2023-11-15 23:48:26 ET
Summary
- CRI’s revenue has grown poorly in the last decade, particularly due to the decline it has faced post-pandemic, with 6 successive quarters of negative growth.
- The company’s competitive positioning is under threat, with e-commerce and low-cost production contributing to increased competition. We struggle to see a moat wide enough to drive strong growth.
- Economic conditions are weighing on the business, compounding its weakness relative to peers. We do not think it is an attractive apparel business.
- CRI does have impressive FCFs, offsetting some of its weaknesses. The company’s valuation, however, is above its fair value.
Investment thesis
Our current investment thesis is:
- CRI has struggled with growth, primarily during the post-pandemic period, with 6 successive quarters of negative growth. We suspect this is a combination of economic conditions and a broader decline in the company's competitive positioning.
- The traditional apparel businesses are facing headwinds, with CRI's position negatively compounded by a decline in the US birth rate.
- We believe there is a high risk that the company will decline further, with continued erosion of its margins. When considered in conjunction with its poor performance relative to its peers, we do not consider CRI an attractive business.
Company description
Carter's, Inc. ( CRI ) is a leading American manufacturer and retailer of children's clothing, footwear, and accessories. Founded in 1865, it operates under various well-known brands, including Carter's, OshKosh B'Gosh, and Skip Hop. The company's headquarters are located in Atlanta, Georgia.
Share price
CRI's share price performance has been disappointing during the last decade, losing value while the wider S&P has performed exceptionally well. This is due to changing dynamics within the apparel industry contributing to a decline in competitive positioning and thus financial results.
Financial analysis
Carter's financials (Capital IQ)
Presented above are CRI's financial results.
Revenue & Commercial Factors
CRI's revenue has grown at a CAGR of 1% during the last decade, below inflation. This is clearly a poor performance, with most of the issues coming in the post-pandemic period, with the company materially below its FY19 level.
Business Model
CRI offers a wide range of products, including baby clothing, sleepwear, outerwear, shoes, and accessories. The company's products are primarily aimed at infants and young children, creating a brand synonymous with this demographic.
CRI sells its products through various channels, including its own retail stores, online platforms, department stores, and wholesale partnerships. The company operates under several brand names, including Carter's, OshKosh B'Gosh, and Skip Hop. This strategy is slightly different from many of its branded-retailer peers, who lock their products behind their retail presence only. In recent years, CRI has expanded its network to include Amazon ( AMZN ). The broad objective is to maximize the company's reach to consumers.
CRI is known for offering good-quality children's clothing at affordable prices. This positioning attracts budget-conscious parents seeking value for money. Unlike many other industries, consumers are very conscious of the quality of children's products, even if affordability is restrictive. CRI balances this well.
CRI's core focus is on its stores, with a forecast of ~70 new locations in 2023. Alongside this, the company has expanded its (relatively) small international presence into Ecuador and Vietnam. Store growth is critical for top-line performance but is also an illustration of how poor the last few years have been, given the inability to achieve growth regardless.
Apparel Industry
Carter's faces competition from companies like The Children's Place ( PLCE ), The Gap Kids (GPS), Gymboree, and Target. Competition is driven by factors like brand recognition, pricing, and product quality.
Consumer preferences in children's fashion can change over time, similar to what we see in the broader apparel industry. For this reason, the industry can be ruthless, with brands falling behind if they are unable to respond to trends or evolving customer demands.
The growth of e-commerce has intensified competition in the retail industry. Further, it has contributed to a significant increase in the number of new entrants, particularly from low-cost producers in the Far East. We consider this a primary reason for CRI's struggles, as the company has been unable to compete on price given its substantial overheads associated with its physical footprint.
In conjunction with e-commerce, online marketing is increasingly becoming important, as consumers use the internet for research on children's products, as well as generally spend more time on the service. CRI has a strong presence relative to its peers, maximizing its reach. This said, from an absolute basis, the company lacks an innovative market strategy to partner with its following, making the returns mediocre.
The company is also struggling with a wider softening in its core market. US individuals, for varying reasons, are having fewer children. This trend has been consistent for several decades, with the expectation that this will continue in the coming years. As a result of this, there is inherently greater difficulty in achieving improved growth.
Sustainability is a key trend in the apparel industry, with consumers becoming more aware of the impact of their consumption on the environment and wider planet. Research by McKinsey has found consumers are buying sustainable products and have a preference for them. This has allowed CRI to develop its "Little Planet" brand well, with significant expansion. The brand focuses on eco-friendly products and is positioned as an accessible premium brand. With a good retailer network with this brand and the launching of new product categories, this could be a key growth area for the business.
