Party City Stock: Contrarian Opportunity, High Leverage, Q1 Miss

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Party Town (NYSE: PRTY) is an American retailer of party supplies such as balloons, candy, decor, catering, fancy dress and seasonal merchandise. It is highly leveraged and recently fell on weak first quarter numbers and a lackluster outlook for 2022.

However, the company may prove to be a retailer with reasonable long-term prospects. It offers a very wide choice of balloons. Balloons are often needed immediately difficult to deliver online. PRTY also sells a host of low-priced items such as candies, plastic hats and party favors. The economics of shipping these items online can be prohibitively expensive, which also provides a degree of protection for Party City business.

So of course, despite the threat posed by a weak consumer struggling with rising fares and high gas prices, 2022 is shaping up to be a positive year for the parties, despite some Omicron-related weakness at the start of This year. However, PRTY’s advice certainly does not imply that.

As such, Party City can be an attractively priced retailer with a long-term moat thanks to its focus on party supplies, a wide range of balloons, and low-cost items.

finance

Before we get too deep into financials, it should be noted that PRTY likes to present FCF as EBITDA minus capex on various presentation slides. It’s obviously a myth when you’re carrying about $1.3 billion in debt like PRTY.

Nonetheless, the company overall generated between $230 million and $280 million in EBITDA per year before COVID. Current interest expense, based on Q1 2022 annualization, is approximately $96 million. With a 30% tax rate, this suggests a net income of about $90-130 million at a normalized level.

In stark contrast, the company assumes a net profit this year of $30 million to $48 million. Part of that is an assumed 38% tax rate, but most of it is margin pressure as we saw in the first quarter of 2022. Targeted capital spending between $110m and $120m works also at around double historical depreciation rates as the company invests in store renovations so net income may overestimate FCF this year.

So will PRTY earn significantly less than it has historically, and will it ever really see a return to pre-pandemic profitability, or even face a shareholder crushed by debt? Or could things improve from here?

Clearly, if PRTY can return to pre-pandemic profitability, shareholders will almost certainly benefit. $90M to $130M in net income, suggests a market cap of $0.9B to $2.6B based on your assumptions of a reasonable multiple (10x-20x) against a market cap of around 0.15 B$ currently. The market therefore clearly does not believe that the good times are coming back. Indeed, the company is trading at 3x-5x its own forecast for 2022. Additionally, the stock was at $10-$15 pre-COVID versus around $1.36 today. As such, it’s unclear whether the market thinks the company will even be able to manage its debt going forward.

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Data by YCharts

Gross margins

The key to PRTY’s current weakness is partly shrinking gross margins and partly risk to the US consumer. The company recorded a gross margin of 32% in the first quarter, 3.2% less than the previous year, mainly due to higher transport costs and, to a lesser extent, higher prices for helium.

The good news is that freight prices are now 30% lower than in the first quarter, although they remain high.

Additionally, although the price of helium may increase in the second quarter (helium is obviously a key input when selling balloons), helium supply and demand are expected to rebalance later this year, as supply disruptions are resolved. The absence of these disturbances reduces the gross margin to approximately 35%.

As such, if we can believe that the high freight costs are one-time, which appears to be the case, and the helium supply issues are also temporary, then perhaps the first quarter didn’t have was quite the disaster that the market interpreted it. This is especially true when considering the seasonality of the business.

Seasonality

Then PRTY is the epitome of a seasonal retailer. They even set up additional temporary stores for Halloween (called Halloween City). The company can potentially comfortably generate a gross margin of 40% to 45% in the fourth quarter. This means that in 2019, Q1 was 21% of annual gross margin, but Q4 was 35%. Therefore, we shouldn’t over-interpret the weak first quarter results, especially if the issues discussed appear to be more weighted in the first half. As with many retailers, the fourth quarter is key to PRTY’s annual results.

The weak consumer

The problem for PRTY is a potentially weak US consumer. January was weak due to Omicron, February was relatively better, but then from the Q1 earnings call there were “softer than expected March trends” and “In April, we’ve seen component retail sales down about 4% from 2021.” Revenues are therefore likely to decline in 2022, although parties may become more common as the pandemic subsides.

Leverage – A Risk

The question then becomes, how much room does PRTY have before its high leverage becomes a problem?

There are two answers to this question, the first is that PRTY does not need to refinance a major tranche of debt until 2025, although $23,000 of debt is due in 2023.

debt levels and maturity

Debt amounts and maturities for Party City (PRTY 10-Q)

The second is that, roughly speaking, if sales drop 10% with a gross margin of 40%, or if gross margins remain below 35% for the year (note – the first quarter was 32%), then the company will be challenged to meet its interest payments. operating cash.

Thus, on the current trajectory, the company is exposed to a certain degree of risk due to its relatively high level of debt, although it seems that things could improve from the first quarter.

CAS Investment Partners

Also in March, CAS Investment Partners was a major investor in Party City (17% stake). We do not have more recent data. CAS Investment Partner’s performance has been relatively weak since the beginning of the year, mainly due to a large position in Carvana, given its very concentrated investment strategy, but PRTY clearly did not help. If CAS Investment Partners sees significant buybacks or chooses to leave PRTY, this will likely put additional pressure on PRTY. It’s unclear if this is contributing to the current weakness, making it a potential reason to invest now, or if this is a potential negative catalyst that could hit equities later in 2022.

Conclusion

We shouldn’t read PRTY’s Q1 numbers too much. It seems clear that freight costs are falling and that helium price and availability could improve in the second half of the year. As such, there is a strong chance that PRTY margins will rebound, both as the first half issues fade and due to the seasonality of the business.

That said, the margin for error is limited due to the company’s relatively high debt, and if we see consumer weakening around the key Halloween trading period and into 2023, the company could have difficulties with his balance sheet.

Nevertheless, against this backdrop, PRTY is trading at a very cheap 3x-5x earnings on its current forecast, and the forecast does not look too aggressive. That seems too cheap for a company that’s dominant in party supplies, with both a retail and wholesale presence and a position in balloons that’s hard to move for others (like Amazon).

I think if the current issues turn out to be transitory, then a fair value for PRTY is conservatively around 12 times earnings on a normalized FCF of maybe $100-150 million. It is clear that they will not encounter that this year, but in the years to come it could be possible. This leads to a stock price of $12 to $16/share.

Of course, we must recognize the challenges for 2022, especially if the consumer remains weak. However, I would characterize the setup as something like below and it presents an attractive, albeit reasonable, risky proposition. This leads to an expected value of just over $4/share, about three times the current price, but, of course, also a material possibility that the shares are trading at zero:

Script PRTY stock price Probability
Complete recession of consumption in 2022, drop in sales of 10% and more $0 (creditors own the business) 25%
The company is structurally challenged and never regains pre-covid profitability $0 to $5 (dealer dying on low multiple) 25%
Any recession in 2022 proves moderate, fourth quarter strong and margins rebound in medium term $12-$16 50%

source: author’s analysis

Risks

Of course, there are many risks for PRTY. High leverage gives little room for error. The results for the first quarter do not inspire confidence. Additionally, the company, like all retailers, is threatened by Amazon to some degree. Also, the Halloween period is so dependent on the Halloween period that any mistake in execution could seriously harm the business. Finally, a large holder may sell shares in size in the future, creating additional price pressure.