Cato Corp (CATO) May 19, 2011
Diluted Shares Out: 29.5 million (April 2011) [27.7 million class A + 1.7 million class B]
Market Cap: $776 million
Net Cash: $261 million (April 2011)
EV: $546 million (estimated)
CATO SELECTED FINANCIALS 2002 – 2011
|Fiscal Year||Sales||Op Income||Net Income||Diluted EPS||OCF||Capex||FCF||DPS||Shares|
Note: All figures in millions except for EPS, DPS.
The Cato Corporation operates as a fashion specialty retailer for fashion and value conscious females principally in the southeastern United States. Its stores offer an assortment of apparel and accessories, including dressy, career, and casual sportswear; dresses; coats; shoes; lingerie; costume jewelry; and handbags. As of January 29, 2011, the company operated 1,282 women’s fashion specialty stores in 31 states under the Cato, Cato Fashions, Cato Plus, It’s Fashion, and It’s Fashion Metro brand names. The Cato Corporation also provides its own credit card and a layaway plan for customers to purchase its merchandise. The company was founded in 1946 and is based in Charlotte, North Carolina. Their mission as per their facebook page is “New fashions every week. Low prices every day.”
The company’s primary objective is to be the leading fashion specialty retailer for fashion and value conscious females in its markets. The key elements of the company’s business strategy are:
Merchandise Assortment. The company’s stores offer a wide assortment of trendy apparel and accessory items in primarily junior/misses, plus sizes and girls sizes 7 to 16 and emphasize color, co-ordination and selection.
Value Pricing: The merchandise is priced below comparable merchandise offered by department stores and mall apparel chains.
Strip Shopping Center Locations: The stores are located in convenient strip centers anchored by national discounters such as Walmart (WMT) or market dominant grocery stores that attract large number of potential customers.
Credit and Layaway programs: The company offers its own credit card and a layaway plan to make the purchase of its merchandise more convenient for its customers.
The company purchases merchandise from approximately 1,500 suppliers but most of the merchandise is purchased from 100 primary vendors. The company purchases most of its merchandise from domestic importers and vendors which typically minimizes the time necessary to purchase and obtain shipments in order to enable the company to react to merchandise trends in a more timely fashion.
All merchandise is shipped directly to the company’s distribution center in Charlotte, N.C. Merchandise is inspected and allocated for shipment to individual stores. Shipments are made by common carrier and each store receives at least one shipment per week.
Most of the stores are located in southeastern United States in a variety of markets ranging from small towns to large metropolitan areas. Stores average approximately 4,000 square feet in size. All of the stores are leased with 96% located in strip shopping centers and 4% in enclosed shopping malls.
Profitability of the business
|TTM||FY 2009||FY 2008||FY 2007|
Balance Sheet (as of April 2011)
· CATO has an excellent balance sheet with $261 million in cash and short term investments.
· Receivables stood at $40 million and Inventories at $125 million.
· No short term- and long-term debt.
A significant portion of the inventory is purchased from foreign suppliers; cost of goods sold is affected by the fluctuation of the local currencies where the goods are produced against the dollar. No details were provided as to the potential impact of currency.
CATO is a consistent dividend payer with dividend history since 1998 on its website. In March 1998, CATO paid a quarterly dividend of 4.5 cents per share and paid $0.19 in the year 1998. Dividend per share has increased consistently to the current annual rate of $0.74 in 2010. The dividend is well covered by free cash flow and dividend payout ratio is about 38%. At current price of $24, the dividend is a healthy 3% yield. The five-year annual dividend growth rate is 7.6%.
Retail Specific Data
|Year||Revenues (in $million)||Gross Margin||Sales per Sq feet||Store Count||SSS|
Gross Margin: The annual gross margins have been pretty consistent over the years and recently have improved from an average of 33.5% to 39%.
Sales per square feet: This is an important metric for retailers and shows the efficiency of the stores. This metric has been trending down over the years and has been recently stagnant around the $165/sq feet. This shows the business is steady but is not a concept that will grow sales per square feet. I assume the increase in sales will come from increased store count.
Store Count: Store count has increased steadily over the years except from 2007 to 2009 the store count actually reduced by 48 stores or 4%. However, it does seem that management plans to open more stores compared to the number of store closures. This should help increase the top line.
