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Michaels has a shrinking core business typical of brick and mortar retail
Much has been written about declining brick and mortar retail businesses. This isn’t meant to be a repetitive discussion of deep value on the bull side versus terminal decline on the bear side. I am focusing on how I expect the market’s expectations for Michaels to evolve over the next 3 months and will largely focus on that, but I will briefly touch on Michaels (MIK) historic financial performance.
Over the past 5 years, Michaels has seen steadily deteriorating profit margins and declining revenues since 2018 as the store count shrinks:
Source: Compiled by author
A trailing P/E of 6.25x should not give investors much comfort as EPS continues to decline. The trailing P/E traded as low as 2.5x in 2019, so it can certainly go lower than where it is today. If you are a true long term investor in Michaels, I would argue that you need to see a path to improving EPS and this would have to come as a result of a combination of the following:
- Improved gross margins. Michaels would either have to raise prices (unlikely as they are trying to compete with online competitors) or their cost on their largely southeast Asia sourced imports would need to come down.
- Revenue growth via increased same store sales or net new store openings. Michaels did actually end FY 2019 with an increase in store count, but did not achieve revenue growth.
I don’t feel particularly strongly for the outlook on these two items.
Outlooks for the critical holiday season is far too rosy
Michaels reported a year-over-year drop in revenues of 27% for their first quarter ending April 2020. The quarter was mired by stores shutting down in response to COVID-19 as well as sales likely being diverted to A.C. Moore’s liquidation of their 150 east coast stores (more to come on this).
A bullish argument being made for Michaels is that lock-downs have driven people into embracing stay-at-home friendly crafting hobbies. During their earnings call, management noted that they had seen 11% same store sales increase in the month of May for stores that have re-opened. But I fail to find 11% comp growth to be very impressive when it is off the back of a quarterly 27.6% decline. On the question of the sustainability of the move, management had this to say:
I mean, how sustainable it is, is unknown. If it’s some craft pantry loading, clearly some benefits from the stimulus checks. And so just some basic pent-up demand, I believe. We’re monitoring it on a daily basis. But we know we’re not providing any back half guidance on how we think it’s going to continue or not continue, but we are encouraged with the reopening start for sure.
-Source: Michaels Q1 earnings call
I highly doubt that COVID-19 is creating a new generation of crafters and sewers that will be looking forward to sheltering indoors once we successfully re-open the economy. But the sell-side seems to think revenues are all clear for Michaels from here on out:
Source: Compiled by author
Holiday season ahead
The above table showing quarterly revenue and EBITDA makes clear how important Q3 and Q4 are to Michaels’ business. That is because a very large amount of their sales comes from fall and winter holiday related activities and decor (Halloween, Thanksgiving, and Christmas).
Now that we are in August and Labor Day is right around the corner, the media and businesses will quickly be turning attention towards flu season, fear of a second/third COVID-19 wave, and the holiday season.
One of the first alarm bells was raised by Hersheys:
Hershey Co. (HSY) said subdued Halloween celebrations this year as a result of the coronavirus pandemic could hurt candy demand during a holiday that typically generates a tenth of its sales.
-Source: Wall Street Journal
Walmart has already announced that they will be closed on Thanksgiving day. How many parents will be letting their kids go trick-or-treating (even when wearing a full costume mask)? How many holiday themed parties will people be attending? How many “Friendsgivings”? How many families are going to go all out decorating for Christmas when no one is coming in town and no one is making the trip to visit grandma? We’ll also be entering cold and flu season and folks will not be permitted to enter a store if they have a sore throat or the sniffles.
While we all want a return to normalcy, the media and bureaucrats have an interest in perpetuating crisis mode. I think it is a bit naive to think that “experts” wont be tripping over themselves to warn about the huge risk of anything that smacks of fun this holiday season. Yet the sell-side believes that Michaels will be selling nearly the same amount of costumes, yard signs, Christmas lights, etc. I think Michael’s P&L could be in for a rude wake-up call.