Competitive Positioning
We consider the following factors to be key competitive advantages of CRI:
- Brand Perception - CRI has a strong brand that is synonymous with quality and design, allowing for consumer trust and loyalty. For many new parents in particular, they are looking for brands that are trusted.
- Scale - CRI has significant scale and expertise within this segment, allowing it to innovate and service the US market in a cost-effective manner, enhancing its competitive position.
- Vertical Integration - Controlling the design-to-retail process allows for cost control and flexibility, allowing the company to respond to market trends and sales information.
Despite these factors, the company's growth trajectory implies there are inherent weaknesses in the company's position.
Economic & External Consideration
Current economic conditions are likely weighing on the business, as elevated rates and high inflation are contributing to reduced spending by consumers. This does not mean consumers are not dressing their children, but more so that consumers are trading down or delaying purchases where possible.
Presented below are CRI's H1 results.
The key takeaways are:
- Revenue has declined (13)%, with 6 successive quarters of negative growth. The concern here is that the last 3 declines exceeded (10)%, implying an acceleration.
- GPM has impressively remained resilient, which implies Management is unwilling to forego margins through discounting to protect sales. We have stressed this strategy could be preferable for retailers, as given the level of competition in the market, it is difficult to subsequently win back the margins lost.
- OPM, however, has declined and noticeably so. This is due to increased S&A spending, partially due to an investment in wages and marketing, but also the lack of variability with declining sales.
Our expectation is for continued struggles in the coming quarters, as expansionary economic policy looks to come in late 2024.
Margins
CRI's margins have broadly remained flat during the historical period. This is a reflection of the company's focus on a specific segment, allowing for an improved competitive position. Also, there is a clear unwillingness by Management to forego margins, with the trade-off being growth.
Balance sheet & Cash Flows
Inventory turnover has declined while CRI's CCC has increased, acting as a drag on the company's cash flows. Despite this, CRI's FCF margin is impressive and has consistently been in excess of 5%.
This has allowed the company to distribute well to shareholders, with consistent buybacks and dividends. CRI's distributable capabilities are a game-changer in our view and highly attractive, as even if the company experiences some margin dilution, its FCF will remain highly attractive.
Outlook
Presented above is Wall Street's consensus view on the coming 5 years.
Analysts are forecasting a continuation of its mild growth, with a CAGR of 2% into FY25F. In conjunction with this, margins are expected to remain broadly flat, implying a return to its pre-pandemic level will not occur in the medium term.
This appears reasonable in our view, aligning with our commercial assessment of the business. We have seen no reason to expect an acceleration in its current trajectory, with expected issues with winning margin back.
Industry analysis
Presented above is a comparison of CRI's growth and profitability to the average of the Apparel industry (29 companies).
CRI's performance relative to its peers is mild. The company is significantly lacking in growth, both revenue and profitability, with the expectation for this to continue. This is a disappointment, likely reflecting the decline in the company's competitive positioning.
Further, margins are not much better, although noticeably better when considering FCF or ROE. This does provide some offsetting benefits, particularly due to the distributable capacity of the company.
Valuation
CRI is currently trading at 9x LTM EBITDA and 9x NTM EBITDA. This is a discount to its historical average.
A discount to its historical average is warranted in our view, primarily due to the continuation of its poor growth trajectory, margin erosion, and the weakness in its competitive positioning. At a discount of 11-13% on an EBITDA level, we do not consider this sufficient.
Further, a discount to its peer group is likely also justified, owing to its lack of revenue growth and margin weakness, even if the company offsets this somewhat with FCFs. CRI is trading at a discount of 31% to its peers on an LTM EBITDA basis, which looks reasonable in our view, although this shrinks to 2% on an FCF basis.
Based on this, we do not see upside with CRI, but more likely further downside. As the following graph illustrates, CRI's valuation has broadly declined during the historical period, with its FCF yield not materially in excess of the average to suggest value in our view.
Valuation evolution (Capital IQ)
Final thoughts
CRI's focus on a niche has allowed the company to expand well but looks to have hit a wall post-pandemic. The company's growth has materially softened and its margins are declining. We are concerned that a "bottom" has not been clearly reached, suggesting further downside is possible.
Looking longer term, we are not overly confident the company can exceed inflationary revenue growth. Alongside a valuation that is likely above its fair value, CRI does not appear to be an attractive investment.
Despite this, we do not consider it a sell. With strong FCF, the company is positioned to protect its share price somewhat through its strong distributions.
For further details see:
Carter's: Growth Concerns Despite FCF Strength