May 22, 2007 - 9:48am EST by
2007 2008
Price: 4.95 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 59 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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XS Cargo is a Canadian retailer of closeout merchandise that is growing its store base by 25 – 30% annually with exceptional store economics and is trading for only 2.2x EV/EBITA or 3.6x P/FCF on next year’s numbers (this FCF figure is fully-taxed and I’m not even including a 4-year tax shield that is worth around 1/3 of the EV and almost half of the market cap). I believe that the company is worth over $23 today, yet the current share price is only $4.95.  Suffice to say, this is an unusually cheap stock for a high growth quality business, even by Canadian microcap standards.
Let’s start with the most obvious question:
How the heck did this get so cheap? 
Over the past year the company has suffered a series of disappointments that have significantly frustrated investors and caused them to give up all hope and drive the stock down to irrationally low price levels.
-          Canadian government announces the phasing out of the income trust structure.  As an income trust, the company does not pay corporate taxes on distributed cash flow.  Existing income trusts will begin to pay a 31.5% tax rate in 2011.  There have been a number of income trust ideas submitted to VIC in the past few years, so I’ll assume that most are familiar with the structure and events of the past year.  At the time of the government’s announcement, XSC’s unit price declined to a greater extent than other trusts.
-          Increased wage costs in Alberta.  The company has around a quarter of their stores, their HQ, and their main distributor center in this province.  Alberta accounts for around 41% of all wage expenses.  The short explanation is that robust activity in the oil sands has caused significant wage inflation for unskilled labour in this area.  It is difficult to quantify the exact impact this has had but I believe that it is on the order of 100 bps of margin contraction.  Importantly, the vast majority of the company’s growth is coming from outside of Alberta, including a new DC in Ontario.
-          They outgrew their inventory management system.  This has had a significant impact on revenues and margins and has been a total disaster for the company.  XS Cargo has been growing very rapidly, and starting in Q4 (obviously a huge quarter for the company), their inventory management system was no longer able to handle such substantial volumes and essentially ceased operating properly.  As a result, their system was unable to allocate inventory to the company’s stores appropriately.  The impact on the company is that they began to suffer significant stockouts at their stores (comps declined from being roughly flat to negative 9-10%) and the company began to incur significant new expenses (increased freight and labour from reallocating products that had been improperly allocated by the system and other tasks where they now had to manually override the system).  Increased freight, for example, has had a negative 300 bps impact on margins (this will moderate starting next quarter).  The company is addressing this problem by implementing a new supply chain management system from JDA Software.  Implementation began in April and will be completed by the end of Q3.
-          They cut their distribution by 50%.  This obviously had a very negative effect on the price of this “income security”, but it also has no impact on the company’s long term fundamentals.  Management does not want to slow down their aggressive store growth plans (around 10 per year off a base of 37 stores) and so they need to temporarily retain capital to fund the business until their new SCM system has been implemented.  Even after cutting the distribution by 50%, the payout will be $0.56, which is an 11-12% yield.  As for their ability to fund this distribution, it amounts to $5.4 M which compares to trailing 12 months EBITDA of $10.9 M (which obviously includes the last 2 quarters that have been affected by the broken inventory allocation system).
Why this is a great business to own?
What makes this story so exciting (other than the valuation) is the combination of very high store growth rates and very high returns on this investment.
The company ended last year with 35 stores, and they intend on opening around 10 new stores per year (which translates into almost 30% store growth in 2007).  They believe that the Canadian market can support at least 70 of these stores, which seems reasonable to me (especially when you consider that Canada has few similar competitors), and will thus allow the company to roughly double the size of the business in around 4 years. 
Secondly, the store economics are phenomenal.  Breaking them down:
1)      Very high store productivity.  Sales per sqft are around $430.  This is astonishing for a broadline closeout retailer.  Sales per sqft for similar companies are: Liquidation World @ $79, Big Lots @ $107, and Tuesday Morning @ $138.
2)      High margins.  EBITDA margins before the SCM-blowup were around 14-15% and have been as high as 18%+ in 2004 (maintenance capex is insignificant relative to EBITDA).  Those margins include all of the corporate and overhead expenses, so store level margins are clearly well above this.  A large factor in achieving these margins is obviously the outstanding store productivity.  Secondly, due to the nature of these stores, they are located in secondary sites which have very low rent (not power centers, malls, etc.).
