Cabot Small Cap Confidential 267

Among all the small-cap stocks I’ve studied in recent weeks one keeps jumping out at me. In fact, I’ve been eying it since March. It’s time to act.

This stock is different in virtually every respect from our typical stock. It’s not high tech and growth isn’t off the charts. That’s because it’s a value stock.

I think once you read my report you’ll “get it.” And in a year or so I believe this stock will be trading 50% to 100% higher than it is now, meaning it could offer the same upside potential as growthier names.

Enjoy!

Cabot Small Cap Confidential 267

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The Big Idea
Covid-19 has changed the way we live and work, what we do for activities, and how we interact with friends and family. Some changes will be transient, while others will hang around for a while.

Two notable trends that should have staying power are relevant to this month’s stock selection.

First, more people have been looking for opportunities to make money working from wherever, and at whatever times, they want.

Second, more people have picked up hobbies and/or are spending more time and money on hobbies they’ve reengaged with. According to a Bank of America survey, number three on the hobby list is arts and crafts, including sewing (home improvement projects and cooking/baking were first and second, respectively).

While vaccinations and economic re-openings have driven people to resume travel, dining and social activities, crafting levels remain much higher than they were before the pandemic. And the resurgence in Covid-19 infections and the looming fall and winter season is, in my view, likely to inspire another uptick in crafting and sewing interest over the next nine months.

To be clear, it isn’t just the ladies over 50 - the historical core customer - who have been driving the wave of craft spending. Industry executives say that while the pandemic inspired many experience crafters to reconnect with their hobby, it also brought in a new wave of enthusiasts too. Nearly 30% of these folks are under 30 years old, while just over 50% are 30 to 60 years old. In other words, everybody is crafting!

These enthusiasts are out there making things for friends and family members, doing projects with their kids, building businesses on Shopify (SHOP), Etsy (ETSY) and eBay (EBAY), and just messing around for their own enjoyment.

The punchline is that a previously very slow-growth industry (1% to 2% a year) had a once-in-a-generation growth spurt during Covid-19. The new wave of crafters and sewers now has more equipment and more knowledge, and they’re going to propel a stodgy industry to grow a little faster (but still slow as compared to most other industries we invest in) for years.

This is creating an opportunity in what looks like the best-in-breed arts and craft and sewing supply retailer. We already saw Michaels Arts and Crafts get taken private (again) by Apollo Global in March, at a price nearly 50% above where it was before rumors began to circulate about the deal.

The remaining public player is arguably more attractive right now, and its busy season is just starting.

So put on your homemade mask, wool mittens with five-inch-long thumbs, and horrible home-knit sweater, because we’re going all in on crafting this month.

The Company
JOANN (JOAN) is one of the largest U.S. retail chains in the $40 billion arts and crafts category. It has an omnichannel sales platform, with 855 stores across the U.S., a mobile-first website (joann.com) and a popular mobile app that has been downloaded over 12 million times.

The company is the market leader (over 30% market share) in fabric and sewing supplies, which account for half of total sales. It is also the craft retailer of choice for people that self-identify as somewhat experienced. Approximately 25% of JOANN’s customer base relies on the company for their livelihood, making products that are sold on Shopify, eBay, Etsy and more.

JOANN has a market cap of $648 million and should be viewed as a high-potential value stock. The current yield is 2.6% ($0.40 a year) and the stock appears very undervalued. More on that in a minute.

While the company just came public in 2021, it is not young, or new to the public market. JOANN began as a single-location shop in Cleveland, OH more than 75 years ago and first went public under the name Fabri-Centers of America in 1969. It changed its name to Jo-Ann Stores in 1998 then sold out to private equity firm Leonard Green in 2010 for $1.6 billion.

The company was reborn in March of this year with a name change to JOANN and with significant debt reduction due to various initiatives and proceeds from the IPO.

