Contest: Asymmetrical Risk-Reward Opportunity With This Beaten-Down, Small-Cap Retailer

Price: $6

Shares outstanding: 50.6 million

Market cap: $303.7 million

Interest-bearing debt: $1.2 billion

Enterprise value: $1.5 billion

Ebitda: $286 million

Thesis

Tailored Brands Inc. (TLRD, Financial) is a beaten-down, small-cap company in a niche corner of the retail clothing market. The business has struggled recently and, at first glance, the company seems grossly over-levered. However, a deeper look into the fundamentals paints a different picture. I believe that the current valuation has priced in an unwarranted amount of negativity that has produced an asymmetrical risk-reward opportunity that, with a little patience, investors can exploit.

Background

Tailored Brands is the holding company that owns, most notably, Men’s Warehouse and Joseph A. Bank. It is a specialty retailer of men’s clothing and the largest men’s formal wear provider in the U.S. and Canada.

The retail stores operate under the Men’s Wearhouse, Tux, Jos. A. Bank, Joseph Abboud and K&G brand names in the U.S. The Canadian stores operate under the Moore’s brand name. Additionally, the company runs an international corporate apparel business with operations in the U.K. and the U.S.

In 2014, Josepha A. Bank made an all-cash offer to purchase all of Men's Wearhouse’s outstanding shares. The latter rejected the offer, eventually flipping the table and purchasing Joseph A. Bank with an all-cash offer of $65 per share, valuing it at about 10 times enterprise value to earnings before interest, taxes, depreciation and amortization.

Men's Warehouse raised $1.8 billion in debt to make the acquisition at roughly a 50% premium to where Joseph A. Bank's shares were trading before the original announcement. The deal ultimately proved to be a severe misallocation of capital. Less than two years later, Tailored Brands (the newly formed holding company) wrote down goodwill by $1.2 billion, completely wiping out its accounting equity. It was clear that management made a mistake and grossly overpaid in the deal.

Leadership change

Last September, CEO Doug Ewert, who was the leader at the time of the acquisition, retired. It took the board too long to get Ewert to step down and there seemed to be a significant lack of accountability by the leadership team. Fortunately, management has been revamped. This past March, the company named Dinesh Lathi as CEO and Theo Killion as chairman of the board of directors.

Lathi served as chairman of Tailored Brands since March 2017, executive chairman since August 2018 and has been a member of the company's board since March 2016. He has extensive experience in leadership roles at many major companies such as eBay (EBAY) as well as eight years in investment banking and private equity.

Killion was previously CEO of Zale Corp., where he led a turnaround effort, which included growing shareholder value by $850 million and delivering 14 quarters of positive comparable store sales. He also held senior roles at Macy’s (M) and Tommy Hilfiger. Tailored Brands believes his extensive merchandising and retail experience provides a strong complement to Dinesh’s deep e-commerce and digital background.

A look at the proxy statement also shows executive compensation is highly aligned with shareholders in that a large majority of pay comes from incentive compensation in the form of stock options, time-based deferred stock units and performance-based deferred stock units. Using Lathi as an example, about 67% of his total compensation is in the form of equity awards. If management really wants to reap the benefits of their efforts, they need to produce results.

Insider purchasing

There has also been some insider buying lately, which is a good sign that the executive team and the board of directors see value at current prices. Jack Calandra, executive vice president, chief financial officer and treasurer, bought 7,500 shares in December at a price of $13 per share. Alexander Rhodes, executive vice president and general counsel, bought 3,804 shares around the same time. Brian Vaclavik, senior vice president and chief accounting officer, bought 4,250 shares in March for around $8 per share and Carrie Ann Ask, brand president of TMW and Moore's, bought 13,500 shares in April for about $7 per share. Insiders own just over 3% of all outstanding stock.

The top line

Tailored Brands operates two segments – retail and corporate apparel. The retail segment is made up of the main brands of Joseph A. Bank, Men's Wearhouse, Tux, Moore’s and K&G and represents 92% of total sales. In 2018, the company produced $3.2 billion in total net sales, down 2% from the year prior. Operating income totaled $211 million, an operating margin of 7%.

