Description

Preface

Let me begin this write up by highlighting a very notable limitation: Jo-Ann’s Store (JAS) is a private issuer and its owners (PE firm Leonard Green) restricts public dissemination of their financials. For instance, sellside firms are not permitted to publish on the name. The company’s limited disclosure policy does not change the compelling value offered by its bonds (in fact, the bonds are perhaps “cheap” given JAS’s restricted financials).  While we believe the company’s limited disclosure allows investors to earn a premium, this write up will include fewer numbers/models than a typical VIC submission to respect the owners’ wishes for confidentiality.

Investment Overview

We believe the Jo-Ann’s Stores 9.75% HoldCo Notes offer an attractive coupon clip of 12% (at a 95 price) with the prospect for refinancing later this year to provide a compelling IRR and total return.

Company Overview

Jo-Ann’s Stores is a specialty-retailer focused on the Arts & Crafts market with roughly 50% of the sales stemming from the sale of fabrics and 50% from crafts. The company has roughly 15% market share in the fabrics market, making JAS the only national player in the market. Within pure-play crafts, JAS commands only around 5% share, trailing leading player Michael Stores (MIK) and also competes with privately-held Hobby Lobby.

Through the end of the October 2016 quarter, JAS has 844 stores in 49 states. Their average stores size is roughly 22,000 square feet and carries an average of 74,000 SKU’s. As we will detail below, the SKU-intensity of JAS’s business is an important competitive barrier for the business.

Capital Structure

Again, JAS is a private company having been LBO’ed by Leonard Green in March 2011 at an EV of $1.6bn. The deal valued JAS at 7.2x and the sponsors put-in roughly $400mn of cash equity (with existing owners rolling $9.3mn of equity). Leonard Green dividend’ed out much of their original investment with a $325mn HoldCo deal (the security we are focusing).

As of 10/30 (the end of the company’s third fiscal quarter), JAS had a $400mn ABL with $140mn of drawing, $725mn TL B (L+500) due 2023, $168mn of 8.125% Senior Notes due March 2019 and $275mn of HoldCo Notes due October 2019.

Investment Thesis

I anticipate that many people will look at the broader retail landscape—particularly within High Yield, where Retail now ranks as the highest yielding sector—and dismiss the JAS story altogether. However, such “first level thinking” (to borrow Howard Marks’ phrase) provides a significant opportunity for investors willing to take a closer look. Jo-Ann’s business is less vulnerable to some of the structural headwinds hindering retailers, benefits from an improved competitive backdrop and new management initiatives and generates significant free cash flow. These dynamics should continue to support JAS’s underling business and ultimately assist in a refinancing transaction early next year, we expect:

• Limited e-commerce threat. Online shopping has gained momentum in the last several quarters providing an existential threat to many traditional bricks-and-mortar retailers. According to First Data’s “Holiday 2016 SpendTrend Report,” 21.3% of all holiday 2016 shopping occurred online compared to 15.4% in 2015. Retail e-commerce transactions increased 12.0% year over year, while retail brick-and-mortar sales grew an anemic 1.6%.

   

  Much of this pain has been absorbed by department stores whose value proposition of offering a variety of product categories and bands under one roof has been easily supplanted by the Amazon’s of the world. Apparel retailers have suffered as well, as e-commerce along with changes in millennial shopping preferences (which deemphasize brands) to create a challenging backdrop.  While certainly not immune, Jo-Ann’s business is relatively well positioned to limit the e-commerce threat.

   

  Quite simply the math for online shopping does not work for in the Arts & Crafts space, even for AMZN. JAS’s average ticket is around $20—a price point that provides little room to compete purely on price/scale, particularly when including free shipping (likely a customer expectation). Additionally, Arts & Crafts tend to represent a more tactile shopping experience, with users often wanting to visit stores to touch, feel and potentially test the products.

   

  The fact that no player of substance has emerged in the space underscores the fact that Arts & Crafts does not translate well online. JAS’s own website joann.com represents an industry leading site, but still represents just 5% of company revenue.

   

• Limited “big box” threat. Big Box represents another threat to the specialty retail channel that JAS largely side-steps. WMT (as well as players like TGT) leverage their purchasing power and overhead to aggressively undercut local and national specialty retailers on price.

   

  The Big Box model largely relies on high turning SKU’s, which is essentially the opposite of the Arts & Craft’s business. JAS has reported average inventory turns of around 2.5x over the last several years. By contrast, WMT has averaged 9.0x turns per annum, highlighting the incongruence of this category in Big Box.

   

  Big Box also relies on a relatively low in-store labor, whereas Arts & Crafts is very much a consultative sales process. “Cut to size” fabric (again, roughly 50% of JAS’s business) represents the opposite of the Big Box business—it’s a non-commoditizes product (in that each piece of fabric must be cut to meet the specification of each customer order) and requires in-store labor.  

   

• Improved competitive environment.  JAS will also benefit from the recent bankruptcy of Hancock Fabrics—formerly a key competitor—leaving JAS as the only national player in fabrics. 70% of former Hancock locations fall within a 10 mile radius of an existing JAS stores, providing an opportunity for significant market share capture.  

