Description

Tilly’s Inc. (TLYS)

Summary

We focus on smaller companies with “Ft. Knox” balance sheets and large & sustainable free cash flow yields and we are typically seeking a double-digit FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.  We focus on small-cap stocks because there is a much better chance to find an attractive investment opportunity which is under-followed or undiscovered.

Tilly’s Inc. (TLYS) is an undervalued specialty retailer located in Irvine, CA focused on casual apparel, footwear, accessories, and hardgoods for young men, young women, boys, and girls with an extensive assortment of iconic global, emerging, and proprietary brands rooted in an active and social lifestyle.  TLYS operates 241 stores in 33 states as of January 2022.  Stores are in a variety of retail centers, including malls, lifestyle centers, power centers, community centers, outlet centers, and street-front locations.  Customers may also shop online, where the Company features substantially the same assortment of products as is carried in brick-and-mortar stores.  TLYS seeks to serve as a destination for the latest, most relevant merchandise and brands that are important to its customers.  Third party brands represented about 75% of total net sales in FYE Jan 22.

Importantly, during the pandemic, TLYS aggressively adopted a digital-first approach to connect with customers, as show below:

We believe this has had a major impact on TLYS long-term profitability and cash flow potential and resulted in a larger and more sustainable business model where ecommerce sales are more closely profitable for TLYS with retail store sales and customers are able to shop TLYS however they like.  TLYS is a very well-positioned omni-channel retailer.

TLYS’s shares currently trade at about $13 per share with about 31m shares outstanding for a market cap of $403m. 

TLYS has a “Ft. Knox” balance sheet with net cash position of about $189m as of 1/3/22 (per a recent press release before an investor presentation at the ICR conference on 1/10/22) for a total enterprise value (EV) of about $214m.  Based on forecasted numbers at the ICR conference presentation of $89m for operating income for FYE Jan 22 plus $20m in D&A results in about $109m of adjusted EBITDA for FYE Jan 22.  TLYS is trading at 2x adjusted EBITDA.  Capital expenditures are expected to be $15m to $20m for FYE Jan 22 so TLYS is trading at less than 3x adjusted EBITDA minus capital expenditures for FYE Jan 22.  TLYS generated very strong free cash flow for FYE Jan 22.  We estimate free cash flow (FCF) (we define FCF as cash from operations minus capital expenditures) was over $65m.  We believe TLYS can sustainably generate at least $50m of FCF per year.  TLYS is trading at a 20% plus FCF yield on an unleveraged basis based on FYE Jan 22 results. 

TLYS has about $6 per share of net cash as of 1/3/22 or about $6 per share.  This compares to a recent share price of about $13 per share or close to 50% of the market cap. 

Based on forecasted diluted EPS of $2.07 to $2.10 for FYE Jan 22, TLYS is trading at a P/E of below 4x, net of cash.  We believe this low valuation does not nearly reflect TLY’s long-term growth potential, as discussed below, even if one assumes TLYS was “over-earning” in FYE Jan 22.

TLYS began in 1982 when co-founders, Hezy Shaked and Tilly Levine, opened their first store in Orange County, CA.  TLYS went public in 2012.  TLYS strengths include the following:  1) destination retailer with a broad and differentiated assortment, by combining proven and emerging fashion trends and core style products; 2) dynamic merchandise model, by closely monitoring trends and shipping to stores several times per week, the company can adjust merchandise mix based on store size and location; 3) flexible real estate strategy, including stores successful in a variety of retail centers and geographies, across 82 markets in 33 states; 4) multi-pronged marketing approach to drive traffic to stores, including integrated digital platform and digital new customer acquisition; and 5) systems the distribution fulfillment infrastructure to support growth, including dedicated ecommerce center

TLYS growth strategy includes: 1) driving comp store sales with new, on-trend merchandise, including proprietary and exclusive brands; 2) increasing operating margins through leveraging comp store sales; 3) continuing to grow ecommerce, which represented 33% of total sales in FYE Jan 21 (during the pandemic) and 21% of total sales forecast for FYE Jan 22, which represents an extension of its brand and retail stores, and where customers typically shop first; 4) improved inventory management, based on specific stores and online characteristics; 5) developing omni-channel capabilities including direct to consumer program that allows orders to be shipped to customers from brick and mortar stores when inventory is otherwise unavailable in ecommerce center; 6) reinvesting in existing stores, to elevate the customer experience, with about 90% of stores remodeled or refreshed in recent years; and 7) real estate opportunities, with only 241 stores at FYE Jan 22, there are numerous attractive opportunities to open stores.