The negative trend in sales began in 2015. Comparable same-store sales were in negative territory through much of 2016 and 2017, but they finally stabilized in 2018 when they increased across all of the major brands. Wearhouse increased 0.8%, Jos. A. Bank grew 1.4%, Moore's was up 2.4% and K&G rose 1.5%.

Unfortunately, comp sales fell off a cliff in the fourth quarter of 2018. Total sales for the quarter were $768 million, down 10.7%. Retail sales were down 9.5%.

The first quarter of 2019 wasn’t any better. Management expected earnings of 10 cents to 15 cents per share assuming negative comp sales across almost the entire brand portfolio. Tailored ended up outperforming its guidance by posting earnings of 21 cents per share, but the stock remained seemingly in a free fall as business conditions continued to deteriorate. Total sales for the first quarter were $781 million, down 4.5%, and aggregate comps declined 3.2%. Here is a look at the same-store comps broken out by each brand for the first quarter:

Joseph A. Bank= -0.7% (Guidance was -3% to -5%)

Moore’s = -4.6% (Guidance was -5% to -7%)

Men's Wearhouse = -4.5% (Guidance was -3% to -5%)

K&G= -0.5% (Guidance was 0% to -2%)

The bear case

The bears believe men’s formal wear is basically going extinct given that many corporations are moving to more casual attire. Add in pressures from online custom retailers (Amazon Wardrobe, StitchFix, Blank Label, etc.) and Tailored Brands will likely see margin pressure as it fights for market share. Losing demand and tightening margins will eat into the bottom line.

Also, who needs four suits at once these days? We’ve all seen the commercials offering 75% off storewide and the “buy one shirt and get four shirts, three suits, two pairs of shoes, two ties and a steak dinner free” advertisements (I made that one up, but you get the idea). Investors are losing faith in the value of the company's brands and are extremely fearful that the negative sales trend will continue until reaching a point as to where it can no longer support the balance sheet that is capitalized with $1.2 billion in debt.

The debt load

When looking at the debt-to-equity ratio, Tailored Brands looks extremely levered at 320 times. The reason for the excessive leverage was Men's Wearhouse's acquisition of Joseph A. Bank, which ultimately resulted in a huge goodwill write down, erasing the book value of equity. Tailored has three types of debt in its capital structure:

First, senior debt due in 2022 with a 7% coupon. There is about $228 million in senior notes outstanding and they are callable and trading near par ($95 to $97 offering about an 8% yield to maturity). In 2018, the company retired about $190 million of these senior notes.

Second, a term loan maturing in 2025. As of February, there is $891 million outstanding on the term loan facility. The rate on the term loan is Libor plus 325 basis points. According to the most recent 10K, Tailored Brands paid down about $100 million of the loan in 2018 and negotiated a 25 basis point reduction in the interest rate.

Considering where the notes are trading and the recent renegotiation on the term loan, it seems as if the bankers and bond traders aren’t too concerned about the company’s ability to repay its debt, even this late into the credit cycle.

Lastly, there is an asset-backed security maturing in 2022. The credit facility provides an extra $550 million in liquidity. With about $30 million in cash on the balance sheet, the company has ample liquidity to get through a period of deleveraging.

From a high of $1.68 billion in 2015, Tailored Brands’ debt now sits at $1.2 billion. The company still carries a speculative rating, but now the balance sheet looks a lot healthier and easier to manage.

Furthermore, when comparing the debt-to-cash flow derived from the underlying business, the picture isn’t all that bad. Debt-to-Ebitda only sits at about 4 times. If operating cash flow keeps falling, however, the debt will be more difficult to service and the situation could get dicey. As a result, investors have punished the stock.

The value proposition

First off, I agree that there are very real and present headwinds facing the business. I do not, however, believe formal wear is going extinct. This is an overreaction.

Some men still need formal attire for work, and those that don’t may need it for meetings, weddings, funerals or other special occasions. Owning a nicely tailored suit is embedded in the fabric of American culture, so I don’t see that completely being phased out.

