Michaels Is Worth Putting on Your Watch List as a Potential Value Purchase

In this conclusion of a recent Motley Fool Industry Focus: Consumer Goods podcast on specialty crafts chain The Michaels Companies (MIK), our team touches on a couple of final risks to consider and argues that Michaels deserves a spot on investors' watch screens over the next few quarters. Click below to hear why analyst Nick Sciple and Fool.com contributor Asit Sharma believe the company may soon become a legitimate value stock.

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This video was recorded on Oct. 1, 2019.

Nick Sciple: Another place where you have to wait until things are really bad before you have some leverage is lease rates. Management is expecting about a 2% inflation in lease rates going forward. There have been some short sellers that are critical of Michaels that have said, "Why are their lease rates going up 2% a year?" Some other retailers -- Best Buy is an example that's been called out -- have been able to negotiate their lease rates down. Looking at that, any high-level thoughts on that? Why are their lease rates going up when it seems to be that, for a lot of major retailers, they have some leverage to push on their landlords to get those lease rates down?

Asit Sharma: One thing that investors should zero in on here is, they are a victim of their own success. Success is relative. In this retail industry, where Amazon and a bunch of other companies who've dived into e-commerce have disrupted what it means to go shopping physically in a store -- in this kind of landscape, it's really difficult to breakeven or show some slow growth. That's what Michaels has done. Renegotiation of lease rates is always a dance between a tenant and a landlord. Most of the time, these triple net type leases, where the tenant is paying most of the operating expenses of the lease -- paying for insurance, taxes, maintenance of common areas -- those get renegotiated sometimes at five and 10-year tranches. But, they have built in annual clauses. So, when a landlord is able to make the argument that, "You're doing alright. You're making enough money to pay me 2% a year," it's more difficult for the retailer to have negotiating power.

The thing about Best Buy or some of these other companies that we've talked about is, at one time or another, they've been in serious trouble. I tell you, when you can look the landlord in the eye and say, "If you don't help me out on this lease rate, I might not be here next year to pay you on a monthly basis," you have some leverage there that a company which is even marginally successful doesn't have. It's an accepted practice in the commercial real estate industry to have a lease rate bump up 1% to 2% a year.

In my opinion, I hear what the short sellers are saying, but they're comparing apples and oranges. Michaels is a victim of its relative success on this front.

Sciple: One last criticism that short sellers have leveled against the company we'll talk about before we reach our final conclusions is on framing. Michaels is one of the largest framers in the U.S.. I'm talking about picture frames, those sorts of things, custom framing. They're the owner of Aaron Brothers. They've recently closed most of the Aaron Brothers stores and have brought those inside Michaels stores as a store-within-a-store concept. It's about 16% of their revenue, but it's significantly higher-margin than their core craft supplies business. There have been some concerns that online disruptors -- Framebridge is one example -- are going to be able to chip away at some of Michaels market share in that space. If that takes place, some of their high-margin business in this framing area may be chipped away, and that is a major driver of their free cash flow. How do you handicap this risk for the company, Asit? It's really hard to tell. What are your thoughts there?

Sharma: It's a risk, but we also have to look at some of the benefits the company gets by moving its framing in-house. A very important metric in the retail industry is sales per square foot of a particular location. What the company is doing is reducing the overhead that it's got in the separately positioned framing stores. Getting rid of all that operating expense, lease expense, bringing it in-house. That does two things. It reduces the economic drag. It also increases the profitability, productivity of each store that receives an in-house framing unit. What else does that unit do? It brings in additional traffic within Michaels locations. Sometimes those are two separate customers. We tend to think of a customer who's going to an isolated framing unit and a customer who's going to a Michaels as the same person, because those results and financials get rolled up into one bucket. However, someone who just goes with the framing needs to a separately identified store may not be a loyal Michaels customer. Now, if they have to go through the Michaels store -- past the end caps, past the maker's spaces, which the company is really trying to ramp up, making the stores more experiential -- it has a chance to upsell while that customer's there for a framing need. It also has a chance to make this new customer into a longer-term customer.

