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The Cato Corporation (CATO): a Value Play
The Cato Corporation is an apparel retailer whose successful turnaround was interrupted by the pandemic.
In 2019 they were gradually recovering from a period of underperformance, with more favorable trends in terms of same-store sales and merchandise margins, inventory control and profitability.
The potential upside is huge in case of the Company being able to recover pre-pandemic levels (150%+ upside under conservative assumptions)
Additionally the Company presents a strong balance sheet, with excess cash, no financial debt and “hidden” assets; and a business profile that could help to better overcome a potential crisis.
The Cato Corporation (CATO) is a retailer of value-priced fashion apparel and accessories. I do know that this may be enough for many people to stop reading this article. Don't be discouraged! This is a really interesting risk/reward opportunity (and in any case the article is reasonably short).
In that sense, let me be clear from the very beginning and reiterate the title of this article: this is a value play. And being a value play (as opposed to a quality investment) the focus moves more to concepts like price or margin of safety, instead of thinking about growth expectations, competitive advantages, moats or this kind of “quality” stuff. The idea is pretty clear here: does make sense what is embedded in the current stock price? Or maybe the market has gone too far and there is an opportunity here.
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Margin of Safety (some sort of)
Look at the following table:
CATO is a company with a strong balance sheet, with $127M in cash plus short-term investments and no financial debt. This is not technically a margin of safety (i.e. market price significantly below intrinsic value), but in some sense reduces the real price paid for a stock (as part of this price equates to cash and short-term investments), making easier for the intrinsic value to be above this real price.
Additionally, the Company holds some land for investment that makes its balance sheet even more resilient. I am not going to spend too much time on this. There is a really interesting article in Seeking Alpha from Nicholas Bodnar (Gate City Capital) where he makes a deep dive on these real estate holdings. I also recommend this interview of Andrew Walker (Yet Another Value Channel) with Mike Melby, founder and portfolio manager at Gate City Capital, where they deeply discuss the Company.
From my side, just minor context. This land held for investments come from an acquisition carried out by CATO in 2012, with plans to build a distribution center. However, in 2015 they finally decided to create a joint venture with Lincoln Harris, a real estate company, to rezone the site and develop office, retail, residential and hotel spaces. In 2020 the first selling operation of a small part of this project took place and CATO recorded a profit of $2.3M: the Company sold $0.9M of land held for investment and recorded a profit of $2.3M, so this means a selling price of $3.2M or more than 3 times its book value.
Making a rough extrapolation, the remainder part of this land held for investment might be worth much more than its book value (~$30M vs $9.3M book value) and this would imply that the current enterprise value would be close to zero. In other words, the market is valuing CATO´s core business at almost zero. Does this make sense? Let’s see.
The Core Business
As commented at the beginning of this article, CATO is basically an apparel retailer and currently operates 1,264 stores across 32 states. It was founded almost 80 years ago by the father and the uncle of the current CEO, and operates through three apparel concepts: Cato, It’s Fashion and Versona.
As many other retailers, the Company has been living in a rollercoaster since the beginning of the pandemic, with a challenging 2020, an artificially-stimulated 2021 and now suffering with the pressure over customer’s discretionary income.
It’s rather difficult to predict what the short-term behavior of the Company will be. It seems that 2023 is still going to be a challenging year and probably CATO will keep suffering the consequences that higher interest rates and inflation have over discretionary spending (or even a potential worsening if finally this instability is transferred to unemployment rates). This recent business volatility makes rather complicated to make a meaningful analysis or to understand where the business is heading in the following quarters. However, in my opinion, for long-term investors those are not the relevant points.
Thinking with a longer-term perspective, there are two key questions that I think should be answered. First of all, would the Company be able to overcome a potential crisis and, if it finally happens, would it be able to do that without penalizing its shareholders (i.e. share dilution)? I think this question has been already answered in the previous paragraph: CATO’s financial position seems strong enough to get through a potential crisis without excessive problems.
The second question is about how the company could emerge from a potential crisis and how it would perform under a more normalized environment. In that sense, it might be useful to have a look at the pre-pandemic period, where we could obtain more meaningful hints.
As we can observe in the chart at the beginning of this paragraph, CATO was almost continuously growing its sales at least since the turn of the century till 2015, being profitable each and every year, even during the burst of the Dot.com bubble or during the Great Financial Crisis.
Since 2016 the Company started a declining period as a consequence of “changing consumer buying habits affecting the entire retail industry, as well as internal merchandising missteps”. In other words, the Company seemed to have difficulties adapting to the new digital/omnichannel environment and at the same time its merchandise was losing popularity and relevance.
