Children's Place PLCE
December 26, 2007 - 5:45pm EST by
msdonut940
2007 2008
Price: 27.36 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 750 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

Children’s Place (“PLCE”)is a specialty realtor trading at less than 4.5x 2008E EBITDA. The stock has struggled in the last as management/merchandise resulted in a significant reduction in earnings guidance.  This has given us the opportunity to buy a leading specialty retailer with new store ROI in the mid-eighties.  The company has years of significant square footage growth; and margins should double from the current depressed levels.  And if the public market doesn’t figure this out quickly, the former CEO, Ezra Dabah, has been rumored to be interested in bidding for the entire firm.
 
Summary of the company:
PLCE is a specialty retailer whose “goal is to be the leading specialty retailer in the children’s space”.  PLCE runs two store concepts: The Children’s Place and The Disney Store. 
 
The Children’s Place focuses on children from newborns to approximately 10 years of age.  The majority of the merchandise is value priced, with some better/best options.  Product is sourced pretty efficiently abroad, with the company having several sourcing offices in Hong Kong, Shanghai and New Delhi.  The concept is expected to have about $1.5 bn in sales this year and approximately 920 stores.  The average store size is about 4700 square feet, and the company is in the midst of changing the store format to have wider aisles (to accommodate strollers) and brighter displays.  About a third of the stores have been remodeled to date, with very solid results from these “Technocolor” stores.  The average new store net investment was $466,000 in 2006, and the average cash flow for new stores was $407,000 in 2006 for a very impressive store level cash on cash returns.
 
The Disney Store was purchased from Disney in 2004 for basically the cost of working capital.  This was a transformational deal for PLCE, adding about $500 mm in sales to their sales base, and over 300 stores.  In exchange for a cheap price, PLCE signed a royalty agreement that gives Disney 5% of all sales as well as the ability to pull the license to the “Disney” name if a number of hurdles are not reached.  This license requires a minimum amount of capex to be spent remodeling the current stores as well as building new ones.  There are limits on the amount/type of promotions that may be run, and there is a change of control provision as well.  However, there is a limit to PLCE’s corporate exposure in the event the Disney operations cannot be turned around.  The license and royalty agreement were signed by a subsidiary of PLCE, “Hop”.  In addition, the lease signer is “Hop”, not PLCE.  PLCE has an agreement with “Hop” to fund a certain amount of the capex upcoming, but that amount is capped.  The rest must be self funded by the subsidiary.  As a result, I believe that PLCE can file “Hop” for bankruptcy and creditors will have no real recourse to the healthy Children’s Place chain.  Given the structure and price of the deal, The Disney Stores remains a very valuable option to PLCE for future growth.
 
Recent Troubles
Lack of SEC Filings
For the past year, PLCE has not had current SEC filings as its accountants worked through whether options had been properly granted.  As Deloitte & Touche worked through the accounts, other examples of poor internal controls appeared, including several inappropriate transactions on the part of senior management.  These included the CEO forgetting to report an increase in his wife’s shares due to a disposition from the trust and his using PLCE stock as collateral to a margin account during the blackout period for management trades.  PLCE is now current with its filings, but it still has some internal control problems, presumably the reason why Deloitte & Touche resigned from being the auditor for the upcoming fiscal year.
 
Loss of CEO
As a result of the above transactions, the board asked Ezrah Dabah to resign on 9/24/07.  Ezrah was deeply involved in the running of the company, and as a result his departure was a real shock to the employees.  News reports imply that Mr. Dabah is extremely upset he was asked to leave the company. 
 
