Carter’s Inc: Near Term Pressures But Long Term Potential

Company Overview

(Please see the previous pst related to Carters for a detailed overview entitled: Carters Inc: A Retailer With Private Equity Appeal). Carter’s Inc owns two of the most highly recognized and most trusted brand names in the children’s apparel industry, Carter’s and OshKosh. Established in 1865, the Carter’s brand is recognized and trusted by consumers for high-quality apparel for children sizes newborn to seven and tops the industry with a 12.8% market share as of June 2010. In fiscal 2005, they acquired OshKosh B’Gosh, Inc. Established in 1895, OshKosh is recognized as a well-known brand that is trusted by consumers for its line of apparel for children sizes newborn to 12. They have extensive experience in the young children’s apparel market and focus on high-quality, essential core products at prices that deliver an attractive value proposition for consumers. Carter’s has developed exclusive private label brands for Wal-Mart and Target, under the Child of Mine and Just One Year monikers.

 

Morningstar View

“Carter’s CRI top line rebounded (up 7.6%) during the third quarter, affirming our view that the weak second quarter (0.2% revenue growth) was a one-time miss. However, the apparel manufacturer posted weaker quarterly margins (down 140 basis points), largely because of increased transportation costs, and warned of further near-term margin pressures from higher cotton prices. While we think the threat is real and have factored in significant margin contraction in 2011 (300 basis points to 10.8%), the current stock price implies that cost pressures will permanently weigh on margins over the long term. But cotton prices, as with any volatile commodity, tend to self-correct over time–prices have reverted to $0.70 per pound over the past 30 years–and we project cotton prices will eventually moderate from their current levels of about $1.30 per pound. Additionally, given Carter’s leadership in kids’ apparel, we remain confident that operating margins can recover to around 12% over the next few years. Therefore, trading at less than 10 times our forward earnings estimate and at an enterprise value/EBITDA of 5.3 times, Carter’s shares look attractive to us.”

 

Risks

• The loss of one or more of their major customers could result in a material loss of revenues
• The acceptance of their products in the marketplace is affected by consumers’ tastes and preferences, along with fashion trends.
• The value of the brand and sales, could be diminished if they are associated with negative publicity.
• They may incur substantial costs as a result of litigation, investigations or other proceedings, including those related to previously filed restatements.
• The Company’s databases containing personal information of retail customers could be breached, which could subject them to adverse publicity, litigation, and expenses. In addition, if they are unable to comply with security standards created by the banks and payment card industry, their operations could be adversely affected.
• There are deflationary pressures on the selling price of apparel products.
• The business is sensitive to overall levels of consumer spending, particularly in the young children’s apparel segment.
• They face risks associated with the current global credit crisis and related economic downturn.
• They source substantially all of their products through foreign production arrangements. This dependence on foreign supply sources could result in disruptions to their operations in the event of political instability, unfavorable economic conditions, international events, or new foreign regulations and such disruptions may increase their cost of goods sold and decrease gross profit.
• Carters Inc source all of their products through a network of vendors. They have limited control over these vendors and may experience delays, product recalls or loss of revenues if their products do not meet quality standards or regulatory requirements.
• They operate in a highly competitive market and the size and resources of some of their competitors may allow them to compete more effectively than Carters can, resulting in a loss of market share and, as a result, a decrease in revenue and gross profit.
• The Company’s retail success and future growth is dependent upon identifying locations and negotiating appropriate lease terms for retail stores.
• Leverage could adversely affect their financial condition.
• Profitability could be negatively impacted if they do not adequately forecast the demand for their products and, as a result, create significant levels of excess inventory or insufficient levels of inventory.
• They may not achieve sales growth plans, cost savings, and other assumptions that support the carrying value of their intangible assets.
• Carter’s inability to remediate their material weaknesses in internal controls over financial reporting could have a material adverse effect on business, results of operations, and financial condition.
• The Company’s success is dependent upon retaining key individuals within the organization to execute the Company’s strategic plan.

 

Fundamentals

Efficiency

One of the first things I look at in a retailer is the Cash Conversion Cycle, which is calculated by the adding the Days In inventory and the Days In Receivable before subtracting the Days Payables Outstanding Figure. Lets deal with each of these separately.

1. Days In Inventory: Tells us how quickly Carter’s Inc is selling its goods or inventory. As can be seen from Carters above, this figure has hovered between 77 and 85 days since 2003. In the most recent earnings announcement, Carter’s however did announce that this figure would be increasing due to the extra inventory required for their online shopping, which is expanding. Closest competitor, Gymboree, has seen their figures fluctuate between 72 and 93 days in this same period.
2. Days Sales Outstanding: Shows us how quickly it collects payment from customers for the goods. After peaking in 2004, Carters have done extremely well to reduce that figure to 20 days in 2009. However, compared to someone like Gymboree (5-6 days) this figure remains high.
3. Days Payables: Reveals how long the company can hold on to the goods itself before it has to pay suppliers (payables). Due to its growing reputation, Carter’s have managed to increase the number of days to almost 33 last year from only 19 days in 2004. The current figure is in line with Gymboree’s 31 days but it is interesting to note that Gymboree’s payables period has been declining since 2007 as the recession took told and supplier demanded payment more quickly.

