surprisingly negative SSS guidance for the third quarter of 2010. While not being able to help the top line (although admittedly dealing with a very difficult macro environment), Nagler did succeed in rationalizing the cost structure while still investing in systems improvements. The company is now leaner, but with systems in place to better leverage an uptick in sales. Long time board member Larry Barenbaum was appointed CEO to lead the turnaround.

Turnaround Strategy

Barenbaum has outlined the turnaround strategy in the last two conference calls. The elements are basically straightforward and success will lie in execution.

Merchandising

Barenbaum understands the first priority is to realign merchandising and reconnect with the core customer. CBK appeals to a slightly different demographic than the rest of their publicly traded peers. The core demographic is the middle income baby boomer and CBK is especially strong in secondary metropolitan markets, which often lack the presence of the other specialty retailers in this niche.  There does appear to be a core group of Midwestern customers with a longstanding affinity for the brand. But the brand has lost touch with the baby boomer desire for more novelty and style along with the basic functionality and fit they expect from their clothing. Online reviewers have commented that the recent selections have been dowdy and suitable for “senior citizens”. CBK has to justify their higher price point relative to lower end stores like Kohl’s by providing more fashion forward items.

On the Q3 conference call Barenbaum laid out the fundamental merchandising changes we should be seeing. CBK does not want to compete on price for basics with Target and JC Penney. CBK needs to offer more novelty and flair within their product mix while still retaining the fit and functionality their customers desire. To that end he rehired Jules Rouse as head merchandiser (the previous chief merchandise officer who had been appointed by Nagler left with her). Rouse had been with the company from 1995 to 2008 and presided over the growth of the brand. Presumably she is a solid pick to realign it with customer preferences. However, due to product manufacture lead times the full impact of her design changes will not be fully seen in stores until this fall, although management has stated some of her styles will be in stores starting in the summer.

Part of this strategy is the continued roll out of a new branded line which debuted in Q4 2010, Tribella, which emphasizes style and commands a higher price point. Tribella is an offshoot of the popular Tribal women’s clothing brand, and represents a significant fashion forward step for CBK.

As the new products being introduced in the fall are more stylish, CBK feels the new look and quality justify raising prices “mid to high teens” percentages across the board. This will still leave CBK priced below its specialty retail peers and thus still convey value, but the price increases will further differentiate CBK from the lower end department stores.

Other changes to the merchandise mix include the continued expansion of accessory lines (such as jewelery and sunglasses) and the roll out of petite sizes in more stores, both initiatives that have been successful thus far.

Store Count and Real Estate Expense

The second key lever management can pull is a change to store count and occupancy expense.

CBK identified about seventy underperforming stores for closure. Half were closed in 2010 and 35 more will be closed in 2011. Additionally, CBK has over 100 stores a year coming up for lease renewals for the next several years. CBK will have the flexibility to easily close underperforming stores or negotiate lower renewal rates in the currently favorable leasing environment.

CBK did announce that they plan to open 31 new stores in 2011. However, none of those stores are traditional format stores (if they were that probably would have been a deal breaker for me). 22 are outlet stores and 9 are dual format stores (which combine Christopher & Banks and the plus size CJ Banks lines). The outlet store format has provided many retailers with an efficient means to move dated inventory and tap consumer demand for value. It should help the gross margins of CBK. The dual format store combines both brands in a store of 4,500 to 5,000 sq. ft. as opposed to 6,500 sq. ft. for two separate stores, which should provide increased sales efficiency.

CBK has had success with both store formats in pilot testing. But these openings come with a projected $18 million capex price tag for FY 12. My strong preference would have been for them to save the cash for now. On the Q4 CC an analyst pressed the CEO as to why they would open more stores until the brand is turned around. Barenbaum didn’t give much of an answer other than saying that they think these new formats are attractive growth opportunities and the openings are not aggressive. Investors do not know how well these formats have done in pilot testing other than anecdotal reports from management, so it is hard to know if customers are really clamoring for them. But the new formats seems to be a fairly low risk growth strategy given they have been tested and an $18 million spend will not wreck their balance sheet.

Online Sales

CBK was late to the ecommerce game. They only started web sales in 2008 and feel they still have room to grow this segment. Indeed, it has been the only segment growing as of late. It was up 13% last quarter, and makes up less than 10% of current sales. They plan to expand online only product offerings and have recently hired a new VP with relevant ecommerce experience.

