2023-06-16 02:42:08 ET
Summary
- The target audience of Citi Trends is sensitive to the deterioration of macro conditions, and the normalization of consumer behavior may occur with a lag to the recovery of real.
- Lower business volumes put pressure on margins due to high fixed costs.
- Despite the relatively low valuation, it is still not the best time to go long, in my opinion.
Introduction
Citi Trends ( CTRN ) shares have fallen 39% YTD. Despite the fact that the company is not valued highly by multiples, I believe it is still not the best time to go long.
Investment thesis
In my personal opinion, in the next quarter, we will see continued pressure from traffic in the stores of the network and the average check on the growth rate of the business's revenue, which will also contribute to pressure on profitability due to the deleveraging effect. I believe that the weak trading trends in 2Q and the lack of clear upside catalysts may continue to dampen the stock's fundamental upside potential. However, the company is currently not valued highly, and a potential change in the macro environment could have a significant impact on target consumers and, consequently, the financial results of the business in the future, so I adhere to the HOLD recommendation, not the Sell recommendation. Personally, I see the company as an excellent bet for real disposable income growth among low-income people.
Company overview
Citi Trends is a value retailer of apparel and accessories. The company's target audience is people with an income of less than $25,000 per year. The main sales channel is the offline format. The company operates in the US market. According to the results of the 1st quarter of 2023, the company has 608 stores in 33 states.
1Q 2023 Earnings Review
According to the results of the 1st quarter of 2023 , the company's revenue decreased by 13.7% YoY and reached $179.7 million. As the main reason for the decline in revenue, I would single out the continued decline in comparable sales by 14.1% YoY as a result of macro headwinds pressure on the company's consumers. We see that the company is facing both a decrease in traffic in the stores of the network and a decrease in the average check. You can see the details in the chart below.
Company's data (Company's data)
Gross margin also decreased from 39% in 1Q22 to 36.7% in 1Q23, and operating margin decreased from 19% in 1Q22 to -5.3% in 1Q23 as a result of the deleveraging effect, due to which the share of spending on SGA (% of revenue) increased from 34.1% in 1Q22 to 39.4% in 1Q23. The main reason for the deleveraging effect is the fact that most of the operating expenses are fixed (rent, salaries), as a result, we see pressure on operating profitability while reducing business volumes.
Company's data (Company's data)
Consumer spending on clothing among the company's target audience is extremely sensitive to the improvement or deterioration of the macro environment, as the company focuses on consumers whose income does not exceed $25,000 per year. At the moment, we see that comparable sales lag behind comparable companies in the industry that operate in a similar segment. In the table below you can see a comparison of Q1 2023 comparable sales between City Trends, Ross Stores (ROST), and TJX Companies (TJX), where I used only the US division.
Companies' information (Companies' information)
The company is still debt-free, with cash and liquid assets on the balance sheet for 1Q2023 at $164 million, which is extremely positive, as the presence of a financial cushion and the absence of debt are especially important factors in an environment of weak trading trends.
My expectations
Based on management's comments during the Earnings Call following the company's Q1 2023 report, we can conclude that early Q2 trading trends are consistent with a weak Q1 2023. Thus, the company's sales in April are at the level of the lower bar of the company's expectations, which is in line with the previously announced guidance on a decrease in revenue in the range of negative mid-single-digits to negative low-single-digits as compared to fiscal 2022. The management also clarified that the trend continued in May.
I believe we will see expectedly weak results for 2Q 2022 as the pressure on revenue growth will, in my personal opinion, continue to contribute to the deleveraging effect due to the high share of fixed costs for rent and wages.
Also, based on my own expectations, general economic trends and comments from the company's management, I can make an assumption that we can see an improvement in financial performance in the second half of 2023 as macro headwinds normalize. I would like to reiterate that the company's target audience is consumers with an income of less than $25,000 a year, who are particularly sensitive to rising costs of living, rising prices and elevated inflation.
Risks
Revenue growth & margin: continued decline in traffic in the chain's stores and a decrease in the average ticket may lead not only to a further decrease in revenue compared to 2022 but also to a decrease in economies of scale, which may contribute to pressure on profitability. In addition, the company operates in the retail business, where the level of fixed costs (rent, salary) is relatively high, so a decrease in business volume can lead to a deleveraging effect.
Macro: the company's target segment is consumers, which are particularly sensitive to rising product prices, so a decline in real income due to high inflation could have a negative impact on both business growth and operating margins.
Drivers
Margin: the company is currently working on the creation and launch of a new ERP system that will help manage inventory in warehouses more efficiently. Thus, the launch of a new ERP system that will replace the old one can lead to an increase in operating profitability by reducing operating costs. In accordance with the comments of management, the launch of the system will take place at the end of summer 2023, however, we will most likely see any significant results and impact of the new system on financial statements only in 2024.
Macro (general driver): the recovery of consumer confidence and the growth of real disposable income of the population can have a significant impact on consumer behavior, while the growth of traffic in the chain's stores and the growth of the average check can provide significant support to revenue growth. In my opinion, a company's business model that relies on consumers with incomes of less than $25,000 is especially sensitive to changing macro conditions.
Valuation
At the moment, in my opinion, the company is cheaply priced relative to its historical level. I believe that the market takes into account the risks that as the macro situation improves, consumers may "take their time" to increase the average check and increase the frequency of visiting the chain's stores. In addition, there is still a risk that macro headwinds will continue to have a negative impact in the second half of 2023.
Conclusion
Thus, I would like to note that at present the company is under pressure on financial performance due to a weakening consumer, which is highly sensitive to changes in macro conditions, and the company's business model implies pressure on profitability with a decrease in business volumes due to fixed costs.
I believe that trading trends in Q2 2023 will be similar to Q1 2023, which is definitely not a positive factor for stock prices. However, I will continue to closely monitor the company's financial statements for Q3 and Q4 2023 and any signals of normalization in consumer behavior among the company's target audience. For now, I'm sticking to HOLD's recommendation, however, I'm happy to change my recommendation to Buy as I believe the company is an excellent bet to improve macro conditions and their impact on the target audience of the business.
For further details see:
Citi Trends: High Potential, But Risks Still Present