3)      Low capital investment.  The stores are kept very simple and are not particularly aesthetically pleasing.  As a result, the company incurs a cost of only $120k in equipment + fixtures.  Along with $300k in inventory, the investment in a new store is only around $420k.
4)      Very high returns on capital.  New stores are doing around $3.5 M in revenues.  Assuming 14% EBITA margins, that’s around $490k in EBITA.  All in, that yields an 80% after-tax ROIC, and the assumption of 14% includes a provision for DC and corporate costs (overall company margins should be at this level).
Furthermore, I believe that closeouts are a particularly attractive niche in retailing.  Sourcing small-sized odd lots of closeouts, returns, or excess inventory is more difficult due to the greater degree of fragmentation, and thus requires a large network of independent brokers to procure merchandise.  The establishment of such a network, and the relationships that the company has built over time, thus constitute a barrier to entry (not an impenetrable moat, but I would argue better than that of a traditional retailer).  Also, closeouts retailing should be at least slightly more resilient during economic downturns as increased business failures create an influx of product supply and consumers seek more value-pricing. 
Let me walk you through how I have arrived at my EBITA and FCF estimates for next year (2008).  I am applying a multiple to next year’s numbers as the current year is still going to be impacted for the first 3 quarters by increased expenses (higher freight and labour costs) associated with the reallocation of inventory.
The company ended 2006 with 35 stores.  They anticipate opening 10 stores over the next two years, and are on track to meet this target so far in 2007.  This means that they will enter 2008 with around 45 stores and end the year with 55 stores.  The average store count for 2008 is therefore expected to be 50 stores.
Before their inventory allocation system blew up, the company’s stores were averaging around 3.9 M in revenues per store.  If you calculate the revenues from new stores, they have been contributing around 90% of this productivity level in their first 12 months, or around 3.5 M in revenues per store.  This relationship has continued to hold even in the past few quarters when comps turned significantly negative.  Note: if you are trying to calculate this for yourself using the “new store revenues” and “new store counts” that the company provides, you need to gross up the revenue number by around 12 – 13% (50% of 1 quarter) to account for stores that were built within the quarter and thus do not have a full revenue contribution in the most recent quarter.
I believe that it is conservative to assume that the company’s 35 stores continue to generate an average of 3.9 M in revenues per store in 2008, and that the company’s new 15 stores remain at the 3.5 M level of productivity.  This basically assumes that any ramping of revenues in these immature new stores will be offset by cannibalization at existing stores.  The 3.5 M level is already well below the productivity of mature stores partly because the newer stores are smaller than the average older store, but also partly because of modest cannibalization.  Although the company’s store base should benefit from maturation, I think it is prudent to assume that the company will be expanding into less productive regions and that the benefits of increased consumer awareness from having a greater store presence will be minimal-to-non-existent.  Using these store productivity levels yields 2008 revenues of $189 M (35 x $3.9 M + 15 x $3.5 M).
Next, we move on to margins.  Before the inventory allocation system blew up, but after the company’s margins were impacted by higher wage rages in Alberta, the company was running EBITDA margins of around 14 – 15%.  I think it is conservative to assume that the company will return to at least 14% EBITDA margins.  The main factor to consider that should place downward pressure on margins is the effect of store cannibalization as they build out their store base.  This, however, should be more than offset by a slew of factors that should place upward pressure on margins.  A short list of these factors includes: modest sales ramping in newer stores, advertising efficiencies from having multiple stores in adjacent markets, leverage from the fairly new Ontario DC as expansion in the eastern provinces continues, cost savings from a brand new supply chain management system, management felt that freight costs even before their systems failed were not optimized, and finally the leverage of corporate and other overhead costs that will not increase anywhere near the company’s 25 – 30% store expansion rate.  While there is obviously a lot of uncertainty as to exactly how effective the company’s new system from JDA Software will be, I think that 14% EBITDA margins should be very achievable considering the company’s prior profitability and all of the winds that will be at the company’s back to improve margins.