Marketing

CBK has begun to overhaul their marketing and branding on several fronts as they reintroduce the improved brand. They have trained managers on the new style direction, begun to overhaul in store visuals, and have shifted direct marketing strategies to emphasize more frequent communication with customers (while not planning to increase marketing spend).

Management has stated that they do not think there is much more room to slash SG&A spend. They have already implemented some heavy cuts to SG&A under Nagler’s watch and feel they are tapped out in that area.

The turnaround plan seems coherent and feasible as it mirrors what has taken place at other specialty retailers (such as ANN), and some of the pieces such as righting inventories and reducing expense structure have already been completed. CBK appears to have the brand equity to at least have a good shot of reconnecting with their customers. Of course talk is cheap and success will depend on management execution. Barenbaum does not have direct experience as the head of an apparel company, having come from the jewelery industry. Additionally, the circumstances of his hiring were a bit odd. Barenbaum was initially dubbed interim CEO, the company said they were doing a CEO search, and then he was named permanent CEO. I have heard speculation that they had trouble finding an industry insider to take the job. On the other hand, Barenbaum has been on the CBK board since 1992 and has been chairman since 2005, so presumably he knows the business well. I think that the downside is well protected by the balance sheet and the continued strong cash flow metrics as I will detail. On the whole, it is hard to see how things get much worse for CBK from here so I think this is a low risk/high reward situation.

Financial Statement Analysis

Revenues

As can be seen from the charts, CBK grew sales until 2008 almost solely through new store openings with very minimal SSS growth (charts by fiscal year):


Store count has dropped since 2007 from 848 stores to 775 at the end of 2010. The tough times as reflected in SSS are common throughout the sector. Only ANN and CHS seem to have turned the corner, though the rate of decline has slowed dramatically for CBK with SSS only down 1% in the past year. Still, CBK is guiding for a “mid single digit” decline in SSS for the first quarter of 2011. They seem to be guiding for the turnaround in SSS to start in Q3 when product reflecting the new design philosophy hits stores. CBK is guiding to end the year with 4 fewer stores on a net basis, although they will be replacing traditional format stores with larger outlet and dual format stores. Barring customers completely rejecting the new design approach it would appear the worst is behind CBK in terms of revenues even if the economy continues to languish.

Gross Margins

CBK breaks expenses on their income statement into four categories: merchandise, buying, and occupancy, depreciation, store asset impairment, and SG&A. Using mechandise, buying, and occupancy to get cost of goods sold we find that gross margins were 34.8% for the last year. Gross margins have gradually dropped from the 40% range over the last four years. This is the result of two major factors: the deleveraging of fixed costs like store rent as sales have declined, and increased markdowns required to move unpopular inventory.

If we back out the rent expense (detailed in a 10-K footnote) from the merchandising, buying, and occupancy line then we get what is roughly just the clothing cost, although it still includes sourcing and distribution costs:

Interestingly, that margin has held fairly constant at around 54% with the exception of 2004, 2008, and 2010 when it went down to 51-52%. It is a bit to hard to analyze precisely as sourcing and distribution are mixed in, but this analysis might indicate that increased rent expense without a corresponding rise in sales has more to do with the general margin decline than increased markdowns. However, in some years merchandise discounts were given to clear old inventory as was the case in 2010. (Note this analysis is using the restated financials, which include only the current Christopher & Banks and CJ Banks stores and back out the shuttered Acorn unit.)

CBK is guiding for a 9-10% drop in gross margins for Q1 as compared to Q1 of last year, following on the large drop in GM in Q4 10. That would mean a GM of 32-33% versus 42% margins in Q1 last year. Their plan is to continue to markdown inventory with older styling to make way for product from the new design team, which will start arriving in June and will make up 100% of store product by August. However, on the CC they admitted there could be some upside if store traffic increases and they do not have to be quite as aggressively promotional to clear inventory.

Longer term, there is obviously much room for gross margin improvement if CBK can improve customer sentiment with the new designs and avoid merchandise markdowns as well as better leverage fixed rent and buying costs. Closing unprofitable stores and replacing them with profitable dual and outlet format stores should also reduce the gross margin drag. Additionally, the higher price point for the new designs will help, although that will be offset to some extent in the next few quarters by higher cotton pricing.

