Change In Strategy – Reviving the Portfolio

I’m going to avoid the Euro Zone and allocate assets to North America (Canada and the USA). I believe all my subscribers live in North America anyways, so it’d better suit your portfolios.

The Euro Zone remains weak despite all the measures the ECB has taken to ‘revive’ it. And the Euro as a currency looks extremely suspect at this point. The Grexit episode is likely to repeat itself in a few years, maybe a Spain-exit and an Italy-exit as well?  Pooling multiple non-correlative economies with independent debt loads under one currency was clearly a mistake. Negative interest rates are supposed to revive the euro-conomy, but hasn’t worked. I don’t know what is going on, but I want to minimize my exposure to the Euro Zone. 8/10 of Britain’s top trading partners are European countries. The other two are U.S. and China, with the U.S. being the largest and accounting for 14% of Britain’s exports.

There’s also the Brexit – Britain potentially exiting the European Union. The career politicians in the U.K. are spelling doom for the U.K. if they leave. If history does indeed rhyme, then Britain is probably more likely than not to benefit from leaving the European Union. These corrupt career politicians always seem to think they know what’s good for the countries, but usually get it wrong. People are starting to realize that creating the Euro was a mistake in the first place – the same politicians back in 2000 said it would be great for everyone, ‘facilitate efficient trade,’ ‘cut transaction costs’ – they forgot to mention the cons. It’s a good thing Britain avoided it.

This is something I’ve been debating for a while, and I’ve finally decided to cut ties with Europe. The portfolio will be approximately 25% Canadian stocks and 75% American stocks. I have just sold off Game Digital. Will be selling Tilly’s later this week. If Tilly’s drops to my break even point before I sell, I’ll immediately get rid of it. CBK will stay until I fill up 80% of the portfolio. I’m going to be coming up with a few more write-ups over the next few weeks. I’m hoping to have one more up by Thursday night.

Mazi Ume

Earnings Watch And Performance Update

This week has been terrible for the portfolio. Both of those positions moved against me. Adobe is up 6% after reporting earnings and Tilly’s fell 14%.

TILLY’S

Tilly’s is likely going to go through a few quarters of inventory deleveraging.. meaning that we’re likely going to see some red ink on the income statement but positive cash flows. If this hits $7.50 again, I’ll probably sell it off and buy it back in a few quarters right before the income statement turns green. The cash, at these prices, makes up just over half of the market cap, so the company is still cheap. Wall Street, however, is short-sighted so it’s a game I have to play I guess.

ADOBE

I still don’t understand how Adobe went from the subscription model and is all of a sudden; the executives are so confident that they can generate 20%+ Revenue growth out to 2018. There was a pop in gross margins, so I’m going to exit this trade depending on what the put options are worth tomorrow. Given that they are far out of the money, the bid/ask spreads are large. We’ll see — it may just be worth holding on to depending on the price. Adobe is going to be cyclical, and if the economy turns, it should still be affected. The company is still expensive at 50x normalized earnings, and the puts go out to 2018.

 

Portfolio Update

The portfolio went from +18% since December 10th, 2015 and +11% MTD last week to just +14.61% and +7.43% as of 3/17. I anticipate it will be just 14% after accounting for the decline in the Adobe put options.

Headwinds included the fed’s decision to keep rates steady – this precipitated a rally in the markets, and given that my portfolio was just 40% invested, I didn’t participate in it and my puts declined all across the board as well. The reality is that since the inception of the portfolio, I’ve been on average just 50% invested. So, my plan going forward is to fill up the portfolio. So I’m going to be coming out with a string of investment theses over the next few weeks. I want the portfolio to go into full swing in April and maximize the potential return going forward. Hoping this was the last blowup for the month.