Despite the low valuation, we believe TLYS has clearly shown an ability to drive long-term growth – considering the following results and growth rates:

We believe a major source of TLYS’s success is summarized in the following slide, which highlights the broad and differentiated assortment which we agree is a significant competitive advantage.  We believe TLYS broad assortment also reduces risk as the company is not too dependent on one brand or style.

We believe TLYS has a major growth runway via expanding its store footprint which is currently far below many competitors.

In addition to store growth, we believe the TLYS ecommerce opportunity is also significant, as indicated below

Even if TLYS is “over-earning” in FYE Jan 22, we believe it is too cheap given its excellent long-term track record and highly cash-generative business model and strong growth opportunities in both retail store expansion and ecommerce.  We believe TLYS deserves a much higher multiple given its strong positioning as an omni-channel retailer.  We believe adjusted EBITDA can grow to $120m or more by FYE Jan 24 due to a larger retail store footprint and a larger ecommerce business.  At 8x our adjusted EBITDA estimate for FYE Jan 24 of about $120m plus $150m of net cash, TLYS would have a market value of close to $1.1b or about $35 per share (+200%).   If TLYS’s management team continues to execute and its retail store and ecommerce businesses continue to grow, we think our target price could be achieved. 

Business Description

Tilly’s Inc. (TLYS) is a specialty retailer located in Irvine, CA focused casual apparel, footwear, accessories, and hardgoods for young men, young women, boys, and girls with an extensive assortment of iconic global, emerging, and proprietary brands rooted in an active and social lifestyle.  TLYS operates 241 stores in 33 states as of FYE Jan 22.  Stores are in a variety of retail centers, including malls, lifestyle centers, power centers, community centers, outlet centers, and street-front locations.  Customers may also shop online, where the Company features substantially the same assortment of products as is carried in brick-and-mortar stores.  TLYS seeks to serve as a destination for the latest, most relevant merchandise and brands that are important to its customers.  Third party brands represented about 75% of total net sales in FYE Jan 21.

Selected third party brands include:

Examples of proprietary brands include:

As of Jan 22, TLYS had 241 stores in 33 states averaging about 7,400 square feet per store.  Stores are located in regional mall, off-mall, and outlet locations.  Stores generated average net sales of $1.5m per store or $202 per square foot, in FYE Jan 21 (which was significantly impacted by the pandemic). 

The table below shows number of stores by type of retail center at the end of the last three fiscal years:

The table below shows the total number of stores by state as of January 30, 2021

The following table summarizes net sales from the Company’s retail stores and ecommerce over the past three fiscal years: 

The following table summarizes the percentage of net sales by department: 

Marketing and Advertising

TLYS uses a multi-pronged marketing strategy to connect with customers and drive traffic.  This is comprised of the following:  1) loyalty program, where customers accumulate points based on purchase activity; 2) email marketing, to build awareness and drive traffic; 3) digital marketing, including pay per click, display, and social and affiliate marketing; 4) social media, as customers rely heavily on opinions of their peers, often through social media; and 5) brand partnerships, where the company collaborates with vendors.

Competition

TLYS competes with various public and private companies, including Abercrombie, Aeropostale, American Eagle, the Buckle, Forever 21, Hot Topic, Pacific Sunwear, Urban Outfitters, and Zumiez.  Other competitors include specialty shops, department stores, off price retailers, and online marketplaces such as Amazon.

Seasonality

The Company has historically experienced fluctuations due to the seasonal nature of the retail industry.  Net revenues are typically smallest in the first quarter and largest during the fourth quarter for a given fiscal year.

Strong Management and Ownership Oriented Towards Disciplined, Long-Term Value Creation

TLYS has a strong management team with significant “skin-in-the-game”.  CEO Ed Thomas took over the CEO position in October 2015 in response to poor results due to a rapid expansion of the store base.  Since then, TLYS has slowed new store growth and focused on improving profitability and efficiency of the existing store base and improving profitability of the ecommerce business.  TLYS strong performance has led management to gradually start to open more stores.  Hezy Sheked is a founder and the largest shareholder of TLYS.  Management is conservative, which we like, and highly focused on profitable growth.  In response to the pandemic, TLYS built significant liquidity very quickly to reduce risk and gradually reopened successfully, despite the heavy concentration of stores in California, which was a difficult market for retailers during the pandemic due to extended government mandated closures. 