Disney License violations
PLCEs’ first attempt to remodel the Disney Stores, the “Mickey” format, was an unmitigated disaster.  Disney didn’t like the design and the performance of the stores was sub-par.  As a result, PLCE abandoned the format and wrote down the fixtures; unfortunately, this was after about 40 stores had been moved to the “Mickey” format.  As a result, PLCE ended up in violation of the licensing agreement which required a certain number of remodels to be complete by the end of 2007.  This disagreement was recently resolved with PLCE agreeing to invest $175 mm in remodels/new stores over the next three years.  In exchange, Disney is allowed to terminate the license agreement at will if PLCE does not comply.  However, despite the harsh language, Disney seems to be willing to work with PLCE ~ giving them a waiver just three months after the agreement was signed.  (PLCE is not able to meet the remodel condition for 2007, and thus Disney is waiving the condition).
 
Poor Results
The company had a fantastic 2006; comps were 11% overall, with 10% comps at Children’s Place and 14% comps at the Disney stores.  The company was literally chasing inventory the entire year at The Children’s Place.  The Disney store was benefiting from the release of Cars, which obviously was not replicated this year and hurt results substantially.  For The Children’s Place concept, management increased their inventory budget for 2007, just in time to face bad weather, and a slowing consumer.  At the same time, they decided it was a brilliant idea to raise the initial markup.  As a result, Children’s Place has spent the entire year marking down inventory, and bringing down guidance. 
 
Now, in the last inning of the year, the company has withdrawn Q4 guidance, and is not giving any commentary with regards to 2008. 
 
Numbers
Stock Price
$27.36
 
Shares
29.084
 
Options
1.26
 
Strike
$22.92
 
Diluted shares
29.289
 
Equity value
$801.3
 
Less: Cash
(111.2)
 
Less: Seasonal Cash
(50.0)
 
Plus: revolving loan
108.9
 
Enterprise value
$749.0
 
 
 
EV/EBITDA
LTM EBITDA
$170.9
4.4x
2007E EBITDA
$131.9
5.7x
2008E EBITDA
$161.1
4.6x
 
Thesis
Children’s Place holds a solid place in its market.  It has competed effectively with Walmart, Target, department’s stores, gap kids, etc. by offering a fashionable value alternative in an easy-to-shop environment for Children.  The Disney stores, while poorly run in the past, are slowly being turned around by new leadership brought in at the end of 2006. 
 
The valuation is obviously discounted for the above reasons.  It has been a tough year for the company, but the current valuation is at a ridiculous discount.  Several of the above issues are completely solved: the Disney violation has been resolved and the SEC statements are now filed.  The other issues, I view more as opportunities.  This is a company that lost 550 bps of gross margin due to markdowns, all of which will be annualized next year.  The new merchandise in the stores is already resonating better with the customers, as evidenced by solid November same-store-sales numbers.  Given the value price point, consumer strength should not be issue for this company, which despite increased markdowns, has had solid traffic and transaction growth the entire year.  As a result, it is possible that earnings will grow at least 30-50% in the upcoming year, even with a poor economy.
 
The second issue, the loss of the CEO, may result in a bid for the company.  By all reports, Ezrah Dabah was a passionately involved CEO that was extremely upset by the board’s request for his resignation.  On 10/15/07, Ezrah filed a 13-D stating he had hired Bear Stearns to evaluate strategic alternatives with regards to his PLCE stake ~ one of the alternatives being a potential bid for the rest of the company.  If you run the company through an LBO model, and assume that the FY ’06 margins can be re-attained in three years, you can get a mid twenties IRR at $32 with only 2.5x total debt to EBITDA.  In order to do this, Ezrah would need to find a partner to put in about $400 mm in capital.  However, with mid twenties returns assuming a conservative exit multiple of 6.0x EBITDA, it shouldn’t be hard to find some private equity money that is interested.
 
Target Price
If there is a bid in the next couple of months, I believe it’ll be in the $30-$35 range given a conservative LBO model and limited financing ability.  While this should provide nice support for the stock, the true value of the company is much greater.  If you normalize the margins, and assume an average specialty retail multiple, this stock should be worth in the mid-sixties.
 