So, I think that there's some real benefit here. Again, the short sellers have correctly identified a risk, but maybe haven't looked at some of the benefit that's coming. I'm not, frankly, as worried about that. I'll note that competitors like Jo-Ann Fabric do pretty well by having some framing facility, although much smaller, located in a strategically placed area of the store, which brings people in. It's like the IKEA concept, you have to wind your way through to the framing area. And by that time, you've inevitably picked up a couple of small items.

Sciple: Yeah, it's like putting the milk in the back of the store, right? You're going to get that thing, you have to walk by all the other items to get there.

Asit, we've walked through the whole story of Michaels. When you look at their free cash flow and some of their operating metrics, there appears to be a decent amount to like there relative to its current valuation. However, when you look at its high private equity holdings, when you look at its debt, its amount of leverage, which is partially due to that high private equity relationship, there are some risks there. When you take a look at all that together, do you think this company is a value stock or a value trap?

Sharma: I'm intrigued by this company. I believe it's a value play. I believe it's a value stock, but one that you maybe want to take some baby steps into or put on a watch list. I'll tell you why. Value to me is finding a quantitatively cheap asset that the market recognizes as fairly valued. In other words, the market sees a low stock price associated with certain companies and says, "That's fair because this company ain't going nowhere. It's got X number of problems." But you, the investor, sees that as quantitatively cheap. You're like, "Look, this is a profitable company. It should be valued more than it is. It's cheap, and I'm going to buy it." Now, I will say, having tried this route before, of investing in value stocks, your idea of what's value is inversely proportional to the pain you'll experience the longer it takes for the market to recognize what you see.

However, there are some things here that Michaels, fairly or unfairly, is also being pelted by. One of those is, it's in a tough industry right now. The reason it's got that very low forward P/E ratio that Nick mentioned at the beginning of the show is because it's part of a group of stocks which has been decimated by online shopping. Michaels presents the customer with a reason to come in store. It's more specialized, it has a specialized product, it has loyal customers. So, it's a little bit better insulated than a generic company like a Kmart, or parent company Sears, or J.C. Penney. Again, all examples of companies that could not cross that bridge. It's got a discount that the market is applying, even though it's profitable. It has the high debt load, and it does have the private equity ownership.

But on the other hand, it's got a pretty savvy interim CEO. If you're listening, Michael's management, I think you should make Mr. Cosby the permanent CEO. What he's doing is trying to get rid of customers like me and Nick. The strategic thrust of the company is to not worry about the one-or-two-timers-every-year, but embrace that core customer and have experiences in the store, partner with companies that make the scrapbooks, and have mini demonstrations in-store. Kind of like what you see in a Home Depot or Lowe's, this idea of classes, which bring a sense of community. It's got some very intriguing positives about it.

If the company could reduce its debt load -- again, not offering direct advice to management -- why not consider getting rid of some of the underperforming stores? Boost that cash flow, boost net income, pay down some debt. I see that this stock could rise once the market recognizes that it deserves a higher multiple. It's worth more than most people are willing to pay. I am going to err on the side of, this is a value play.

I am immensely curious, Nick, what are your thoughts? Is this a trap? Or is this a value stock, in your opinion?

Sciple: From my perspective, I tend to see this as a value stock as well. I think qualitatively, as you mentioned, it's one of these retailers that, you can tell a story of why they should still exist despite the onset of e-commerce. When you go to buy a craft good, seeing that thing in front of you -- seeing what color that paint is, or what texture that canvas is, that sort of thing -- is something that can't be replicated online. There's a reason to come into the store. Their performance, as we mentioned, their free cash flow is strong. And because of those qualitative characteristics I just described, I expect that should be able to be maintained over time.

However, the leverage is a concern to me, and the private equity interest does raise a little bit of a concern. There could be a conflict between the major holders and an individual shareholder. To your point, I would be reticent to buy the stock until they have a permanent management team in place so that I can know that the strategy that they're taking today is something that is going to carry through over the next several years. For my stance, today, I think it's a stock that you put on your watch list, you follow whatever the final management team's strategy is, and check off that they are able to see some traction from those sorts of things. And then, I think it's a stock you have to just buy and hold and wait for the market to realize that value. When you're buying value stocks, you have to be comfortable to look a little dumb for a while when you buy these things. This stock is no different.