Same Store Sales: CATO releases monthly, quarterly and annual same store sales. There is a lot of variation when you look at monthly and even quarterly SSS. However, on an annual basis there is not so much variation. The last two years have been pretty good in terms of SSS at +3%.
|Apr 2011||+17% (due to shift of Easter Sales to April)|
|Mar 2011||-9% (due to shift of Easter Sales to April)|
|Apr 2010||-7% (due to shift of Easter Sales to March)|
|Mar 2010||+24% ( due to shift of Easter Sales)|
Experienced and Long duration
Mr. John Cato, 59, has been employed as an officer of the company since 1981 and has been a director of the Company since 1986. Since January 2004, he has served as chairman, president and chief executive officer. From May 1999 to January 2004, he served as president, vice chairman of the board and chief executive officer.
Mr. John R. Howe has been employed by the company since 1986. Since September 2008, he has served as executive vice president, chief financial officer.
Ms. Sally Almason has been employed by the company since 1995. Since April 2009, she has served as executive vice president, general merchandise manager for the Cato division.
Mr. Michael T. Greer has been employed by the company since 1985. Since May 2006, he has served as executive vice president, director of stores of the company.
Mr. Howard A. Severson has been employed by the company since 1985. Since January 1993, he has served as executive vice president, chief real estate and store development officer.
Low Insider Ownership
Management ownership with the exception of Mr. John Cato is quite low. As per the 2010 proxy statement, all directors and executive officers as a group only owned 385,344 shares which amount to 1.3% of total shares. Mr. Cato due to his ownership of the entire class B shares has a 6.7% equity stake.
Why is the price cheap?
· Dual share class structure: As of March 30, 2010, CATO had 27.8 million shares of class A common stock and 1.74 million shares of Convertible Class B Common stock outstanding. Holders of Class A Stock are entitled to one vote per share and holders of Class B Stock are entitled to ten votes per share. John Cato owns the entire 1.74 million class B shares and 212k class A shares which entitles him to 39% of total voting power while owning 6.7% of actual equity stake.
· High CEO compensation: John Cato who is the founder, chairman and CEO commands a high salary of about $1 million. His total compensation for years 2007-2009 was $1.7 million, $2.7 million and $3.7 million.
· Low analyst coverage: As per CATO’s website, only two analysts cover the company.
· Recent SSS: CATO reported flat SSS for Dec 2010 and negative 4% for Jan 2011. Several other retailers reported positive SSS for the same period. This may be a reason for the recent share price drop. [ Refer : http://retailindustry.about.com/od/statisticsresearch/a/January-2011-Same-Store-Sales-Figures-Complete-Us-Retail-Industry-Comps-List.htm ]
· Boring company: CATO does not have a sexy growth profile. No stores in California and very few in New York means not many analysts would have spotted a store.
· Low growth profile: CATO has not been able to grow sales at a fast clip compared to other popular retailers like American Eagle, Aeropostale, etc.
At the current price of $26.39 and TTM EPS of $2.15, CATO appears reasonably valued trading at a TTM P/E of 12.3. However, if we back out the significant cash balance of $261 million ($9 per share), we arrive at a cash-adjusted P/E multiple of 8.1.
Since EPS/Net Income of CATO has not increased in a straight line over the years, I also considered the average EPS of CATO over the last 5 years which was $1.35 and divide into the stock price, I arrive at a P/E of 19 and if we back out the cash and use the average EPS, we get a P/E of 13.
Since CATO has so much cash, I also consider the EV multiples. CATO has about $261 million in cash on its balance sheet out of a market cap of $776 million, giving an Enterprise Value of $546 million. FY 2010 Operating Income was $87 million and TTM number after Q1 is $95 million. Using the TTM Op Income, I get a 5.8x EV/Op Income multiple. Average Op. Income over last three years was $66 million. CATO is trading at 8.2 times this average op. income.
On an EV to FCF basis, CATO is trading at about 9x the FY 2010 FCF. The average FCF over the last five years was $58 million, CATO is trading at about 9.4 times this average FCF which is quite cheap.
|Enterprise Value||$600-650 million||$660- $715million||$720- $780 million|
|Expected share price||$30 - $31||$32- $34||$34 – 36|
Calculation = Market Cap = EV + net Cash.
The estimated valuation range is $30-$36. If we take the $33 as the target price, we would need to buy shares at 25% discount to have a decent margin of safety. That means a $25 price as the target purchase price. And here we are not talking about 15x FCF. At 15x FCF, CATO would be worth $900 million ($1150 market cap) and $39/ share.
Using CapitalIQ to look at historical valuation of CATO, I find that from 2006 to 2011, the average EV/ EBIT has ranged from a low of 6.8x EBIT to a high of 9.8x EBIT. The average EBIT multiple over these years was 8x. The current valuation of 5.8x EBIT is much below the average valuation.