In conclusion, Carter’s Cash Conversion remains higher than that of Gymboree but it has been declining steadily since 2007. Due to the emergence of their online retail business, inventory will climb once more and most likely send the CCC figure higher in the short term. What will be important to determine over the coming quarters is whether the inventory build up is due to this online presence alone or whether a potential failure to pass on price increases to customers is having a negative effect.

Profitability

I like to see Return on Assets in excess of 10 and Return on Equity higher than 12. In the case of Carter’s, we can see that post the recession, they have managed to achieve these numbers, although prior to 2007, that was not the case with regards to ROA. The financial leverage figure in the past was a somewhat artificial boost to ROE as it reached a 4.71 in 2000. Fortunately, Carter’s have become less reliant on debt and the debt situation has been approving once more since 2007 to 2.17.

Financial Health

Current and Quick ratios are extremely solid and although I would ideally like to see a lower financial leverage figure, the company stands in good financial health.

Management

Morningstar makes a point of preferring to see companies adopt CEO’s that are independent of Chairmans. In Carters however, Michael Casey was appointed as both in 2008, rendering the management style with a cautionary flag. Casey though has been with the firm since 1993 and also owns 1.5% of outstanding common stock, thus aligning his interests with that of shareholders. One final thing I like to see is a payment structure whereby most of the incentive is given toward achieving results in the future. This seems to be the case with Casey as his compensation for 2009 was $700,000 in salary, $1.7 million in equities and $2.1 million in other compensations.

 

Valuation

Looking at the above P/E, P/B and P/S figures, the company looks cheep relative to the industry. Further signs that the stock may appear to be cheap are the greater than industry averages for ROE, Revenue Growth, EPS growth and both Operating and Net margins.
In order to estimate a fair value for Carters, I first applied managements guide for the final quarter of 2010 to the model and came up with a base case EPS figure of $2.39, which is slightly lower than the mean Wall Street analyst estimate of $2.42. Looking toward 2009, again in accordance with some of managements outlook, I have applied revenue growth of 10% but this is more than offset by an estimated 13% increase in Cost of Goods Sold, due primarily to higher cotton prices. I have also forecast SG&A to increase slightlywhich results in a much lower Operating margin of 10.5%, compared to the 12.5% forecase for this year. As a result, I think EPS for 2011 will decline to $2.06, significantly lower than the Wall Street average estimate of $2.30. At todays price of $28.05, I believe Carters currently trades at 13.60 times forward earnings.
Looking beyond this, I am strongly convinced costs will stabilize and revert to the mean. If I apply 10 year averages to the cost figure and forecast solid revenue growth on the back of new initiatives such as online retailing, I see forward P/E multiples to 10.4 by 2014.
operating cash flow will be weak next year with higher capital expenditure. I have forecast a 3.9% FCF/Sales ratio for 2010. The average FCF/Sales over the past 5 and 10 years is 7.2% and 4.8% respectively. Assuming Carters can achieve 4.9% FCF over the next 5 years (including 2010) and applying reasonable growth and discount rates, I determined a Fair Value Estimate for the company.
That fair value is $30.77 which represents an almost 10% margin of safety. I also calculated near and bull case scenarios to determine adequate entry and exit points as will be discussed below.

 

Brooks Wealth Strategy

I currently own shares of Carter’s and would like to add to this position, but not at current levels. Carter’s Inc share price has jumped above $28 recently and therefore only trades with a 10% margin of safety to my fair value. Instead, I would like to add to my position if the stock retreats to approx $23.50, which represents a 30% margin of safety to my fair value estimate and an almost 20% reduction from todays price. I would consider selling my position at $37.50. I did also calculate one bear and one bull scenario, to acknowledge that past trends are not necessarily indicative of future trends. These valuations should also allow me to observe moments of extreme pessimism or exuberance. The bear valuation is $19.56 while the bull scenario is $43.12, further reinforcing my view that the potential upside outweighs the downside in so far as Carters in concerned.

I admit to being worried by the continued rise in cotton prices and think that it will have a significant effect on next years earnings. Wall Street Estimates are too high for my liking right now and I am anticipating these estimates will be reduced in the coming quarters to further reflect the difficult operating environment and the pressure on margins from increased cotton, labour and transportation costs. Indeed, I am hoping that if analysts do reduce their forecasts, it should inflict downward pressure on the share price and provide a suitable entry point as a result. For now I sit on the shares I already own but continue to monitor the price closely.

 

At Brooks Wealth, we utilize Morningstar’s Premium Membership facility to identify opportunities within the stock market. We believe the platform provided by Morningstar can educate investors of all skill and expertise, to further develop their research methods. We highly recommend you avail of the 14 day free trial which can be accessed by signing up here:Morningstar 14 Day Free Trial. The charts used in the above post are from the Morningstar site.

James Brooks, of Brooks Wealth, owns shares in the above named security, Carter’s Inc.