CRI: Great Short into 2012

Conclusion: CRI is one of the most expensive names in retail. Valuation alone is a bad reason to sell. But growth trajectory and margin are both not sustainable. We think that once the calendar turns into 2012, CRI will be ripe for a far larger group of short and long sellers.

Sales growth of +24% was the strongest CRI has reported in the last 5-years. Looks great optically, but when taking into account the newly acquired Bonnie Togs business – which accounted for +7% and the sales pulled forward accounting for another +1% (adjusting for Q3 sales that were pulled into Q2), organic sales growth actually came in closer to +15%-16%. Good stuff, but this marks a sequential deceleration from the prior quarter at the same time CRI is about to go up against double-digit sales growth driven by accelerating sales in both Carter’s wholesale and mass businesses this time last year.

Margins continue to be under pressure with fall product costs up ~25% with mid-teen increases persistent through the 1H of F12. AURs are up anywhere from MSD to high-teens depending on the channel, but CRI is having the most success at Carter’s wholesale where units are actually up +8% on a +6% increase in pricing. In all other channels units are flat to down. We expect continued SG&A leverage to the top-line though think the opportunity for more meaningful cost reduction is modest with incremental Canadian retail expense and U.S. retail store growth investment of nearly $10mm each through the 1H of next year.

One thing to keep in mind as it relates to margins is that the sales/inventory spread has been negative for the sixth quarter in a row.

In addition, CRI pulled sales forward from Q4 while deferring the operating costs associated with those sales (when the company expected to realize the revenues) – that’s not a pretty setup for Q4. Is it enough to really derail the quarter? No. The call is bigger than that, but it certainly doesn’t help.

We’re not saying Carters isn’t a good brand, it’s actually a very good brand, but we don’t think the company is going to have the benefit of both pricing AND unit growth next year. Retailers, for the most part have taken and passed price increases along to the consumer – so far. But a major factor we can’t ignore is the real potential for a price war in the mid-tier channel in 1H12 spurred by JCP’s EDLP strategy. These companies (KSS, GPS, M) are doing their one-on-ones and telling people that they’ve got it under control and that no price war is brewing – but with all due respect, they don’t have a clue.  To intimate in any way that these companies have any certainty on pricing 2 or 3 quarters out is simply arrogant. Wal-Mart is also getting heavier in basics, which won’t help anyone. And who is to say that product costs easing in 2H will be good for Carter’s? As product costs come down, guess what happens? Competitors produce more product. And we all know that 99% of the product needs to sell at the end of each season – i.e. price will come down to accommodate that.

We’re shaking out a 10% top-line growth next year driven by retail store growth (3-4%), incremental international/Bonnie Togs (~3%), and another 1-2% each from Carter’s wholesale business and e-commerce. With the acquisition, you’re looking at a MSD-HSD top-line grower. That’s where we come out in F13 while the Street is assuming another double-digit year. Where we’re going to be most different from consensus is on gross margins. We’re modeling a -100bps decline in F12 as the company expects to pass through roughly two-thirds of future costs in the 1H. With cotton costs down sharply in recent months, we think discussions are going to be more challenging come spring for a brand like Carters that has increased prices by as much as mid-teens in some channels. With modest leverage in SG&A (-25bps) we are shaking out at $178mm in EBIT and $1.85 in EPS. Let’s not forget that Carter’s own retail stores boast an average 40% discount on day 1 for 90% of the product. Yes, it competes with itself.

The bottom-line is that execution risk is extremely high here, much is outside of CRI’s direct control, and there’s very little margin for error. With the stock now trading at 17.5x earnings and 10x EBITDA off next year’s Street estimates – and 21x and 11.5x ours – expectations are lofty to say the least. Has Carter’s all the sudden become a mid-teens grower – we don’t think so. Even if we were to give CRI the benefit of the doubt and assume a return to peak margins (~14%) some 500bps+ from where the model is today, we’d be looking at a stock trading at 11x P/E and 6.5x EBITDA F13 numbers – that’s where most of CRI’s peers are trading on current numbers. Those former margins represented a period of severe over-earning. We’ll never get back there again.

This thing appears to be trading on the Berkshire factor. This is an environment where you don’t get paid, lose your job – or both – for being short a company that’s rumored to be LBO’d and it actually happens. With 2 months left in the year, appetite for risk on small cap names like CRI is not too high on anyone’s list. So people are going along with the herd.

We think that once the calendar turns into 2012, CRI will be ripe for a far larger group of short sellers (or long sellers).

This one is right up there at the top of our short list.

Longs: NKE, LIZ, RL, AMZN

Shorts: JCP, UA, HBI, CRI, GIL

CRI: Great Short into 2012 - CRI S 10 11