It is also true that online retailers are a threat, but formal wear is not something most men will typically buy online. Nice clothing is intended to fit appropriately and, oftentimes, the clothing needs to be tailored. The numbers back this up as Tailored Brands’ custom business more than doubled in 2018 to over $220 million. Management noted on the call that in 2019 they are averaging over $6 million per week in custom sales. This would result in $312 million in sales for the year. I expect the negative trend to stabilize as the company reinvests in the business.

Cash flow

In 2018, Tailored Brands generated $320 million in cash flow from operations, $286 million in Ebitda and produced net income of $83 million. Over the past five years, excluding any one-time adjustments, the company has been able to generate about $250 million in Ebitda annually. Last year, interest expenses came in at $80 million, putting interest coverage at 3.1. With $80 million in capital expenditures, the company was left with $240 million in free cash flow.

The underlying business produces relatively strong free cash flow that can be used to continue to pay down debt, reinvest to improve the business and even pay shareholders a dividend. This should help both the company and its shareholders weather the retail storm.

The dividend

The company has paid a quarterly dividend of 18 cents and an annual dividend of 72 cents per share since 2012. It distributes about $37 million in annual payouts to shareholders.

Tailored Brands' dividend payment represents only 15% of the $240 million in free cash flow it produced in 2018. At time of writing, the company is paying out roughly a 13% dividend yield.

On the first-quarter earnings call, management said they are very comfortable with the level of dividend they are paying when looking at the current cash flow and liquidity and that returning cash to shareholders is an important part of their value proposition. On June 24, management went even further to show confidence in their liquidity by confirming the dividend payable in September.

It seems like most investors believed a dividend cut was in the cards and the price jumped 8% on the announcement. With that said, given the difficult retail environment, a dividend cut may be prudent and the cash better used to pay down debt. In the meantime, this is not a bad return.

Valuation

The business is currently priced at half of its 2018 revenue with sales of $3.2 billion and an enterprise value of $1.5 billion. Using the trailing 12-month numbers, the enterprise value-Ebitda ratio is 5.2, the price-earnings ratio is 4.8 and the price-free cash flow ratio is 1.7. The stock is cheap for a reason, but at these price levels I see more room to the upside rather than the downside.

Here is a look at Tailored Brands compared to a handful of its competitors for context. Note there are not many publicly traded companies that explicitly focus on men’s formalwear – another reason I do not see the company going bankrupt.

I see a significant margin of safety when using extremely pessimistic assumptions in my free cash flow model as well. I used a two-stage free cash flow model to value the operating assets of the company and then incorporated the balance sheet.

I assume that sales fall by 10% in 2019 and then 7% annually over the next four years. I also assume the company never returns to growth (0% perpetual growth) in the long run. I then decrease the free cash flow margin to account for increased competition and tighter margins, ultimately reducing free cash flow by about $100 million to $145 million in 2019. Discounting these cash flows by a 7% weighted average cost of capital that gradually increases to 9% to account for the reduction in debt, results in a $1.8 billion valuation for the operating assets. Note that even with such a dramatic outlook on free cash flow, the debt remains serviceable. After incorporating the balance sheet, the result is a fair value of $15.72 and a margin of safety over 160%.

Catalysts

There are three main catalysts to propel the stock price higher. The first is the 13% dividend yield. We’ve already seen the impact the announcement confirming the September dividend had on the stock price. I expect the dividend will provide a floor to the stock price and entice investors as the business’ cash flow generation becomes evident in the coming quarters.

Second is an improvement in fundamentals and a stabilization of the sales decline. If the management team can execute the turnaround, the custom clothing line continues to grow at a fast pace, or the business simply is not in as much trouble as investors think, then the share price should increase given how much pessimism is priced into the stock.

The third catalyst is the possibility of a short squeeze. Roughly 20% of the tradable stock is currently sold short. Buying back stock to take profits or to cover their position if the business stabilizes may create significant demand for shares of Tailored, sending the stock higher.

Disclosure: The author has a position in Tailored Brands.