Citi Trends, Inc. (NASDAQ:CTRN) is a specialty retailer focused on low-income African American customers in the US.
This article covers the company’s 1Q24 results and earnings call. The results were mixed, with a slight revenue mix and a beat on (negative) EPS. Revenue grew for the second consecutive quarter, which is a great development. Gross margins also expanded YoY. However, the company is still generating operating and net losses.
The article also analyzes recent corporate developments, including a shareholder agreement with a shareholder owning 22% of the stock and the introduction of a new CEO.
I 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 a challenge to the model coming from ultra-cheap retailers like Temu and Shein. The potential discount to normalized earnings presented in Citi Trends’ valuation was insufficient to compensate for the risk of the fundamentally challenged model.
Today, the company trades at a market cap 15% below my last article and has posted two-quarters of revenue growth. I believe the EV/NOPAT multiple of 10x on a potential recovery is fair, but not low enough to compensate for an (also probable) negative scenario. For that reason, I believe Citi Trends is not an opportunity today but would reconsider at a price below $17.15.
Mixed Q1 with positive data points
The results for Q1 cannot be called good, given that Citi Trends posted operational losses. However, they have positive data points.
The most promising data point is top-line revenue, growing by 3.7% YoY (3.1% comparable). After dismal results for almost two years, 1Q24 is the second consecutive quarter of top-line growth (the chart below ends in 4Q23).
The second positive point was a recovery of 160 basis points in gross margins, led by lower freight costs and lower markdowns (meaning better merchandise management). This led to gross profits expanding 9% YoY. The gross margin improvement is also a positive after two years of margin deterioration (the chart below ends in 4Q23).
Unfortunately, SG&A grew 4.8%, absorbing a big part of the revenue and gross profit improvement. The operational result was still negative at almost $7 million (-3.75% margin). The loss narrowed from $9.5 million a year ago (-5.2% margin).
However, out of the $3.4 million in higher SG&A, $1.4 million came from non-recurring charges (which I believe are related to the CEO transition and shareholder agreements, but this has not been indicated by management). If we remove this one-time charge, SG&A grew by 2.8%, providing some much-needed operational leverage to the company. In fact, if we remove the one-time charge, the company was close to EBITDA breakeven (-$800 thousand adjusted EBITDA). This is a very positive development if it can be maintained going forward.
New Board, new CEO
In February, Citi Trends announced a shareholder agreement with Fund 1 Investments. The fund was allowed to nominate 3 of the 9 directors proposed by the Board for the general meeting on June 20th (proxy). Fund 1 has 22% of the company’s shares as of the proxy materials date and is allowed to buy up to 30% of the shares without triggering a poison pill.
This means the company will have a Board with members nominated by a large shareholder in June. Citi Trends lacked this feature in the past. I believe having a large shareholder with a stake in the company in key governance roles is important for the company’s long-term development.
In late May, the company announced that its CEO would step down. The new interim CEO is unrelated to Fund 1, but I speculate that the large shareholder had some space to intervene in the decision. If not, a new permanent CEO might be announced after the new Board is in place.
The new CEO commented on strategic actions in the 1Q24 call. In my opinion, the two core areas will be merchandise and SG&A efficiency. On the merchandise side, he called for “putting more treasure in the treasure hunt of product choices” and “sharpening the value equation.” I believe this implies offering products or focusing on categories that are cheaper than the competition (ex, Temu). On the SG&A efficiency front, he considered that “our total sales have decreased while our 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, most 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 generate an operating income of $21.5 million, or NOPAT of $16 million (using a 25% effective tax rate).
We consider fixed SG&A going forward at about $287 million and gross margins of 38%. Citi Trends should post revenues of $808 million to generate NOPAT of $15.2 million in this case. This represents a revenue growth of 7.3% over TTM revenues.
Management’s guidance for the year (reaffirmed in the 1Q24 call) was for the company to post EBITDA of between $4 and $10 million. This would imply negative operating margins, since yearly D&A is about $20 million (and so are CAPEX expectations). This is a middle scenario, with losses in the near term and the potential for a recovery to operating profitability (maybe to the second positive scenario above).
On the other hand, a pessimistic assumption is that the company cannot recover profitability in the future and that the recent results were temporarily good. Given the challenge posted by cheap retailers like Temu, which focus on the same type of cheap, impulse, treasure-hunt buy that the company offers, I believe this scenario still holds a significant probability. The company could eventually decide to change its assortment model to avoid competing with Temu or Shein, but this is too speculative.
Valuation
Today, Citi Trends trades at a market cap of $210 million, which, adjusted 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 (back to pre-pandemic profitability), the EV/NOPAT multiple is about 9.5x. For the second positive scenario (fixed SG&A and gross margin with revenues growing 8%), the multiple is about 10x. Finally, there is no multiple in the negative scenario in which the model is challenged and irrecoverable, and Citi Trends would have a low going-concern value.
I believe a 10x EV/NOPAT multiple for Citi Trends is fair, and given two-quarters of growth at 2/3% rates, seeing revenue growth of 7% in the next two years is not impossible either. However, Citi Trends’ current EV already discounts this positive scenario.
Also, as expressed above, I believe the probability of a negative scenario is still substantial. The off-price retailers from the Internet (like Temu) or B&M (like TJ Maxx) will not go away, and therefore, Citi Trends has to find a niche where it can compete at lower prices than these giants. This is difficult to do, but the two-quarters of consecutive growth is a good signal.
For those reasons, I believe Citi Trends, Inc. stock is not an opportunity at these prices. However, with the information at hand today, I would consider the stock an opportunity at an EV/NOPAT of 7x of a positive scenario, coincident with a share price of $17.15 or lower.
Conclusions
Citi Trends’ 1Q24 results still show challenges in the bottom line but also promising results in the top line, accumulating two-quarters of YoY growth. Revenue growth, paired with operational leverage, is what the company requires to return to operating profitability.
On a more long-term view, the company needs to show that it can offer a valuable assortment to customers who can choose other options, like PDD Holdings’ (PDD) Temu or TJ Maxx (TJX). The company’s new CEO seems to point in that direction.
In terms of valuation, I believe the probability of Citi Trends returning to historical profitability levels is not low. In that case, the company’s current EV would offer a fair EV/NOPAT multiple of 10x. However, I also believe the probability of the company’s model being fundamentally challenged is also high. Therefore, I require a higher discount on the positive scenario to bear the risk of the negative scenario.
For that reason, I continue to believe Citi Trends, Inc. stock is a Hold that I would reconsider at prices below $17.15.
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