This is not a rapid-growth company, even though revenue grew by 23% to $2.76 billion in 2021. That was pandemic-related growth as demand for arts and crafts supplies surged during lockdowns. Current consensus estimates suggest sales could dip by 5% to 10% in 2021 as trends smooth out, then trend up in the low single digits (2% to 5% per year) afterward.

That said, JOANN’s busy season is just starting and a rise in Covid-19 cases could easily driver higher-than-expected purchasing activity.

It is critical that investors recognize that while the current fiscal year will likely be down from last year the customer and revenue base will likely normalize at a significantly higher level than it otherwise would have without the Covid-19 pandemic. This puts JOANN in a much stronger place to grow and further strengthen its balance sheet. There are many initiatives in the works that should create value over the coming years.

For example, many of JOANN’s customers have recently purchased machines (sewing, Cricut, etc.) that require materials that cannot be purchased just anywhere. JOANN has a huge variety of fabrics that customers often need to see and feel, meaning they return to the store.

In aggregate, management’s initiatives could easily create opportunities for JOANN to grow faster than currently expected and turn it into a more growth + value stock. These types of stories can often evolve from fine to good, then good to great. However, faster growth should not be expected right now. If it happens that will be icing on the cake and should drive shares even higher than expected.

For now, I see JOANN as a value stock that trades at far too steep of a discount to arguably less attractive retail peers. Through that lens the stock looks extremely attractive, offering 50% to 100% upside over the next twelve months.

Let’s get into some details.

Platform & Products
JOANN offers a huge selection of arts and crafts (52% of fiscal 2021 sales) and sewing (48% of fiscal 2021 sales) products to consumers via its 855 stores, website and mobile application. Stores stock up to 95,000 SKUs, while 245,000 SKUs are available online. Over 50% of in-store net sales cannot be directly comparison shopped due to JOANN’s own-brand portfolio, copyrighted and/or proprietary fabric patters, and factory direct relationships.

This assortment of products, combined with JOANN’s exceptional customer service and knowledgeable team members (many of whom are crafters and sewers) sets the company apart from mass retailers and pure-online players.

JOANN offers video tutorials on its website, a YouTube channel, and the subscription video tutorial platform Creativebug, which helps customers improve skills like painting, drawing, sewing, quilting and more.

Central to the company’s operations is its omnichannel platform that has taken some time to build but which now leverages consumer data to drive operational improvements and consumer insights that can only be gleaned with digital capabilities.

Customers can now interact with JOANN however they choose, including through 855 stores, a redesigned mobile-friendly website (joann.com) or the mobile app. As of the end of January 2021 JOANN had over 70 million addressable customers in its database, nearly 17 million in the email database and over 4 million in the SMS text database.

This platform now allows JOANN to offer customers a variety of order fulfillment options, including buy online pick-up in store (BOPIS), curbside pickup and ship-to-home. The omni-platform is highly profitable and leverages central and third-party capabilities, as well as JOANN’s efficient in-store fulfillment network.

Sewing
Sewing made up 48% of JOANN’s fiscal 2021 sales and includes exactly what it sounds like: cotton, fleece, home decorating, utility, fashion, sportswear and special occasion fabrics, sewing construction supplies (thread, zippers, tapes, buttons, etc.) and seasonally themed and licensed fabric designs (professional sports, college teams, pop culture prints, etc.).

Arts and Crafts, Home Décor
The balance of sales comes from all the other items you see in craft stores, including yarn, papers, stickers, scrapbooks, stenciling, paints, kids’ crafts, art supplies, seasonal and home décor items, frames, books, magazines, organizers, lights, irons, sewing machines and more.

Growth Initiatives
Store Refresh Initiative: JOANN recently began a seven-to-ten-year program to refresh stores with renovations, assortment enhancements and customer experience improvements. It will also relocate some stores and close others. Over the last two years it has trimmed nearly 20 stores (to 855) and, in time, could ramp back up to over 1,000. In aggregate, this program could add 1% to 2% to annual growth. That doesn’t sound like a lot but in a value stock like this it will make a difference. Management expects to refresh 10 to 15 stores this year than ramp up to 60 to 70 stores next year. Expected payback time is four years, on average.