If the EV/EBIT were to return close to the average, then the possible stock prices could be:
|EV/ EBIT multiple||7x||8x||9x|
|Using current EBIT $95 million||$32||$35||$38|
|Using 3 yr avg EBIT $65 million||$25||$27||$29|
From this table, $25 is the low end of the valuation if the EBIT were to drop from TTM $95 million to a three-year average of $65 million. I consider $25 as the margin of safety price.
On the high end, the range is from $32-$38. To buy shares at a 25% discount of the mid-point ($35) and have a decent margin of safety, a $26 price would be the target purchase price.
DCF: To see what is implied by current stock price, I employed a DCF with 1% FCF growth rate, discount rate of 12% and starting FCF as $60 million to arrive at current stock price of $24.
If I used a reasonable 5% FCF growth rate, discount rate of 12% and starting FCF as $60 million, I arrive at an intrinsic value of $28 which would represent only a 13% MOS. In order to have atleast a 25% MOS, recommended buy price is about $20-$21.
Valuation based on recent transactions
· Bain Capital Fund X, L.P. of Bain Capital Private Equity signed a definitive agreement to acquire Gymboree Corp. (NasdaqGS: GYMB) for $1.8 billion in cash on Oct. 11, 2010. for an implied EV/ EBITDA of 7.7x, 9.4x EBIT and 16.4x Net Income
· Leonard Green entered into a definitive agreement to acquire Jo-Ann Stores for $1.6 billion in cash on Dec. 23, 20010, for an implied EV/ EBITDA of 7.4x, 10.2x EBIT and 17.9x net income.
· TPG Capital through its fund TPG Partners VI, L.P., Leonard Green & Partners, L.P. through its fund Green Equity Investors V, L.P. and Millard Drexler, chairman of the board and chief executive officer, entered into a definitive agreement to acquire J. Crew Group Inc. (JCG) from Millard Drexler and other shareholders for $2.8 billion in cash on Nov. 23, 2010. The deal implies a valuation of 8.4x EBITDA, 9.9X EBIT and 17.6x net income.
Using the above multiples on EBITDA and EBIT, we would get the following EV and stock price for CATO.
|Metric||EV||Stock Price Range|
|EBITDA||$740 - $840 million||$33 - $36|
|EBIT||$790 - $860 million||$35 - $37|
CATO currently has a EV of $546 million and trades at 4.7x EBITDA and 5.8x EBIT. While CATO does not have the same profit margin and sales growth profile as the companies that have recently been acquired, the current multiples represent a large discount to the acquisition multiples paid. If you consider the low end of the valuation of $740 million from the above table, the current EV sits at 66% of valuation. This represents a meaningful discount. Using the lowest stock price of $33, a purchase price of $25 would represent a 25% discount to potential acquisition price.
Most of the Comps are struggling to survive (forget profitability). Despite that, CATO is the most attractively valued on most measures.
Stock Repurchase Program: In Fiscal 2008, the company repurchased 199k shares for approximately $2.4 million. Continued buyback activity could act as a catalyst.
Increasing dividend: The dividend per share has steadily increased over the years. Continuing this policy of a dividend increase could re-rate the shares higher.
Private Equity Buyout: There has been a spate of recent acquisitions in the retail space. An offer for a buyout could increase share price.
· Margins at risk due to increased sourcing costs/high cotton/ transport costs
· Reduced sales due to consumer retrenchment and continued high unemployment.
Cato Corp is a well managed specialty retailer. CATO is conservatively managed and sports a solid balance sheet where cash makes up 34% of the market capitalization. CATO produces consistent free cash flows and has been steadily profitable over the last decade. CATO is also share holder friendly and pays a healthy dividend yield of 3% which is well covered by cash from operations. The dividend has grown at a five-year annual growth rate of 7%. Valuation of CATO @5.8x TTM EV/ EBIT is quite compelling.
Disclosure: This is not a recommendation to buy or sell any security mentioned in this article. Please do your own research. The author of the article did not have any position at the time of writing.
About the author:Motiwala Capital is a fee-only independent, investment management firm based in Irving, Texas. We invest in public securities primarily listed in the United States. We manage separately managed accounts. You are welcome to read our Letters to clients and also check out our blog.
Adib Motiwala is founder and owner of Motiwala Capital LLC. Adib Motiwala received his MBA from the Univerisity of Texas at Dallas. He also has a Masters degree in Computer Science from Texas A&M University.