Liquidations flooding the crafts market
This past November, east cost based crafts retailer A.C. Moore announced that all of their 150 retail stores would be liquidating. The process ran from late November through Q1 of 2020. Then more recently, Tuesday Morning (NASDAQ:TUES) filed bankruptcy on May 27th and has since announced the closing and liquidation of 130 of their 680 locations, with plans to close 100 more. Tuesday Morning has hired Great American Group as their liquidator and has stores in 40 states.
Conventional wisdom would look at this situation and think that it would play out as follows:
- Competitor closes stores and temporarily takes sales from surviving business via their liquidation.
- Surviving business now has less competitors and will get more sales after a temporary lull.
Here is how it will likely work out for Michaels:
- Competitor closes business because it is in structural decline, even before COVID-19.
- Competitor liquidates inventory of crafts, decor, fake flowers, etc. at rock bottom prices. Inventory comes from all 150 stores plus a 760,000 square foot warehouse (roughly 17.5 acres) that is packed floor to ceiling with the same inventory of Halloween costumes, paint brushes, etc. These warehouses have racks that are three stories tall.
- As liquidation progresses, prices are slashed further and further to offload every last piece of inventory. Buyers now have enough water color paint and fake flowers to last them a very long time.
- Rinse and repeat with Tuesday Morning which will be liquidating as much inventory as possible to raise desperately needed liquidity (although they have sales/inventory outside of crafts and decor). It is still possible that the entire firm will transition to a liquidation.
- After all is said and done, your business is still in structural decline.
AC Moore warehouse:
A.C Moore and Tuesday Morning are much smaller companies than Michaels, so this isn’t to say that they are going to cut into Michaels’ sales by +30%, but I do think the head-wind will last longer than people generally expect.
Q2 Macro Outlook
The sell-side is currently expecting revenues in Q2 (May, June, July) to bounce back 26% from Q1’s levels. This would amount to only a 2.2% decline YoY for Q2, roughly in-line with the decline experienced by Michaels YoY in Q2 2019.
While not apples to apples on months, it is widely expected that US GDP will bottom in Q2 2020.
Keep in mind the GDP figures presented above annualizes quarterly results, but regardless, its going to be a tough quarter. Does retail sales data give us reason to believe in a 26% recovery? Below is the actual macro data for retail sales through June with the categories that I felt most closely resembled Michaels’ business, with sports goods, hobby, book, and music stores being the best proxy. Since July results are not available yet, I am using July 2019 as a “back to normal” estimate.
Source: Compiled by author from FRED advanced monthly retail sales data
We see a clear trough in April and a strong rebound in May and a further rebound in June. It is entirely possible that the rebound gets even stronger in July, but it would have to be a significant acceleration to push May through July retail sales figures meaningfully above February through April. July also witnessed a stalling out in the trend of decreasing continuing jobless claims as the week ending July 18th saw a ~6% increase in claims from 16.2M to 17.1M The macro data is not particularly supportive of a 26% recovery for Q2 revenues.
Tying it together
Michaels business is clearly structurally challenged. One of their main competitors failed even before the COVID-19 crisis was upon us. After a near 27% revenue decline in Q1, I think any Q2 benefit from folks stocking up on crafts will be minimal, especially as re-opening efforts hit pause or even reversed in large portions of the country. I then expect a terrible holiday season for them as unemployment stays high, concerns about in-store shopping linger going into cold and flu season, and most importantly, they experience depressed demand for holiday themed decor. Their liquidating competitors have also soaked the market with a great amount of cheap inventory that will satisfy a portion of customer demand.
Expectations and trading position
I expect Michaels to announce disappointing Q2 results when they report (likely in early September) and I believe by that time investors antennas will be raised towards the possibility of a very disappointing holiday season for Michaels’ crafts and decor. My price target on the subsequent sell-off would be $5.00, where the stock has found support before, for a 30% sell-off. If the stock fails to hold $5.00, the 200 dma sits near $4.50 and I would expect some level of support at obvious price levels, e.g. $3.50, $3.00, etc.
I would re-think my thesis if Michaels traded back above their June high of $8.86 or if it started looking that we could have a normal holiday season.
Disclosure: I am/we are short MIK. 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.