The spike in cotton pricing to record highs has been a major topic of discussion in the retail apparel community, but the spike appears to be a temporary one and not structural. A recent Bloomberg survey of commodity analysts revealed that they anticipate cotton pricing declining by 51% by the end of the year as supply increases for the first time since 2007.

SG&A

The SG&A line includes all employee salaries except for those of buyers and distribution personnel as well as marketing and other corporate level costs. It has come down dramatically from $172.3 million in 2008 to $142.5 million in 2010. Most of the cuts came on the store expense level, although marketing expense and corporate salaries have been cut as well. However, on an absolute basis SG&A is about what it was in 2006 when revenues were $100 million higher. There is room to dramatically leverage SG&A as sales rise. Management is guiding for SG&A of Q1 to be the same on an absolute dollar basis as Q1 of last year. They have stated that they do not think there is much room to further cut SG&A.

CBK’s store level efficiency metrics such as sales per square foot, store, and employee are all very low for a mall based retailer and have been declining for years. For example, sales per square foot has languished under $200 (and even pre-recession they were only modestly above $200) while ANN is in the $300-$400 range and CHS is over $600:

While CBK’s lower price point means they probably will never match the efficiency of an ANN or CHS their metrics still appear very low. New York & Company (NWY), which is similar to CBK in terms of price point but aimed at a younger demographic, does over $300 in sales per square foot. CBK’s metrics are closer to a strip shopping center discount retailer like Cato (CATO). There is much room to better leverage store and corporate expenses and improve margins by driving more traffic across stores and closing underutilized stores.

Inventory and Working Capital

The first job for a retailer with declining sales is to bring inventories in line with lower sales so as to avoid excessive markdowns. CBK has already done a fairly good job of this. Gross margins had not totally collapsed until the most recent quarter when they began clearing inventory for the new designs. We should see another quarter or two of lower margins. Overall, their working capital management has been decent. Inventory turnover has held even in the 7-8X range while their competitors are in the 4-5X range. Interestingly, they have an unusually low payables period in the 20 day range while most of their competitors are getting 40+ days. Management has said they have revisited their sourcing relationships in the past quarter, which should lead to better terms and free up some cash.

Liquidity and Capital Allocation

CBK has book equity value of $164.2 million. This is a high quality balance sheet with $106 million in cash and investments and no intangible assets. The investments totaling $62 million are in municipal bonds. They also have a $50 million line of credit that has not been drawn on at all. CBK has been CFO positive for every year as a public company except for one (1995), so it is hard to envision a cash crunch. Apparel businesses tend to be strong cash flow generators as long as inventories do not get far out of line.

CBK has a 6 cent a quarter dividend they have paid for a number of years ($8 million a year), which is a nice 4% yield with the stock at $6. They also have a history of doing a decent amount of stock buybacks, although none since 2007 when they bought back $18 million in stock.

CBK has slashed capex spend in the last two fiscal years to $8.4 million in 2009 and $6.0 million in 2010. For context, capex ranged from between $18.4 million and $30.9 million from 03-09. They were still building new stores in 2009 and 2010, so it seems fair to estimate that maintenance capex can’t be much more than $10 million.

Unfortunately, as discussed CBK is still guiding for $18 million in capex spend to build the 31 new stores (although 35 are closing). Capital allocation is something to watch out for here. I would like to see them return additional capital to shareholders beyond the current dividend. They don’t appear to have any growth avenues right now aside from the outlet stores. And the business even in the current trough is still cash flow positive so there doesn’t seem to be a need to hang on to $100 million plus in cash as a safety cushion. Management seems to agree they don’t have anything do with the cash as evidenced by the shift of some of the cash into longer duration municipal bonds over the past year.

Deferred Lease Liability

An interesting balance sheet feature to note is the deferred lease liability. Landlords give upfront cash to tenants for initial store buildouts in return for higher lease payments down the road. This cash flows into PPE and becomes a deferred lease liability that is amortized over the life of the lease as a reduction to lease expense on the income statement. Therefore cash rent expense is higher than accounting rent expense on the income statement. For some of CBK’s peers such as CWTR this can be a major drag on cash flows. CBK does not have a particularly large liability and they are running it off as they close stores and slow down new store builds. It has dropped to $15 million from $23 million at the end of 2009.