   

• New management. JAS’s former CEO, Travis Smith, resigned in August 2014 and the company’s CFO Jim Kerr served on an interim basis until the current CEO, Jill Soltau, joined in March 2015. Ms. Soltau has installed a number of new senior executives over the last several months (e.g. a new CFO, new EVP of Operations, new Merchandising team) and has launched a number of initiatives to improve merchandising and operations.

   

  JAS’s recent results have already begun to reflect the company’s improved operations. Despite topline declines, the company reported EBITDA margin improvements in each of the first three quarters of fiscal 2017.

   

• Less vulnerable to traffic declines. The Arts & Craft channel is generally destination based shopping. People visit a Jo-Ann’s Store because they are working on a project or they want to find a new craft project. This category is therefore less dependent on broad-based retail traffic, particularly relative to many “inline” mall-based retailers.

   

• Attractive cash flow dynamics. JAS throws-off significant free cash flow, which will help delever the capital structure. The company improved its FCF profile by refinancing $282mn of its Opco Notes with a new Term Loan (L+500), which should lower the company’s interest cash expense going forward.

   

  As for the reminder of this year, JAS has historically generated around $100mn of FCF in the fourth quarter, helped by seasonal NWC unwind; management has intimated that it would earmark these dollars for ABL pay down. As for next year, based on my model, which forecasts EBITDA essentially flat, I calculate JAS generating total free cash flow of $76mn, or roughly 6.0% of debt—objectively attractive for a High Yield issuers. We expect these dollars will be used for debt repayment as well.

We would note that the company has few options for deploying this capital other than debt repayment: the company is not looking to aggressively expand its store footprint; the company has consistently invested in e-commerce removing the need for “catch up” spending; and capex ranges a modest 1.25-1.50% of revenue. Most importantly, JAS does not have RP capacity at the HoldCo level to pay a dividend. Hence, we expect JAS will aggressively pay off debt in the coming quarters. To emphasize the point, Leonard Green cannot take another penny out of this structure until our bonds have been taken out.

• Refinancing opportunity. We expect JAS will look to refinance the remainder of its Opco and HoldCo Notes into a single Opco bond later this year. Such a move will simplify the structure (removing the HoldCo box), lower their cost of debt and term out their debt profile. If JAS continues to demonstrate operational improvement—even without topline growth—we believe a refi is likely.

   

  We calculate leverage will be 4.9x as of the end of FY17 (ending Jan 2017), which would imply that the company’s debt remains fully covered on an EV basis. Again, JAS had been LBO’ed at a 7.2x valuation and its closest public peer, Michael Stores (MIK), trades at 8.3x. JAS needs to trade at a discount to MIK given the thinner margins of fabric (vs. crafts), but we feel comfortable conservatively valuing JAS at 6.0x, which suggests at least a turn EV cushion.  

   

  Admittedly, given the abysmal sentiment in the High Yield retail universe, a refi is not a lay-up. By my model, the company should generate $150mn of cash in FY18 and FY19, which should predominantly go to repay the HoldCo Notes. In a draconian scenario, should the market completely collapse, the company has a $400mn ABL (which should be largely paid-off after FY4Q17) that the company could tap as a last resort.

Conclusion

We find the JAS HoldCo Notes appealing, particularly in the context of a credit market that offers few yield opportunities. I would emphasize, that this is a credit investment. Given the difficult market backdrop, it’s difficult to envision growth from any traditional brick-and-mortar retailers right now. This dynamic, however, is a problem for growth oriented equities or retailer that have levered beyond their EV. JAS’s reasonable capital structure and attractive free cash generation makes this an intriguing fixed income investment. A 95 purchase price would imply an IRR of around 14% with a refi later this year, a respectable fixed income risk/reward.   

Threats:

• Continued SSS weakness could hinder JAS’s access to the capital markets

• No obvious “exit” for the owners—not enough growth for an IPO and likely no bid from PE

• As a public company, competitor MIK faces market pressure for growth, which could promote them to open stores more aggressively in JAS territories.

• Competitor Hobby Lobby is a family run-business, with very limited disclosure. Market participants have anecdotally suggested that Hobby Lobby deploys capital with less discipline than a PE or publicly owned business, creating a less-rationale competitor.

• The market has priced-in the upside from management’s new initiatives and the exit of Hancock Fabrics. Should JAS failed to deliver in 2017, some market participants could abandon the story.

• Waddell & Reed is among the largest holders of JAS’s HoldCo Notes and the firm saw some turnover among its top managers in 2014. Given the small size of JAS’s issues, an exit from any of JAS’s top holders would have a significantly negative impact on bond prices.

• The House GOP has proposed implementing a new tax system whereby COGs sourced from outside the U.S. would not be tax deductible. Such a sweeping change to our tax system would likely negative impact retailers, like JAS, who primarily source goods overseas. It is impossible to handicap such an eventuality, but we believe JAS  would be well positioned to pass along higher costs given the low price of their goods.  

• Credit market are admittedly “hot” right now. Should the market experience a pocket of weakness, I would expect downside price volatility (though not likely trading activity) in this name.  

Catalyst

This is less of an event driven story than a compelling coupon-clip. That said, we expect the company will look to refi the capital structure later this year to reduce their interest burden, term-out their debt and simplify the structure. A near-term refi pushes the IRR in the mid-teen's, compelling in this market.