Bennett Raglin
City Trends, Inc. (Nasdaq:CTRN) is a specialty retailer focusing on low-income African American customers in the United States.
This article discusses the company’s Q1 2024 results and earnings call. The results were mixed, with a slight mix of revenue and cadence On (negative) earnings per share. Revenues grew for the second straight quarter, which is a great development. Gross margins also expanded year over year. However, the company is still incurring operating and net losses.
The article also analyzes recent developments at the company, including a shareholders’ agreement with the shareholder holding 22% of the shares and the appointment of a new CEO.
We previously covered Citi Trends in February 2024 with a Hold rating. The article contains more details about my long-term reading of the company. The Hold rating was based on deteriorating business metrics and the challenge facing the model coming from ultra-cheap retailers such as Timo and Shane. The potential discount to normalized earnings included in City Trends’ assessment was not enough to offset the risks of a fundamentally challenged model.
Today, the company’s stock is trading at a market cap 15% lower than my last article, and it has posted two quarters of revenue growth. I think a 10x EV/NOPAT multiple on a potential recovery is fair, but not low enough to compensate for the (also likely) downside scenario. For this reason, I think Citi Trends is not an opportunity today but I would reconsider below $17.15.
Q1 mixed with positive data points
The first quarter results cannot be described as good, given that Citi Trends reported operating losses. However, they do have positive data points.
The most promising data point is overall revenue, which grew 3.7% year over year (compared to 3.1%). After nearly two years of dismal results, 1Q2024 marks the second straight quarter of top-line growth (chart below ends in 4Q23).
The second positive point was the recovery of gross margins by 160 basis points, as a result of lower freight costs and lower write-offs (which means better merchandise management). This resulted in total profits rising by 9% year-on-year. Gross margin improvement is also a positive after two years of margin decline (chart below ends in 4Q23).
Unfortunately, SG&A grew 4.8%, absorbing much of the improvement in revenue and gross profit. The operating result was still negative at around $7 million (-3.75% margin). The loss narrowed from $9.5 million a year ago (-5.2% margin).
However, of the $3.4 million in top SG&A, $1.4 million came from one-time charges (which I believe are related to the CEO transition and shareholder agreements, but this was not indicated by management). If we remove these one-time charges, SG&A would have grown by 2.8%, providing some much-needed operating leverage to the company. In fact, if we remove the one-time charge, the company was close to breakeven EBITDA (-$800k adjusted EBITDA). This is a very positive development if it can be maintained in the future.
New board of directors and new CEO
In February, Citi Trends announced a shareholder agreement with Fund 1 Investments. The Fund was allowed to nominate 3 out of 9 directors proposed by the Board of Directors to the General Assembly held on June 20 (by proxy). Fund 1 owns 22% of the company’s shares as of the date of the proxy materials, and is allowed to buy up to 30% of the shares without triggering a poison pill.
This means that the company will have a board of directors with members nominated by a major shareholder in June. Citi Trends has lacked this feature in the past. I believe that having a large shareholder with a stake in the company in key governance roles is important for the long-term development of the company.
In late May, the company announced that its CEO would step down. The new interim CEO has nothing to do with Fund 1, but I think the large shareholder had some leeway to intervene in the decision. If not, a new permanent CEO may be announced after the new board is formed.
The new CEO commented on the strategic actions on the Q1 2024 call. In my opinion, the two key areas will be merchandise and SG&A efficiency. On the commodity side, he called for “putting more treasure into the treasure hunt for product options” and “sharpening the value equation.” I think this means offering products or focusing on categories that are cheaper than competing products (for example, Temu). On the SG&A efficiency front, he considered that “our total sales have declined while SG&A has steadily increased” and that “increasing sales will help, but we also need to find cost efficiencies to offset inflationary pressures.”
Scenarios
The first, more optimistic scenario is a return to pre-pandemic profitability. At an operating margin of 2.85% (average from 2015 to 2020 below), with current TTM revenues of $753 million, the company would have operating income of $21.5 million, or NOPAT of $16 million (using an effective tax rate of 25%). .
We consider fixed SG&A going forward at approximately $287 million and gross margins of 38%. Citi Trends would have to generate $808 million in revenue to generate a NOPAT of $15.2 million in this case. This represents revenue growth of 7.3% compared to TTM revenue.
Management’s guidance for the year (reaffirmed on the 1Q24 call) was for the company to post EBITDA of between $4 million and $10 million. This means negative operating margins, given that D&A is around $20 million per year (and so are capital projections). This is the middle scenario, with near-term losses and the possibility of operational profitability recovering (possibly for the second positive scenario above).
On the other hand, the pessimistic assumption is that the company cannot regain profitability in the future and that recent results have been temporarily good. Given the challenge posed by cheap retailers like Temu, who focus on the same kind of cheap, impulsive buying and treasure hunting that the company does, I think this scenario still holds great potential. The company may eventually decide to change its lineup model to avoid competing with Temu or Shein, but this is highly speculative.
evaluation
Today, Citi Trends trades at a market cap of $210 million, which, after adjusting for cash holdings of $58 million and no borrowings, implies an EV of $152 million. We can compare this to several scenarios.
In the first positive scenario (return to pre-pandemic profitability), the EV/NOPAT multiple is around 9.5x. For the second positive scenario (flat SG&A and gross margin with revenue increasing by 8%), the multiple is about 10x. Finally, there is no multiple in a negative scenario where the pattern is challenged and unrecoverable, and the value of City Trends will be low relative to persistent concerns.
I think a 10x EV/NOPAT multiple for Citi Trends is fair, and given two quarters of growth at 2/3% rates, seeing 7% revenue growth in the next two years isn’t out of the question either. However, the current electric vehicle from Citi Trends already rules out this positive scenario.
Also, as stated above, I think the probability of a negative scenario is still high. Discount retailers are not going away from online (like Temu) or B&M (like TJ Maxx), so Citi Trends has to find a niche where it can compete with lower prices than these giants. This is a difficult thing to do, but consecutive growth over two quarters is a good sign.
For these reasons, I believe Citi Trends, Inc. shares… Not an opportunity at these prices. However, with the information available today, I would consider the stock an opportunity at an EV/NOPAT of 7x for a positive scenario, coinciding with a stock price of $17.15 or less.
Conclusions
Citi Trends results for the first quarter of 2024 continue to show challenges in the bottom line but also show promise in the top line, accumulating two quarters of year-over-year growth. Revenue growth, coupled with operating leverage, is what a company needs to return to operating profitability.
From a long-term standpoint, the company needs to demonstrate its ability to offer a valuable lineup to customers who could choose other options, such as Temu (PDD) or TJ Maxx (TJX). The company’s new CEO appears to be pointing in this direction.
In terms of valuation, I think the likelihood of Citi Trends returning to historical profitability levels is not low. In this case, the company’s current EV would provide a fair EV/NOPAT multiple of 10x. However, I also believe that the likelihood of the company’s model being fundamentally challenged is also high. Therefore I suggest a higher discount on the positive scenario to bear the risks of the negative scenario.
For this reason, I still believe Citi Trends, Inc. stock is… It is a contract I would reconsider at prices below $17.15.