2008E Children's Place sales
1,600.0
2008E Disney sales
680.0
 
 
'06 EBIT margins for Children's Place after overhead
10.3%
Assumed Margin for Disney after overhead
3.0%
 
 
Normalized EBIT for Children's Place
165.3
Normalized EBIT for Disney
20.4
Total EBIT
185.7
D&A
82.0
EBITDA
s267.7
08E EV/EBITDA multiple
7.0x
Enterprise Value
1,873.6
Equity Value
1,926.0
Per Share
$65.76
 
Risks
1)      Fraud ~ given the large number of management departures and the comments by Deloitte & Touche, it is possible that there are more serious issues in the books.  However, given the valuation is around 0.5x sales and the company is currently net cash, there seems to be limited downside from here.
2)      More merchandising mishaps
3)      Lack of committed leadership.  None of the senior managers have been at the company for more than a year.  The President of Children’s Place had been there longer, but he resigned a couple of weeks ago in order to become the President of Zales.
4)      Poor Q4 results
 
Catalyst
1)      Improving sales trends in 2008 leading to better margins
2)      Better Disney release schedule in the upcoming year.
3)      Bid by former CEO ~ Ezrah Dabah.

Catalyst

Catalyst
1) Improving sales trends in 2008 leading to better margins
2) Better Disney release schedule in the upcoming year.
3) Bid by former CEO ~ Ezrah Dabah.
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    Description

    Children’s Place (“PLCE”)is a specialty realtor trading at less than 4.5x 2008E EBITDA. The stock has struggled in the last as management/merchandise resulted in a significant reduction in earnings guidance.  This has given us the opportunity to buy a leading specialty retailer with new store ROI in the mid-eighties.  The company has years of significant square footage growth; and margins should double from the current depressed levels.  And if the public market doesn’t figure this out quickly, the former CEO, Ezra Dabah, has been rumored to be interested in bidding for the entire firm.
     
    Summary of the company:
    PLCE is a specialty retailer whose “goal is to be the leading specialty retailer in the children’s space”.  PLCE runs two store concepts: The Children’s Place and The Disney Store. 
     
    The Children’s Place focuses on children from newborns to approximately 10 years of age.  The majority of the merchandise is value priced, with some better/best options.  Product is sourced pretty efficiently abroad, with the company having several sourcing offices in Hong Kong, Shanghai and New Delhi.  The concept is expected to have about $1.5 bn in sales this year and approximately 920 stores.  The average store size is about 4700 square feet, and the company is in the midst of changing the store format to have wider aisles (to accommodate strollers) and brighter displays.  About a third of the stores have been remodeled to date, with very solid results from these “Technocolor” stores.  The average new store net investment was $466,000 in 2006, and the average cash flow for new stores was $407,000 in 2006 for a very impressive store level cash on cash returns.
     
    The Disney Store was purchased from Disney in 2004 for basically the cost of working capital.  This was a transformational deal for PLCE, adding about $500 mm in sales to their sales base, and over 300 stores.  In exchange for a cheap price, PLCE signed a royalty agreement that gives Disney 5% of all sales as well as the ability to pull the license to the “Disney” name if a number of hurdles are not reached.  This license requires a minimum amount of capex to be spent remodeling the current stores as well as building new ones.  There are limits on the amount/type of promotions that may be run, and there is a change of control provision as well.  However, there is a limit to PLCE’s corporate exposure in the event the Disney operations cannot be turned around.  The license and royalty agreement were signed by a subsidiary of PLCE, “Hop”.  In addition, the lease signer is “Hop”, not PLCE.  PLCE has an agreement with “Hop” to fund a certain amount of the capex upcoming, but that amount is capped.  The rest must be self funded by the subsidiary.  As a result, I believe that PLCE can file “Hop” for bankruptcy and creditors will have no real recourse to the healthy Children’s Place chain.  Given the structure and price of the deal, The Disney Stores remains a very valuable option to PLCE for future growth.
     