Crafting Trends Stay Stronger for Longer: People got into hardcore crafting when the pandemic hit, and those crazy days won’t last forever. It has already slowed down. That said, crafting activity should stay stronger than it otherwise would have and with fall right around the corner, Delta circulating, and moms, dads and school age kids likely to be spending more time at home in the coming months I believe crafting will continue to be a popular activity for longer than many think.

Have Equipment, Will Sew: With JOANN having sold many more sewing and Cricut machines than normal in 2020 and early-2021 there are a lot of folks that have already made the capital investment and will continue to need materials. People who make these investments tend to spend around $800 on materials over the subsequent two years, and these are higher-margin sales than the equipment. Management says it expects to retain 60% to 70% of these new customers and that, so far, they are continuing to visit stores about twice as frequently as the average customer and spending 15% to 20% more per visit.

Operational Improvements: Management is working to improve aspects of operations, from strategic sourcing of materials (including direct from factories) to improving inventory management (less overstock, higher turns, etc.) to optimizing discounts and reducing clearance markdowns. These improvements should drive gross margins higher over time, despite expected short-term increases in supply chain costs.

Omnichannel + Selection = Success: While JOANN is far smaller than the mega retailers (Walmart, Target, etc.) it is relatively large among those selling fabric and arts and crafts supplies. With a lot of SKUs and an omnichannel platform the company makes it easy for customers to buy, especially as compared to smaller independent stores.

Value Stock with Upside Potential: JOAN is a clear value stock with a financial profile that’s getting better, with more to come. Net debt was near $1.2 billion (6-times EBITDA) in January 2020 and has since fallen to $750 million and should be closer to $600 - $650 million by January 2022 (roughly 2.5-times EBITDA). Free cash flow, which was near $50 million before the pandemic and will be around that same level this year, should jump into the $125 to $150 million a year range for fiscal 2023 and beyond. These metrics matter to value investors and should give the financial flexibility for dividend increases (which also matter).

The Business Model
JOANN is a straightforward business. It is a U.S.-focused omnichannel retailer selling through 855 stores, its website and a mobile app. The company sources products from a variety of sources, some of which are exclusive, and sells to consumers. In recent years JOANN has been using customer data more successfully and this has helped it develop it’s omnichannel platform.

The Bottom Line
JOANN’s fiscal year ends in January. In fiscal 2020 revenue shrank by 3.6% to $2.24 million as the impact of tariffs had a negative effect. Sales then exploded by 23.3% to $2.76 million in fiscal 2021 as the pandemic drove a ton of at-home arts and crafts and sewing activity.

In Q1 fiscal 2022 (ended April 30) revenue was up 15% to $574 million and sales were spread across product categories, channels and geographies. Overall, customers just bought more, and more frequently. Adjusted EPS was $0.44 and gross margin expanded by 3.5%. In the first quarter as a public company debt was reduced to $750 million and management sees another $100 - $150 million in debt reductions (to $600 - $650 million) by January 2022. Management initiated a $0.10 quarterly dividend, with the first payout delivered on June 25.

Analysts currently see Q2 fiscal 2022 revenue of $532 million, representing a 25% drop from the pandemic-driven sales boom of Q2 fiscal 2021 (when revenue exploded 38%). Don’t sweat this projected decline. For full year 2022 analysts see revenue down 7% to $2.58 million and adjusted EPS of $2.84. Again, don’t sweat the slowdown – it’s not rational to expect JOANN can surpass those pandemic-driven numbers.

A more normalized growth rate should appear in fiscal 2023 when revenue is seen up 2% to $2.63 billion and adjusted EPS climbs 6% to $3.01 million. I do believe these numbers are conservative and that JOANN will ultimately beat them. The uptick in Covid-19 cases being driven by the Delta variant could help drive higher sales.