Taking $189 M in revenues at 14% EBITDA margins yields 26.5 M in EBITDA.  I believe that maintenance capex should be running around $600k (to put this in perspective, management claims maintenance capex for each of the years from 2002 to 2004 was only 120 – 140k).  From that I arrive at 25.9 M in EBITA (EBITDA minus maintenance capex).  FCF is simply that $25.9 M, less 1.7 M in interest expense, and reduced by a 31.5% tax rate -- which gives you $16.6 M.
The market cap (including management’s stake in the LP and is reported as a minority interest) is $59.2 M.  With $26 M in debt, this yields an EV of $85.2 M.  Because the company is structured as an income trust, they will not pay taxes until 2011.  I will spare you the details, but I have valued the present value of this tax savings using a 10% discount rate at $28.6 M.  Subtracting this from the enterprise value yields an adjusted EV of $56.6 M, which is only 2.2x my estimated 2008 EBITA.
On a FCF basis, the $59.2 M market cap divided by $16.6 M in FCF yields a fully-taxed P/FCF ratio of 3.6x.  This of course gives absolutely no value to the significant tax shield that the company will have for the next few years, and which I have valued at almost 50% of the company’s current market cap ($28.6 M).  Valuing the company at 15x 2008 FCF, a reasonable valuation considering the quality of the business and its significant growth prospects, I arrive at a value over $23 / share, over 4.5 times the current share price.
Perhaps some investors might be worried that the company’s EBITDA per store is permanently impaired and that the inventory management system is being used as an excuse to disguise an erosion in the business caused by other factors.  I believe this is highly unlikely for several reasons.  First of all, the fact that the decline in comps and profit margins has been both very sudden and sharp makes the company’s explanation of a sudden systems failure brought on by Q4 volumes greater than they’ve experienced before a very believable one.  Secondly, it is important to note that the revenue declines (which management claims are due to higher stockouts from having poorly allocated product) are actually a relatively small part of the decline in profitability.  This is consistent with the company’s explanation that profitability has been impaired by a dramatic spike in freight and labor costs associated with the reallocation of product among stores.  Furthermore, these are incremental costs that are clearly not needed by a retailer with a functioning inventory management system (you should never be shuffling product back and forth between the DC and several stores before arriving at its final destination), which suggests that assuming the company can eventually implement a proper SCM system (currently in the works) these additional costs will go away and margins should be at least as high as they were before these problems emerged.
Even with a disastrous Q4 (a quarter typically responsible for generating around 40% of EBITDA) and an average store base of around 31 stores, the company still managed to generate $13.8 M in EBITDA in 2006.  Even at this meager level of profitability, the valuation is only 4.1x trailing EBITDA and 7.9x fully-taxed trailing FCF (excluding the substantial 4-year tax shield).  As disappointing as Q4 was, the company is still generating a significant amount of free cash flow and is trading at absurdly low multiples of these highly depressed earnings.
A few other important factors that should be noted.
The fact that management has not backed away from their store growth plans shows a great degree of confidence that they will be able to rectify their inventory allocation problems.  More importantly, their confidence is not likely to be just wishful thinking as they are backing it up with a significant equity stake in the company.  The income trust has a 51% stake in the operating business, with management holding the other 49%.  The CEO alone owns 33% of the company.
Secondly, while there are risks here (as you would expect in any growth story), I believe that the sizeable margin of safety more than compensates for them.  I believe that the most notable risks are the company being unable to fix their inventory allocation problems and a failed entrance into the US market (which the company would like to enter).  Fortunately, the modest capital requirements and low store operating costs help to minimize the amount of capital that the company could potentially destroy through failed market expansions.  Also, if the company needs their debt covenants loosened at some point before the new system is up and running properly, and if lenders refuse to loosen these covenants, the company in that case may have to resort to a dilutive equity raise.  I think this scenario is unlikely, but if it occurred it would at least modestly lessen the upside potential.  Given the significant degree of undervaluation, this would be an unfortunate, but not a disastrous, occurrence.


The new system from JDA Software is implemented by Q4 and EBITDA margins return to their prior levels.
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