In order to turn around the business, the Company took some actions specifically aimed at improving its merchandise, mainly the launching of a new internal design team and the implementation of sourcing offices in Asia in order to have a better control and flexibility in the manufacturing process. Additionally, the Company also started a store rationalization process, getting rid of unprofitable stores and reducing its footprint. As a result of these measures CATO bottomed out in 2017 and started a gradual recovery in 2018, which continued in 2019, as it can be observed should we zoom in on those years:
Looking at these charts we can see that CATO was recovering its luster when the pandemic hit the economy. The store rationalization process was starting to bear fruit and the Company seemed to be again reconnecting with its customers with a renewed focus on product and merchandise assortments. Despite the reduction of sales and store footprint, CATO was increasing its profitability levels on both an absolute and per-store basis, with more favorable trends in terms of same-store sales and merchandise margins, and improved inventory control. There was still a lot of work to do in order to recover pre-2016 levels, but there is no doubt that the Company was regaining some lost ground.
Additionally, this is a company with a loyal customer base and with a strong focus on value and this confers with a resilient business model that could help to better overcome uncertain macroeconomic environments. As macroeconomic concerns and consumers’ pressure have both increased, its diversified assortment and value proposition put CATO in a relatively advantageous position compared to other retailers.
In summary, and trying to answer the second question, even when there is no doubt that CATO would be harmed in case of a potential crisis, there are currently no specific issues that invite to think that this Company, once the discretionary spending starts to recover, will not return to the recovery path initiated before the pandemic.
In order to understand how undervalued this company is, let’s make some rough calculations:
The idea of this chart is to use 2017 EBIT (bottom year) and 2019 EBIT (recovering year) in order to have an estimation about a potential intrinsic value of this Company. The chart uses 5x and 10x EV/EBIT multiples, which are basically the top and bottom of the range where CATO was fluctuating during the last 20 years. Additionally in this valuation the land held for investments has been disregarded (i.e. valued at zero).
As we can see, even if we take a disastrous year, like 2017, and the lowest multiple (5x) there would be some upside (11%) from the current valuation. If we take a more optimistic approach (2019 EBIT and 10x multiple) the upside would be much more interesting and we would not be using excessively optimistic variables (i.e. far from ~$60M EBIT 2000-2019 average).
But what could we consider a (conservative) base case?
This valuation uses 2019 EBIT and the mid-point of the EV/EBIT multiple range (7.5x), and values the land held for investments at book value ($9M). Once consumer spending restarts, those EBIT levels should be more-than-achievable and the multiple is far from being tight. In this case the upside would be 155%, which is a pretty interesting risk/reward opportunity, but with a lot of additional upside in case of the Company being able to recover the cruising speed of its turn around, interrupted by the pandemic, and to sell additional parts of the real estate project.
Some Negative Aspects
Apart from the main one that is that we are in front of an apparel retailer at the onset of a potential crisis (even though a relevant part of this contingency might be already embedded in the price), there are two points that deserve to be highlighted.
The first one is closely related with this nature of the Company as part of a mature industry and dependent on discretionary spending, and it is the lack of specific catalysts that could generate a relevant change in investors’ perception. The valuation of the Company will change with the market sentiment. It is not expected the Company to make meaningful changes in its activity or way of doing business, so it is not expected any specific issue that could make a sudden and explosive change in the valuation. In other words, this investment will probably require patience.
The second one is the relevant interest of the principal shareholder and CEO, John P. D. Cato who, according to the last Proxy Statement, beneficially owns approximately 14% of the shares but 51.7% of the voting power. Till now this has not been an issue for the Company but clearly this makes even more difficult any event that could meaningfully change the Company’s valuation, as for instance corporate transactions or activist investors jumping in.
As commented all across this article, this is a pure value play. This is a mature business, apparel retail, brick-and-mortar, don’t expect fireworks here. However, this is a long-tenured business, that has already successfully navigated previous crisis, that presents a strong balance sheet and “hidden” assets to buffer potential business-climate deterioration, and that was doing a good job in the pre-pandemic period to turn around its declining situation. In other words, this is some sort of bet on mean reversion once the discretionary spending returns to more normalized levels. This is a cyclical business potentially navigating the most difficult moments of the cycle (or at least the most difficult moments in terms of “financial-markets cycle”, which tend to anticipate real markets) which represents one of the best risk/reward opportunities I have found during the last months.
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