Conclusion: There were puts and takes in the CRI quarter, but the major standout to us is the change that we’re seeing in the capital intensity of the model. The colossal rise in capex and spike in SG&A ups the ante for the well-telegraphed ‘14% EBIT Margin’ bull case we need to see come to fruition in order to prevent a decline in returns. If this happens we think you’ve got 16-17x $4.25 in EPS in 2015, or a 8-10% annualized return on a number that you have to wait 3-years to see. If our concerns about pricing spreads and high cost/low return of international growth play out, we think CRI has downside to about 13x on $3.00, or $15 downside over the next year. Capital deployment shorts don’t play out overnight, but at a minim we’d avoid the long side of this name. There are far better places to be in our opinion.
Obviously the market doesn’t like the CRI print today, and we agree. But we think we don’t like it for different reasons. The stock started to trade down just as CEO Casey mentioned that 1Q to date showed negative comps in Carter’s stores. While that’s not good, we think a bigger negative was the change in tone regarding capital allocation and margin makeup.
Harvesting Is Over: We think CRI is entering a meaningfully different stage in its investment cycle. The way we see it, it just made its second international acquisition in 18 months, it is bringing its product sourcing from 20% of total today to 50% in 5-years, it just took SG&A up 40% in the latest quarter on top of a 14% sales growth rate, and management noted that GM upside (ie pricing better than costs – something it has sparse control over) will need to happen in order to offset higher planned costs. Furthermore, capex in the coming year is slated to be $200mm. As a frame of reference, this is 4x the rate of Carter’s D&A, and it has never spent even half that much in a given year (even as a % of revenue) in all the years it has been public.
Don’t get us wrong. We like when companies spend money – at least those who prove to be good stewards of capital and drive returns higher through share subsequent share gain or margin improvement. But CRI is simply unproven in that regard. We’re not saying that it will fail. But rather that you need to believe that it will succeed in order to buy the stock here.
The ‘14% margins due to direct sourcing’ bull case is very well telegraphed. If we assume that the company gets there within 3-years, we’re looking at about $4.25 in earnings power. That’s a great lift over the $2.86 it printed last year and $3.28 it is guiding towards in 2013. But with the stock at $55, you’re paying 12-13x a best-case earnings number that may or may not happen in 3-years.
In the interim, there are some puts and takes.
International is clearly growing, US Carter’s retail is still putting up mid-teens square footage growth, and dot.com is growing nicely – up to 18% of store sales in this quarter vs 11% last year. The new DC should keep this heading higher.
On the flip side, we remain concerned about more normalized product costs and increased competition by both retail partners and competing brands alike. In addition, while International is nice, it’s definitely not a slam dunk.
a) Bonnie Togs comping down only 2-quarters after it is included in the comp base.
b) The new dual-brand stores in Canada are launching, but are not proven yet.
c) Just after CRI anniversaries the Canada acquisition, it’s investing capital in the last place we want to see incremental money put to work – Japan. For a luxury brand (like Kate Spade, Kors, or Ralph) perhaps that makes sense, but not for a kids mass apparel maker. Also, keep in mind that the dominant brand for CRI in Japan is Osh Kosh, which it has a hard enough time growing in the US nevermind Japan. The opportunity is for the for Carters brand, but Japanese Moms are not US moms. It will cost money to build that opportunity.