For the chart below, SPX – S&P 500, VT – Vanguard Total World Stock Index, EFA – iShares MSCI EAFE. The screenshot is from Interactive Brokers.

portfolio update

Mazi Ume

Earnings Watch: Tilly’s, Adobe $TLYS $ADBE

Tilly’s reports earnings after market close. Numbers to watch:

  1. Inventory levels
  2. Store Count
  3. Cash Balance

The high cash levels and no debt was what initially drew me to Tilly’s. That was around $6/sh. It trades near $8/sh today. I was contemplating on selling parts of the position earlier this week but did not since the portfolio is now just 38% invested after adding more cash, selling off 80% of CBK and the entire Reitmans position. I currently have about 24% equity on the position. If we see another jump in inventories or store count, I’m out, regardless of price. I ignored the inventory levels because of the cash balance. The inevitable path of ballooning inventories is always red ink. This is precisely what we are seeing in Crude oil today. When companies run out of space to store their inventories, they discount the goods. Ed Thomas was just rehired, so lets hope Investors cut him some slack as CEO. One odd thing from the December earnings call was that he said that there’d be no need to close any stores, but this chart from the original thesis says otherwise. If Sales/sq ft has been falling for seven years, then there has to be at least a few stores that are underperforming.  Q4 is usually the high cash quarter, so the cash balance should at least increase. Tilly’s makes up 8.35% of the portfolio after adding money to the portfolio.
Sales:Sqft

Adobe reports on Thursday, the only important metric to watch is the gross margin. The short thesis says that gross margins should not improve since the acquisitions that are propelling the growth are not profitable, and probably won’t ever be. If we see a reasonable jump in gross margins, then that’s the cue to sell off the puts. A decline in gross margins would strengthen the short thesis. I guess we’ll see how everything plays out.

Mazi Ume

Tilly’s Inc. Q3 Earnings recap

Side Note: I’ve been extremely busy with work lately, and I have not had much time to post anything. I’m going to try to post some more over the next few days and this weekend. I still have some goals to meet; I now plan on getting at least nine long positions out before the end of the year.

Tilly’s reported earnings today:

Real Time price: TLYS 9,32 +0,44 +4,95%

  • Total net sales increased 7.9%, comparable store sales increased 3.3%.
  • Gross profit increased 10%, and we saw a 60 bps increase in gross margins; from 30.9% to 31.5%.
  • Store count increased by 1.8% or 4, to 220.
  • Net Income decreased from $5.1 million to $2.8 million. The $2.8 million according to the filing was impacted by non-cash store asset impairment charges of $0.705 million, charges related to the former CEO’s contract of $0.569 million, and charge of $0.418 million due to the expiration of stock options that resulted in a write-down of deferred tax assets.

Management Outlook: negative comparable store sales next quarter of about -2 to -4%.

Negatives

Inventory numbers: Merchandise inventories increased 62,196 to 70,110 or 12.7% total sales increased only 7.9%. Something obviously needs to be done about this. The positive aspect of this, however, is that sales are actually up.

Positives

I previously mentioned in my original thesis for Tilly’s that what I wanted to hear from Ed Thomas, Tilly’s new and previous CEO, was that he would implement something along the lines of slowing down or decreasing the amount of opened stores and focusing on the profitability of existing stores. He said exactly that in the call! Although he mentioned that he didn’t plan on closing any stores, the focus on slowing down on the new stores and focusing on the profitability of the existing stores is sufficient for me.

Cash Balance

Cash balance increased slightly to $76.3 million. This is huge because Q4 is usually the largest for retailers. Operating Income for Q4 last year was $27 million. Management expects to spend 6.5 to 7.5 in Q4. Subtracting approximately $3.5 million of stock-based compensation, I expect FCF of approximately $16.5 million. I expect cash balance to increase to ~$92.8 million. This would put the Enterprise Value at about $82 million or 5x FCF. CEO was asked if they planned on repurchasing shares during the earnings call, management is resilient. Co-founders also have control of the company, so there is not much that can be done. Shares currently trade at $6.15, and I’m buying more shares at market open. My price target remains unchanged at $11.18. I plan on buying about 489 shares for a total of 978 shares. Tilly’s will now make up 6% of my portfolio.