Profitability and Cash Flow

CBK was extremely profitable in the 2000-2003 period with EBITDA margins in the 20% range. In 2004-2007 the company ramped up store growth to a breakneck pace and while sales rose, profitability was hit as SSS growth slowed and EBITDA margins declined to the low teens:

 

The ROE numbers reflect the same phenomenon, declining from the mid 20s to the mid teens.

In 2009, the company managed to stay almost break even on the operating income line through cost cutting. The further decline in sales from $455.4 million in 2009 to $448.1 million in 2010 pushed the company to an operating loss of $14.6 million in 2010. This is a good example of the high degree of operating leverage in the business. A 1.6% drop in sales increased the operating loss from $1.4 million to $14.6 million.

Looking at cash flows, the cash generation of the business is quite strong. Even in the high sales growth phase of 2000-2006, CFO ranged between 60 to 86 percent of EBITDA plus asset impairment charges. From 2007-2009 CFO was greater than EBITDA plus asset impairment charges. In 2010 CFO was $7.5 million versus $13.3 in EBITDA plus asset impairment charges. That is mainly due to an increase in prepaid expenses and a decline in other accruals so it appears to be a timing issue and not a substantive change in the business.

CBK generated strong free cash flow even as it spent heavily on growth capex. FCF remained strong until the past year despite declining sales as the company was able to cut back on working capital and capex. As the company reaches a mature phase with stores already built out we could expect very strong FCF if they can normalize sales. With a steady level of sales, working capital needs will remain constant. And maintenance capex for store updates should be minimal, as evidenced by depreciation far in excess of capex the past two years as new store builds have slowed.

The cash generation of the business is also noteworthy from the standpoint of downside protection. CBK could probably sustain another small drop in sales and still remain CFO positive. And the last two years have shown that they can scale back capex to under $10 million if needed. So barring even more severe sales declines or terrible capital allocation it is hard to envision how CBK whittles away the cash on the balance sheet.

Valuation

We can start the valuation looking at the asset base. CBK has book value of $164.2 million as of Feb. 26. $106 million of that is in cash and investments. There is no goodwill on the balance sheet. Barring some upside surprises the next quarter or two will probably see net losses so some of the book value will continue to erode, although that is hard to quantify. But at present CBK is trading at 1.3X book value, which provides a margin of safety. Specialty retailers generally trade well above book value (ANN currently trades at 3.8X BV) as much of their value lies in the intangible assets of the brand and distribution systems. Additionally, 50% of CBK’s market cap consists of cash and investments. The operating business with over 700 stores is almost being given away. Given that they have stayed cash flow positive throughout the downturn and have minimal maintenance capex requirements it seems difficult to envision CBK burning cash for an extended period. Therefore, I think the cash on the balance sheet provides solid downside protection.

As a point of peer comparison, Talbot’s, which has also seen top line declines and was not profitable last year is trading at 2X BV and 2.4X tangible BV. Additionally, Talbot’s has a much poorer balance sheet with only $10 million in cash, $26 million in debt, and large deferred rent and pension plan liabilities.

For an earnings based valuation I think it is most helpful to try to model what CBK might do on a normalized steady state basis. There doesn’t appear to be any long term growth left in the business. If CBK can turn around then the store count should remain constant and the business should basically be run for free cash flow (a big assumption for a public company, but presumably value investors would sell out before they started rolling out a major expansion).

The basic idea behind this model is to build earnings up from the store base assuming normalized sales volumes as measured by a sales per square foot metric. Based on current guidance from the company we will not start to see normalized sales numbers until Q3 of this year.

I have taken the average store square footage assumptions from the 10-K, with the exception of the outlet stores which they do not list. I have put the outlet stores at 3,400 sq. ft., in between the average C&B and cj Banks store. As of April they had 765 stores. They plan to close four stores net this fiscal year, and I am unclear on whether any openings or closings have been made as of April. I will assume they have not so that 35 C&B and cj stores will be closed and 22 outlet stores and 9 dual stores will be opened as they announced on the Q4 CC. That leaves 761 stores total and about 2.6 million sq. ft. of gross selling space, which shrinks the store base to about 2007 levels.