    Recent Troubles
    Lack of SEC Filings
    For the past year, PLCE has not had current SEC filings as its accountants worked through whether options had been properly granted.  As Deloitte & Touche worked through the accounts, other examples of poor internal controls appeared, including several inappropriate transactions on the part of senior management.  These included the CEO forgetting to report an increase in his wife’s shares due to a disposition from the trust and his using PLCE stock as collateral to a margin account during the blackout period for management trades.  PLCE is now current with its filings, but it still has some internal control problems, presumably the reason why Deloitte & Touche resigned from being the auditor for the upcoming fiscal year.
     
    Loss of CEO
    As a result of the above transactions, the board asked Ezrah Dabah to resign on 9/24/07.  Ezrah was deeply involved in the running of the company, and as a result his departure was a real shock to the employees.  News reports imply that Mr. Dabah is extremely upset he was asked to leave the company. 
     
    Disney License violations
    PLCEs’ first attempt to remodel the Disney Stores, the “Mickey” format, was an unmitigated disaster.  Disney didn’t like the design and the performance of the stores was sub-par.  As a result, PLCE abandoned the format and wrote down the fixtures; unfortunately, this was after about 40 stores had been moved to the “Mickey” format.  As a result, PLCE ended up in violation of the licensing agreement which required a certain number of remodels to be complete by the end of 2007.  This disagreement was recently resolved with PLCE agreeing to invest $175 mm in remodels/new stores over the next three years.  In exchange, Disney is allowed to terminate the license agreement at will if PLCE does not comply.  However, despite the harsh language, Disney seems to be willing to work with PLCE ~ giving them a waiver just three months after the agreement was signed.  (PLCE is not able to meet the remodel condition for 2007, and thus Disney is waiving the condition).
     
    Poor Results
    The company had a fantastic 2006; comps were 11% overall, with 10% comps at Children’s Place and 14% comps at the Disney stores.  The company was literally chasing inventory the entire year at The Children’s Place.  The Disney store was benefiting from the release of Cars, which obviously was not replicated this year and hurt results substantially.  For The Children’s Place concept, management increased their inventory budget for 2007, just in time to face bad weather, and a slowing consumer.  At the same time, they decided it was a brilliant idea to raise the initial markup.  As a result, Children’s Place has spent the entire year marking down inventory, and bringing down guidance. 
     
    Now, in the last inning of the year, the company has withdrawn Q4 guidance, and is not giving any commentary with regards to 2008. 
     
    Numbers
    Stock Price
    $27.36
     
    Shares
    29.084
     
    Options
    1.26
     
    Strike
    $22.92
     
    Diluted shares
    29.289
     
    Equity value
    $801.3
     
    Less: Cash
    (111.2)
     
    Less: Seasonal Cash
    (50.0)
     
    Plus: revolving loan
    108.9
     
    Enterprise value
    $749.0
     
     
     
    EV/EBITDA
    LTM EBITDA
    $170.9
    4.4x
    2007E EBITDA
    $131.9
    5.7x
    2008E EBITDA
    $161.1
    4.6x
     
    Thesis
    Children’s Place holds a solid place in its market.  It has competed effectively with Walmart, Target, department’s stores, gap kids, etc. by offering a fashionable value alternative in an easy-to-shop environment for Children.  The Disney stores, while poorly run in the past, are slowly being turned around by new leadership brought in at the end of 2006. 
     
    The valuation is obviously discounted for the above reasons.  It has been a tough year for the company, but the current valuation is at a ridiculous discount.  Several of the above issues are completely solved: the Disney violation has been resolved and the SEC statements are now filed.  The other issues, I view more as opportunities.  This is a company that lost 550 bps of gross margin due to markdowns, all of which will be annualized next year.  The new merchandise in the stores is already resonating better with the customers, as evidenced by solid November same-store-sales numbers.  Given the value price point, consumer strength should not be issue for this company, which despite increased markdowns, has had solid traffic and transaction growth the entire year.  As a result, it is possible that earnings will grow at least 30-50% in the upcoming year, even with a poor economy.
     
