THE HEDGEYE EDGE
This is not a terminal story. CRI has a great brand, good management, just not margin-accretive growth, which means definitely not a good stock. Share gain is slowing at the tail of the economic cycle, its running out of meaningful US growth, with margin pressures and demographics going the wrong way. Also, there's the serious risk of a massive shift in the apparel consumption paradigm from potential Trump border tax adjustments.
INTERMEDIATE TERM (TREND)
We think the 4Q earnings report coming around late February will be a tough one. Especially considering the weakness shown when CRI reported its third quarter, missing for the first time in 25 quarters where they had actually guided up the full year. CRI is historically a beat and guide down company, to keep the bar low each quarter. They almost never miss and they have never missed and guided up. This deviation from the norm is concerning if you own this stock heading into 4Q.
Additionally, cotton prices have continued to rise, from the bottom seen in March, and this margin pressure has to start flowing through to the P&L. We think that happens as soon as the 4Q print.
LONG TERM (TAIL)
Let’s just agree up front… this is a good company, with great brands, and above-average management.
- It has been a consistent share gainer in every category in which it competes.
- Its product distribution is diversified across brand, consumer (baby/toddler/child), channel and geography.
- Management has put up a very steady 13% EPS CAGR over three years, and has driven margins to a new peak of near 12%, RNOA from 9% to 12%, and has driven debt/equity from 85% to 65% over the same period – while squeezing out 28% ROE.
No surprise, therefore, that it’s commanded a 20x-25x EPS multiple and 12x EBITDA multiple as we entered the back half of this economic cycle. But… there are a few factors we don’t like.
A) Demographics – which have been a big tailwind for CRI – are starting to go the wrong way. We’re not so disillusioned to think that a declining birth rate will all of a sudden make CRI miss a quarter by 20%. But the backdrop is enough to cause its multiple to test lower highs and lower lows.
B) Market Share – Any way you slice it, the company’s rate of share gain is slowing. It went from 5% share of the children’s wear market in 2008, and is now over 10%. But what was 80-100bp share gain annually went to 70bp in 2013, 50bp in 2014, 20bp in 2015, and does not appear to be heading higher in 2016.
C) Channel Diversification is a double edged sword, and share changes over a decade are very interesting to us.
- Simply put, this screams balance. We’ve seen department stores go from 37% of sales to 23%.
- Mass (WMT/TGT/COST) go from 17% to 12%.
- CRI-owned (leased) stores hanging tight at 40%.
- E-comm above 10% from zero just five years ago.
We still think that CRI does not have enough product differentiation by channel, and the online growth in both its own channel as well as the online growth in wholesale partners will allow the consumer to get much smarter in arbing a better price/value. As noted, that was not enough to hang our hat around at the start/midpoint of this economic cycle, but we think it has more teeth than it did before.
D) We don’t like Carter’s lease trends. Again, this is not a near-term ‘long thesis killer.' But CRI’s weighted average lease duration has gone up by 25% since 2008. For most companies, this is net bearish – as it suggests that they are locking in longer obligations (i.e. betting that stores will be more relevant for a longer time period) or are signing steeper rent escalators to buoy near-term affordability. Perhaps in CRI’s case this is a function of Int’l stores – it’s possible. This is definitely something for us to research further.
E) Trump is looking to reintroduce protectionist trade policies. Deflation in Consumer Non-durables due to the elimination of an arcane protectionist policy took down cost by 50% and took up per capita UNIT consumption by 100% over 20 years. This drove the most powerful consumption trend most of us will see in our careers.
This resulted in more mediocre brands and retailers being ‘allowed’ to exist – simply because consumption increased so rapidly regardless of elasticity. Carter's is a great brand, but if the policy change is passed in 2017, everyone should lose. Companies with a high percentage of its merchandise made in Asia (like CRI) will lose the most. Hedgeye’s policy team currently pegs a 30% chance that we’ll see these measures pass – with cost increases of 15% or higher.
ONE-YEAR TRAILING CHART