The critical assumption is the sales per square foot metric. In a conservative base scenario I assume they can get back to $200 a sq. ft. As noted, this is still quite low for a mall based retailer and CBK was substantially over $200 a sq. ft. pror to 2008. I assume normalized gross margins (as measured by merchandise and buying expense ex occupancy) at 53%- below the 54% where they have been for most of the last decade, but an improvement from the depressed margins of the past year. They will see some margin pressure from cotton pricing in the next few quarters, but that appears to be temporary as noted above.

I assume rent expense continues its decline. It has come down from 86 in 2008 to $72.5 in 2010. I will put it in at $70 million. They should be able to get another $2.5 million in savings between net store closings, replacing mall stores with cheaper outlet store real estate, and renewing leases at lower terms. This yields a 40% gross margin with rent, which is on the lower end of what they were doing before the recession. I assume SG&A up slightly from $142 to $145 million. Management has guided for SG&A to stay flat next quarter and I don’t see why SG&A can’t be flexed to much higher sales dollars. As a sanity check, in 2006 $141 million in SG&A drove $533 million in sales.

These assumptions yield $60 million in normalized EBITDA on $519 million in sales for a 12% EBITDA margin, which is on the low end of what CBK has done in the past and in line with average sector margins.

Depreciation has declined the last three years, as capex has lagged depreciation for the last 3 years and will do so again next year. It was $24.7 million last year so I will put it at $23 million. The model then yields $37 million in EBIT for a 7% percent EBIT margin. This would be lower than pre-recession levels for CBK (they were doing over 9%) and also about average for the sector. After taxes this would be $23 million in net income, or .64 cents a share.

Assuming they will pay $14 million in taxes and using EBITDA as a proxy for CFO otherwise, they would generate $46 million in CFO. If we put maintenance capex at $10 million that is $36 million in FCF (defined as CFO – capex).

Here is the model (the Excel sheet can be downloaded here):

What earnings multiple can we assign to the business? Profitable apparel companies seem to be assigned above market multiples, but CBK will probably deserve a discount to peers assuming there are no growth avenues. It is hard to find profitable comps right now, but we can look at ANN, CHS, and CATO (though not exactly in CBK’s sector). Realistically I don’t think the market will award CBK the multiple of ANN or CHS, which are larger and probably regarded as stronger bands. But I think it should trade at least in line or at a slight premium to CATO, which is a discount retailer.

 

Even at 5.5X EBITDA or a P/E of 12 there is 80-100% upside (when taking into account the value of cash on the balance sheet). Assuming the normalized $60 million in EBITDA and $36 million in FCF one can buy in at 1.8X EV/EBITDA or a 34% FCF yield on the operating business.

What is the downside scenario? The main assumption to question is the sales per square foot metric. I feel fairly confident about the expense assumptions, considering CBK has already cut their expense base and there doesn’t seem to be a reason they can’t leverage the expense structure if their customers come back. Whether or not the new design and pricing strategy will succeed seems much more open to question. Maintaining the expense assumptions, the EBIT break even in my model is $174 in sales a sq. ft., which is above the $154 in 2010 but below the $188 in 2008. By closing unprofitable stores and opening what should be popular outlet stores it seems very likely that CBK improves on the $154 a foot sales number even if the design change is not a huge success. So I think even on an earnings basis the downside is limited to about break even. And as we have seen the past two years maintenance capex can be scaled back to under $10 million so even at minimal sales levels the cash on the balance sheet should be safe.

I have not added any non-operating interest income to the normalized EPS number (and the value of the cash is taken into account if the valuation uses enterprise value), although if they continue to hold a large amount of cash on the balance sheet this could be quite significant in a more normal interest rate environment.

Risks

Consumer Spending-  Macro risk that discretionary spending persists in not returning to the missy sector. Some retailers have seen a slight pick up in sales and across the sector the rate of sales decline has slowed. CBK has the financial strength to survive if the downturn continues.

Merchandising- CBK might botch the brand overhaul. Their direction makes sense and meshes with what I have seen online reviewers demand from CBK. And head merchandiser Rouse seems competent. She must have done something right when the brand grew dramatically in the 2000s. But continuing to miss on fashion is certainly a risk. Additionally, I am bit concerned about whether CBK will be able to sell their price increase to consumers coming out of recession. If the brand is really finished then the high operating leverage might make the situation painful very quickly. Given the long history of the brand and a strong niche in the Midwest, I don’t think the brand just falls apart in the next year or two.