Bought more shares of Tilly’s Inc. $TLYS

Real Time price: TLYS 9,32 +0,44 +4,95%

 

Today, I bought 163 more shares of Tilly’s Inc. at $5.95. The first purchase order was for 326 shares for a total of 489 shares. The weighted average purchase price of $6.52. Tilly’s now makes up 3% of the portfolio. My next trigger buy will be at $5.44. Ideally, I would like to see what strategy the new CEO takes before buying in. Should the shares hit $5.44 before the December earnings report, I will most likely add-on ~80 additional shares. 97% of the portfolio is cash for now. I plan on adding at least one other long equity to the portfolio by the end of this week.

Tilly’s (TLYS)

Real Time price: TLYS 9,32 +0,44 +4,95%

Market Cap: 194 million
Enterprise Value: $118 million
Stock Price at purchase date (11/6/2015): $6.80

I am posting this today, but I bought shares on Friday morning. You can track my portfolio on MarketWatch; you may need to log in. I dollar-cost average my purchases, and never buy all at once — this is the first of 3 or 4 equal buys for 8% of my portfolio. The next buying trigger point will be at 80% of my original purchase price.

Tilly’s is a destination specialty retailer of action sports inspired apparel, footwear, and accessories. On March 18th, 2015, Tilly’s reported a 4.5% increase in sales y/y for FY’ 14, but then also said that comparable store sales decreased 2.8% and the stock price is down 60% since that date. On May 27th,  2015, Tilly’s reported an 8.1% increase in revenues and same-store sales increase of 2%, but then forecasted a Q2 same-store-sales decline of 2%. Former CEO, Dan Griesemer, and the CIO/COO stepped down. Last month, the board appointed former CEO, Edmond Thomas, to turn the company around. Edward Thomas was CEO of Tilly’s from 2005 to 2007 and then left for WetSeal, stepped down from WetSeal in 2011 and then has now been rehired to turn the company around.

One can grow revenues to heaven, but if profits do not follow, then those revenues are soon lamented as a result of the inevitable store closures. Tilly’s faces the same problem WetSeal faced: executives and directors of retail department stores prioritize rapid revenue growth and expanded in the sense of increasing the number of stores. or increases fixed costs, and if those stores do not work out as planned, the company is stuck with an operating or capital lease situation where the lessor has all the leverage — that is what the WetSeal executives did. Comparable store sales never recovered, and the fixed costs ate the company up. Ed Thomas knows that just increasing the number of stores does not work, as he saw from his time at WetSeal. I am hoping that he applies that knowledge here at Tilly’s.

I do not believe that anyone person can consistently run one of these companies. JCPenny’s has had issues of its own, even while being an established brand. Bill Ackman tried to turn it around, took a significant stake in the company, and even hand-picked a CEO, Ron Johnson, from Apple. It didn’t quite workout — he sold his JCP stake at a $700 million loss.

Attempting to predict technological trends is simple, but not easy: release a product that is more efficient and easier to use than your competitors. In the retail sector, however, you have to either figure out how to cut costs per sqft or predict what customers will want to wear next year. Oh, and the executive team also has to be able to predict what cities and states will prove to be goldmines for new stores while having fickle customers as well as tons of competitors selling identical goods.

As Buffett says, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” The retail apparel department store biz is what it is. Bad economics. That statement does not entirely apply to the high-end apparel retailers. Most apparel retail Executives, teen retailers especially, attempt to predict general retail trends, which no one can consistently do. Sometimes, being a successful regional retailer with decent margins is superior to omnipresence with suppressed margins. During industry slowdowns, the retailer with the best margins four the most relative liquid assets less debt is best prepared for the storm.