Over the past five years, TLYS has paid $5.70 per share in total special dividends, most recently paying special dividends of $1 per share in July 2021 and December 2021.  We believe TLYS will continue to return excess cash to shareholders through special dividends and share repurchases and two $1 per share special dividends were most recently paid in July 2021 and December 2021.

Attractive Valuation with Large and Sustainable Free Cash Flow Yield

TLYS is currently trading at about 2x adjusted EBITDA, which is very attractive for a specialty retail business that we believe can grow revenues long-term at least mid-single digits organically with modest capital investment needs and strong free cash flow.  We believe TLYS can sustainably generate free cash flow of $50m+ per year as compared to its current enterprise value (EV) of about $204m for an unleveraged FCF yield of 20%+.  We believe this is attractive when compared to 10-year treasury rates near 2%.  We describe below some reasons why TLYS’s results might be more sustainable than its current market valuation would indicate. 

Further, TLYS has provided strong special dividends payments to shareholders very consistently over the last several years, such that shareholders are likely to receive a 5% to 10% cash on cash return annually based on current share price levels and company performance.

Strong Cash Flow Generation and Highly Cash-Generative Business Model

TLYS has consistently generated strong cash from operations and free cash flows.  For LTM 10/31/21, cash from operations was $65m and FCF was about $50m.  Absent a severe recession, we believe these strong levels of cash from operations and FCF can be sustained and can grow over the next few fiscal years.  These results reflect TLYS’s highly cash-generative business model, which has limited working capital and capital expenditure requirements.  TLYS believes maintenance capital expenditures are about $5m to $10m per year.  This compares to over $100m in adjusted EBITDA.

TLYS has several tools at its disposal to drive long-term shareholder value. We believe TLYS is likely to use its strong cash generation to drive shareholder value over the next few years via special dividends or large share repurchases.

Strong Growth in Sales and Operating Income over the Past 5 Years

Although the market has given TLYS a low valuation, more appropriate for a dying retailer, in fact, TLYS has generated strong growth over a long period of time.  Further, management has greatly improved TLYS ecommerce business which reduces business model risk from online competitors like Amazon and others and enables its young customer base to purchase merchandise on an omnichannel basis, either in physical stores or via ecommerce.  We do not think the market is recognizing TLYS significantly improved business model and profit growth potential over the next five years.

Long-Term Growth Potential Via Enlarged Retail Store Footprint and Improved E-Commerce

We believe TLYS has significant long-term growth potential in a larger retail store base (only 241 stores at present).  New stores have performed extremely well, with paybacks of close to two years.  TLYS has been very methodical about its retail store base expansion but has projected 10 – 15 new stores in the current fiscal year.  TLYS has only 16 stores in Texas.  Similar companies such as American Eagle (894 stores) and Zumiez (603 stores) have much larger store bases.  There are many geographic markets that TLYS has not even entered yet.  In five years, we believe TLYS could have a much larger store base.

TLYS can also grow revenue through its ecommerce business.  TLYS significantly improved its ecommerce business during the pandemic in terms of selection, ease of use for customers, and profitability.  While ecommerce grew from $98m in FYE Jan 20 to $174m in FYE Jan 21 due to the pandemic impact, as stores and the economy reopened in FYE Jan 2022, TLYS is projecting to generate ecommerce sales almost equal to pandemic FYE Jan 2021 levels.  Further, contribution margins on ecommerce sales are almost equal to physical store sales margins as ecommerce profitability has been greatly improved during the pandemic.  We believe TLYS will be able to sustainably grow revenues through both retail stores and ecommerce over the next couple of fiscal years.

High Returns on Invested Capital

TLY’s specialty retail business model requires small net working capital investments and small capital expenditures.  Capital expenditures over the past few years have averaged less than $10m.  As a result of these limited capital requirements, TLYS has been able to earn high returns on invested capital and generate substantial free cash flows.  To evaluate return on invested capital or ROIC, we like to look at operating earnings (EBIT) or free cash flow (FCF) compared to the net investment in tangible assets which is the investment in: (a) net-working capital excluding cash, plus (b) net PPE.  These are the tangible assets the business requires to generate the EBIT or FCF.  At Oct 21, non-cash working capital for TLYS was about negative $52m and net PPE was about $49m for a net investment in tangible assets of about zero.  This compares to EBIT of about $80m+ or far above a 100%+ return on invested capital (ROIC).  We believe this high ROIC business model is extremely rare and attractive, especially for a growing specialty retail business with a strong and profitable ecommerce business.