Management Execution- Lacking apparel experience, Barenbaum seems somewhat of an odd choice to lead an apparel turnaround. He has said all the right things on the conference calls, but the proof is in the pudding.

Capital Allocation- The downside protection here is the strong balance sheet and therefore the decision to spend $18 million this year mainly on new store capex was disheartening and leaves me somewhat worried about capital allocation. It is clear from the financials that CBK has plenty of stores and I would not want this management team continuing to grow store count or try to roll out a new concept.

Source of Opportunity

The turnaround thesis for CBK is clearly not in vogue. The three sell side analysts following CBK have estimates for 2012 at $444 million in revenue and -.04 EPS. (The analysts have CBK doing worse in 2011 at $433 million in revenue and -.31 EPS., but 2011 will be a transition year and irrelevant to the long term thesis if it plays out.) I think it is always helpful to ask why the market is providing an investment opportunity:

  • The market has a bias to growth and CBK is a busted growth story. Even if Barenbaum can right the ship there doesn’t appear to be any growth potential. CBK tried a higher end concept with the purchase of Acorn in 2004, but it proved a disastrous acquisition and Acorn was closed in 2008.
  • In specialty retail the market has a narrow focus on recent SSS trends as opposed to considering the sales numbers in the context of the financial strength of the company.
  • Analysts are clearly skeptical about whether Barenbaum can lead a turnaround and whether the brand is still relevant in the face of discount retailers who sell fairly high quality clothing. But as it often does, the market is undervaluing balance sheet strength.
  • The market is also perhaps anchoring on the current year’s poor earnings numbers and ignoring the possibility that earnings can turn around very quickly with a slight uptick in sales.
  • The company may just be somewhat obscure and ignored. CBK easily has the smallest market cap in the sector. And while three analysts do cover the stock, I am surprised how little attention it gets in the financial media even when all of its sector peers are being discussed. As noted earlier, I have seen value oriented stock write-ups for every other stock in the sector aside from CBK.

Timeline

What is the timeline for the thesis to play out? The designs from Rouse’s team will start arriving in June and be fully in stores by August. It will probably take at least two quarters from that point to know whether the design change has been a success. I would like to see at least mid single digit positive sales comps in the quarter ending in November and some serious sales traction for the quarter ending in February. I don’t know how aggressive management will be in ramping inventory ahead of an anticipated sales increase, so it might also take a few quarters to get inventories in line with higher sales volumes.

Position Size and Portfolio Exposure

I like CBK as a high upside/low downside pick, though I admit the upside is somewhat speculative. I feel confident to go in as a mid-level conviction pick, which for me is a 7-8% position size. CBK exposes the portfolio to consumer discretionary spending. It is my only retail pick right now so I am okay with the exposure, but I would have to think hard before adding another one.

Disclosure- I own shares of CBK.

 

 

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6 Responses to Christopher & Banks (CBK) – Specialty Retail Turnaround
  1. adib
    May 26, 2011 | 1:54 am

    wow. One of the best analysis for a fashion retailer.

    Reply
  2. Elie
    May 26, 2011 | 2:35 am

    Thanks Adib!

    Reply
  3. Omar samalot
    May 27, 2011 | 8:30 am

    Excellent analysis. I usually shy away from retailers but your analysis is forcing me to take a look. Good luck!

    Reply
    • Elie Rosenberg
      May 28, 2011 | 10:13 pm

      Thanks Omar! I agree retailers have many unattractive attributes, but in certain situations they can be interesting.

      Reply
  4. Maura Henley
    June 17, 2011 | 12:04 pm

    Pretty nice post. I just stumbled upon your blog and wished to say that I have really enjoyed browsing your blog posts. In any case I will be subscribing to your feed and I hope you write again soon!

    Reply
  5. Christopher & Banks Q1 Results – Signs of Hope | ValueWalk.com
    July 5, 2011 | 7:52 am

    [...] & Banks (CBK), which I profiled here,  reported first quarter earnings yesterday. They had guided for a terrible quarter, and produced [...]

    Reply
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