Risk
Ocean Freight: Supply chains are still messed up and one risk to gross profit margin is the cost of freight. Management said on the Q1 call in June that at the extreme level container freights are up 10-times versus normal. While gross margin was up 3.5% in Q1, and management expects to keep some of that, we’re likely to see some pressure from items like freight.

Reopening Trends: Given the current infection trends it feels like we could see more growth in at-home-activities than away-from-home activities as we head into the fall, and that could play into the hands of JOANN. That said, there is some risk that consumers will be more focused on doing things outside the home regardless of what infection trends do. This is a risk that could be more severe as stimulus payments, child tax credit payments and unemployment benefits trail off.

Competition: Roughly half of JOANN’s sales come from general arts and crafts items, many of which are also sold by large competitors, including Amazon, Walmart, Target, Hobby Lobby and the dollar stores. While this risk is likely reflected in JOAN’s current stock price we’ll have to keep this risk in mind for the foreseeable future.

New IPO: JOAN came public in March and as a newly-public small cap stock might fly under the radar of many investors. That said, with the buyout of Michaels there is institutional money looking to go into hardline retailers, and JOAN offers a great and simple solution, especially given the attractive valuation.

Competition
JOANN closest competitors for sewing and fabric supplies are a large number of small mom and pop type stores and some larger competitors, including fabric.com, which is owned by Amazon (AMZN). In the arts and crafts and home decor categories it competes with Michaels (now private), Hobby Lobby, Dollar Tree (DLTR), Dollar General (DG), Walmart (WMT) and Target (TGT).

The Stock
Trading Volume: JOAN trades an average of 430,000 shares daily. Heavy days are over 1 million shares and that has happened on eight days since the company came public. On six of those days the stock has closed higher, including the three occasions since mid-April.

Historical Price: JOAN came public at 12 on March 12 and closed up 2%, then promptly fell to 9.75 by the end of the month. Over the next three months shares made a series of higher highs and higher lows, going on fierce rallies (often over 40%) then making sharp corrections of 20% or more. Despite the wild ride, the trend has been up. After the Q1 fiscal 2022 report on June 3 the stock shot up 31% to hit an all-time high of 17.5. It pulled back to below 15 within two weeks then fell as low as 14 (to the 50-day line) on July 8. Still, shares never fell apart and, since hitting that low, JOAN has been trending upward at or above its 50-day line. A recent pullback to around 15 appears to offer a good entry point.

Valuation & Projected Price Target: On average, hardline retail stocks trade at an enterprise value-to-EBITDA multiple near 12-times using fiscal year 2023 estimates. Michaels, a close competitor to JOANN, was recently taken private at a multiple of 6-times. A similar multiple implies JOAN should be trading closer in the 25 to 30 range right now. That multiple could go up if the fundamentals improve. For now, we’ll start with a price target of 28, implying more than 75% upside.

Buy Range: In the near term expect to buy in the 14 to 17 range. My expectation is that JOAN will continue to find support at or near its 50-day line (it is slightly below that trendline now). All factors being the same I would see a dip to 14 (or slightly below) as a great buying opportunity. Conversely, in the near term I’d want new information in order to buy above 18.

The Next Event: Management is expected to present Q2 fiscal 2022 results near the end of August. An official date has not yet been set.

Updates on Current Recommendations

Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.

Glossary

Buy means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying the stock no longer apply, and I recommend exiting the position.
Sell a Half means it’s time to take partial profits. Sell half (or whatever portion feels right to you) to lock in a gain, and hold on to the rest until another ratings change is issued.

Disclosure: Tyler Laundon owns shares in one or more of the stocks mentioned. He will only buy shares after he has shared his recommendation with Cabot Small-Cap Confidential members and will follow his rating guidelines.

The next Cabot Small-Cap Confidential issue is scheduled for September 2, 2021.

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