    The second issue, the loss of the CEO, may result in a bid for the company.  By all reports, Ezrah Dabah was a passionately involved CEO that was extremely upset by the board’s request for his resignation.  On 10/15/07, Ezrah filed a 13-D stating he had hired Bear Stearns to evaluate strategic alternatives with regards to his PLCE stake ~ one of the alternatives being a potential bid for the rest of the company.  If you run the company through an LBO model, and assume that the FY ’06 margins can be re-attained in three years, you can get a mid twenties IRR at $32 with only 2.5x total debt to EBITDA.  In order to do this, Ezrah would need to find a partner to put in about $400 mm in capital.  However, with mid twenties returns assuming a conservative exit multiple of 6.0x EBITDA, it shouldn’t be hard to find some private equity money that is interested.
     
    Target Price
    If there is a bid in the next couple of months, I believe it’ll be in the $30-$35 range given a conservative LBO model and limited financing ability.  While this should provide nice support for the stock, the true value of the company is much greater.  If you normalize the margins, and assume an average specialty retail multiple, this stock should be worth in the mid-sixties.
     
    2008E Children's Place sales
    1,600.0
    2008E Disney sales
    680.0
     
     
    '06 EBIT margins for Children's Place after overhead
    10.3%
    Assumed Margin for Disney after overhead
    3.0%
     
     
    Normalized EBIT for Children's Place
    165.3
    Normalized EBIT for Disney
    20.4
    Total EBIT
    185.7
    D&A
    82.0
    EBITDA
    s267.7
    08E EV/EBITDA multiple
    7.0x
    Enterprise Value
    1,873.6
    Equity Value
    1,926.0
    Per Share
    $65.76
     
    Risks
    1)      Fraud ~ given the large number of management departures and the comments by Deloitte & Touche, it is possible that there are more serious issues in the books.  However, given the valuation is around 0.5x sales and the company is currently net cash, there seems to be limited downside from here.
    2)      More merchandising mishaps
    3)      Lack of committed leadership.  None of the senior managers have been at the company for more than a year.  The President of Children’s Place had been there longer, but he resigned a couple of weeks ago in order to become the President of Zales.
    4)      Poor Q4 results
     
    Catalyst
    1)      Improving sales trends in 2008 leading to better margins
    2)      Better Disney release schedule in the upcoming year.
    3)      Bid by former CEO ~ Ezrah Dabah.

    Catalyst

    Catalyst
    1) Improving sales trends in 2008 leading to better margins
    2) Better Disney release schedule in the upcoming year.
    3) Bid by former CEO ~ Ezrah Dabah.

    Messages


    SubjectMSDonut - A couple comments/q
    Entry12/28/2007 01:25 PM
    Membercanuck272
    MSDonut -
    A couple comments/questions.
    You didn't address the issue of inventories, which appear to be in bad shape. As of 11/3/07, inventories are up 30% from a year ago, on a sales increase of around 8%. Heavy markdowns may partly explain the good November sales. any thoughts on this?
    Taking the revised agreement with Disney into account, what do you expect CapX and free cash flow to be over the next 3 years?
    Thanks in advance for your reply.

    SubjectTo be honest, a lot of merger
    Entry01/17/2008 09:17 AM
    Membermsdonut940
    To be honest, a lot of merger arb funds are taking risk off the table, especially in the realm of potential deals vs. a signed agreement. (See QMAR and Rio Tinto results for the last two weeks.)

    The current credit markets will make it difficult to even get 2.0 debt/EBITDA for a retailer, though I will argue that if you buy the entire company for cash outright today, it will still give you a good return. Maybe you just lever up in a year and juice your IRR then if its important to a PE partner.

    Subject$24/share
    Entry02/07/2008 10:32 AM
    Membermsdonut940
    Dabah, former CEO, stated today that he plans to make an offer at $24/share. He has received interest from Golden Gate with regards to participating in the deal. Given the state of loan market, my original assumptions with regards to financing costs need to be updated. However, I'm still getting extraordinarily healthy returns at $24, so I expect that this is just the first volley.
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