Risks  

Rising inventory

Inventories increased faster than sales over the past few quarters. The CEO will most likely take a big bath to “turn around” what his contemporary did. I expect a large inventory write-down in the coming quarters. Though this is a non-cash expense, the stock might temporarily get punished for it.

Retail Sector downturn

Virtually every retailer has been hammered YTD, and this includes the high-end retailers. As comparable store sales have been slowing and in a lot of cases, declining. This should be only a temporary price risk for Tilly’s,, assuming that the new CEO makes the right moves, and curbs new store expansion to focus on the profitability of the others. Tilly’s has $76mm cash on the balance sheet; sufficient cushion for the storm.


So, why in the world am I buying Tilly’s?

Catalysts

Operating MarginMean Reversion

Operating and net margins have been beaten down over the past few years as a result of rapid expansion and underperforming stores. Inventory buildup has occurred as a consequence of the underperforming stores. I expect the new management to improve operating margins by 220 basis points back to Tilly’s five-year average of 6.6%.

 

Sales:SqftSlow down investments in new stores

Rapid expansion is eating up cash flows. Management has been opening up new stores across the country, and those stores have been performing poorly. Comparable store sales have declined over the past two years, and Sales/sq ft has been declining since 2008. The obstacle seems to be the rapid expansion. Management needs to cut off growth by stores, and focus on the profitability of the current stores.

Substantial Margin of safety/Liquid Assets

Tilly’s has no debt, carries $76 million in cash with a $194 million market cap. Operating cash flows even with the small margins last year was $37 million, subtract maintenance CapEx of $16.3 million, and we have $20.7 million. With an Enterprise value of $118 million, we have an EV/FCF multiple of 5.7 – This is with the operating margins at 4.4%.

Effective Management Compensation

Tilly’s Co-Founders own 93% of the Class B shares, giving them 89% of the voting power. They don’t care about impressing Wall Street. I expect them to make smart long-term decisions for the company. The new CEO has been given the Option to buy 500,000 shares at the Oct. 7 price of $7.79, that will vest over four annual installments. There is a 14% upside to that price. Management is also extremely strict about metrics. They are compensated on the basis of Same store sales growth and operating income, which are appropriate metrics for the industry. Last year, 75% of management’s bonus was based on hitting the operating income metric, and 25% on the comparable store sales growth metrics. Operating income of 46 million and comparable store sales growth would have given the CEO 200% of his base salary as a bonus.

Executive compensationx

Executive Compensation

Management did not get a bonus last year because they missed the comparable sales growth metric and only hit the minimum for operating income. Their options are also worth a lot less at this point, as a result of the poor performance of the stock price. I suppose that Edward Thomas will be compensated in the same manner. He has every incentive to drive Tilly’s to profitability; the stock price should follow.

Valuation

DCF Assumptions

Operating Margin

Tilly’s, as of FY’14 had a 4.4% operating margin. The average operating margin of their fellow teen retailing competitors is 5.82%. We have an upside of 32% to that average.

EV/EBITDA

Tilly’s has an EV/EBITDA ratio of 2.5; their competitors’ average is 5.2. We have a 108% upside to that average.

DCF Conservative

 On a conservative Discounted Cash Flow basis, my assumptions were:

  • -6% revenue growth next year and then trickles down to 0% over six years and then grows at 1% terminally.
  • Operating margins revert to past five-year average of 6.6% from 4.4%.
  • Tax Rate of 39%.

DCF Aggressive

  • Zero revenue growth next six years, and then 1% terminal growth.
  • Operating margins revert to the 2011 high of 8.7% from 4.4%.
  • Tax Rate of 39%.

Price Target

The average of all four estimates is $11.18, for an upside of 64%. I will also be willing to sell early if one of Tilly’s competitors become more attractive or if the CEO does not implement something along the lines of curbing the opening of new stores and focusing on the profitability of the existing stores.

Time Frame: 6 – 24 months