Michaels (MIK) is a company which operates in a special corner of retail and while the company was treated like the wider category, shares have been performing well recently. This has happened for the right reasons as its specialty has just become quite a bit more popular as of recent.
As 2020 is such a special year, my base case starts with the 2019 numbers, a year in which Michaels was seeing some troubles as lackluster operating performance resulted in real pressure on the share price amidst a very leveraged balance sheet, in itself resulting from past private equity ownership and too aggressive share buybacks.
The Base Case – 2019
Mid-March, when the Covid-19 outbreak was in full swing, Michaels reported its 2019 results. The company reported a 3.8% fall in full year sales to $5.07 billion of which half the decline was explained by a decline in comparable sales growth.
This caused real pressure on margins with adjusted operating earnings down 15% to $573 million. There are two really positive things about these margins and that is first that GAAP operating profits came in almost as high, at $515 million. Second, even based on GAAP accounting margins exceed 10% of sales, very comfortable margins, even for a specialty retailer.
With the company reporting adjusted earnings of $2.11 per share and shares starting the year around the $8 mark, it was very clear that there were large concerns with shares trading at just 4 times earnings. The reasons for that is simple and that relates to the debt load, as while the shares represented a $1.2 billion valuation at $8, net debt stood at $2.26 billion! With adjusted EBITDA of $734 million for the year, leverage ratios were pegged at around 3.1 times, yet given the negative trends were real concerns. Besides debt overhang, the concern about the business and the role of retail at large was the other overhang of course.
I noted when I looked at the shares at the time that the leverage situation is manageable, in part because the company is so profitable, but unfortunately too much money has been earmarked for share buybacks at too high levels in the past.
Ironically shares had fallen from $8 at the start of the year and traded near the lows at $1 and change mid-March when the market realised that Covid-19 might be the end of the company, as these weeks the 2019 results were actually released.
First quarter results, for the quarter ending on May 2 (and thus only including about one and half a month of Covid-19 and its measures) revealed a 27% decrease in comparable sales with revenues down $294 million to $800 million. Worrisome is that operating losses deteriorated by $162 million towards a loss of $62 million, as net debt inched up to $2.33 billion with adjusted EBITDA evaporating to a break-even result.
These results were released early June and a big momentum induced rally and some old-fashioned short covering made that shares briefly traded at $8 again at that point in time. There were some bright spots however, including a 300% increase in e-commerce sales, and the fact that 80% of stores were open in early June. Furthermore, these stores reported positive comparable sales growth numbers (as arts/craft/hobbies became more popular during Covid-19), and e-commerce finally obtained management attention which was long deserved.
Nonetheless, I concluded that the green shoots were quite aggressively recognized by the market, after all shares were trading at levels seen ahead of Covid-19 at the time already.
A Solid Second Quarter
Second quarter results, for the quarter ending on August 1, were quite spectacular if you ask me. Second quarter sales rose 11% to $1.15 billion on the back of comparable sales growth with e-commerce sales up 353%. With sales up $114 million in actual dollar terms, adjusted operating earnings rose $30 million to $105 million. On the bottom line an adjusted profit of $45 million worked down to earnings of $0.30 per share as strong inventory control resulted in net debt down to $2.0 billion. Quarterly EBITDA of $158 million results in solid earnings power, certainly in combination with the tight working capital management of the business. This provides real comfort on leverage (ratios), certainly if 2019s EBITDA can be matched or beaten.
These results have propelled shares higher to $10 now, making that they trade comfortably above the pricing ahead of the Covid-19 outbreak as investors appreciate that these results and make that more focus is on deleveraging of the balance sheet, certainly helpful as the interest bill at $150 million a year is quite substantial expense on top of the overhang which it causes on the business at large.
With shares having gained significant ground, not just from the lows but from pre-Covid-19 levels as well, I can only conclude that current momentum is solid, lack of e-commerce operations is addressed, as the same applies for the leverage situation. The issue however is that expectations have risen quite a bit and moreover that second quarter momentum might not be maintained, as the second quarter saw an uplift as a result from stimulus packages as well as a beneficial trend that many people were still working or residing at home, although management confirms that the start of Q3 has been solid, in line with second quarter trends.
That said, there is another driver and that is that management could actually decide to engage in some share buybacks, although I would not applaud that (certainly not at these levels). The fat that past private equity owners hold a bit stake in the business, in combination with a large short position creates a limited float and real room for a short squeeze certainly given the modest valuations, potential if growth continues and buybacks might be initiated as well.
Hence, I consider shares largely fairly valued here as it is quite obvious that there are very reasonable arguments to both the up- and downside, and both largely depend on the situation surrounding Covid-19 which remains highly unpredictable. Right here and now I think shares trade in a large neutral zone here, which given the above-average volatility seen in the shares, the retail sector at large and between different players, I continue to love (pair) trading in this sector!
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.