“Ft. Knox” Balance Sheet Reduces Risk and Creates Opportunities

TLYS has a “Ft. Knox” balance sheet today with a net cash position of $189m at 1/3/22 (based on a press release issued prior to its ICR presentation).  We believe the Company’s strong balance sheet substantially reduces risk and gives the Company opportunity to take advantage of strategic opportunities which are both organic and inorganic.

This “Ft. Knox” balance sheet and strong net cash position represents close to 50% of TLYS current market value or about $6 per share of net cash on the balance sheet, versus a current share price of about $13 per share.  For us, TLY’s “Ft. Knox” balance sheet greatly reduces the long-term risk of an investment in TLYS at current price levels.

Conclusion and Target Price

Even if TLYS is somewhat “over-earning” in FYE Jan 22, we believe it has valuation multiples that are far too cheap given its excellent track record and highly cash-generative business model and strong growth opportunities in both retail store expansion and ecommerce.  TLYS has a business model that has achieved an ROIC of 100%+, something we might expect for a software company, not a specialty retailer.  We believe this speaks to TLYS unique business model and strong and diversified merchandise mix.  We believe TLYS deserves significantly higher multiple given its unique financial characteristics and it strong position as an omni-channel retailer.  We believe adjusted EBITDA can grow to $120m or more by FYE Jan 24 due to more retail stores and its larger, more profitable, and stronger ecommerce business.  At 8x our adjusted EBITDA estimate for FYE Jan 24 of about $120m plus $150m of net cash on the balance sheet, TLYS would have a market value of close to $1.1b or about $35 per share (+200%).   If TLYS’s management team continues to execute and its retail store and ecommerce businesses continue to grow, we think our target price could be achieved. 

(a)     TLYS had 22.8m Class A shares and 7.3m Class B shares on April 12, 2021.  Class A shares are entitled to one vote per share and Class B shares are entitled to 10 votes per share.

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(a)    Per press release on 1/10/22 which indicated $189m of cash and no debt as of 1/3/22 and ICR Presentation on 1/12/22.

              Quarterly Consolidated Results

Catalysts

1.       Highly cash-generative business model with strong free cash flow of $50m+ per year or 20%+ unleveraged FCF yield.

2.       Strong business model niche in specialty retail for teens and young adults with much stronger ecommerce business, which is much larger and more profitable in response to the Covid-19 pandemic.

3.       Cheap valuation of 2x EBITDA and 20%+ unleveraged FCF yield for a niche specialty retailer with solid organic revenue growth and strong operating income growth over the past 5 years.

4.       Strong omni-channel retailer with ecommerce profitability almost equal to physical store profitability.  TLYS is indifferent to where the customer shops.

5.       High ROIC business model – based on EBIT to net PPE plus net working capital, ROIC is over 100%.

6.       Small retail footprint (241 stores) relative to similar retail concepts implies tremendous growth pathway over the long term.

7.       New retail stores have been highly successful, with 2-year paybacks.

8.       “Ft. Knox” balance sheet with net cash position of $189m as of 1/3/22, even after two special dividends of $1 per share in July 2021 and December 2021 ($61m in total dividend payments).

9.       Highly cash-generative business model with sustainable free cash flow of $50m plus per year.

10.    Broad merchandise assortment which is a major competitive advantage for TLYS’ teen and young adult customers (almost a mall within a store, one stop shop for its target customer age groups).

11.    TLYS has a conservative and smart management team and a Board with a major ownership stake in the business and lots of skin in the game.

12.    TLYS has paid $5.70 per share in special dividends over the past few years out of its strong free cash flow.

13.    Highly resilient business model through the pandemic which continued to generate strong cash flows.

14.    Acquisition by a larger specialty retailer or private equity group which might seek to accelerate its store base expansion and the growth of its ecommerce business.

Risks

1.       Economy turns down sharply, and/or U.S. consumer spending is sharply curtailed.

2.       TLYS is unable to match or exceed its strong results generated for FYE Jan 22 in subsequent fiscal years.

3.       TLYS misallocates capital into a poor acquisition.

4.       TLYS is unable to execute on its plan to drive higher sales and margins via an enlarged store base and larger ecommerce business.

Disclaimer

Disclaimer:  We own shares of TLYS.  We may buy or sell these shares at any time without notice.  The information in the write-up is believed to be correct as of the date written but readers should do their own verification of this information and analysis of this potential investment.  We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst

See above.