Michaels: The Lure and Risks of a Publicly Traded Crafts Chain

The Michaels Companies (MIK) has retail outlets in 49 states and enjoys household name status among crafters and hobbyists. While its stock has slumped over the last few years, it's possible that it could soon find favor among value seekers.

In this segment from The Motley Fool's Industry Focus: Consumer Goods podcast, we provide listeners with background information on Michaels and delve into basic financial information potential investors should consider.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Oct. 1, 2019.

Nick Sciple: We're going to talk about Michaels today. The context we're going to talk about them is, this is one of those companies that, if you look at the numbers, it really looks like it could be a value stock; however, we're going to walk through some concerns that could make it a value trap.

Before we dive into that, let's just give some brief history of the company and where it's come from in recent years. Can you walk us through Michael's history as a public company, and where it sits today?

Asit Sharma: Sure. Michaels was founded in 1974 by a businessman named Michael Dupey in Dallas, Texas. This company began trading on the NASDAQ in 1984 as The Michaels Companies. It was taken private by private equity firms Bain Capital and Blackstone Group. Those are two pretty familiar names if you are familiar at all with the private equity world. That was in 2006, for a price tag of $6 billion. The company was reintroduced to the public markets in June of 2014. They raised $472 million in that offering. Most of the proceeds were allocated to pay down the company's oversized debt load. At that time, it was $3.7 billion. Debt load is going to be a recurring theme today. Bain still owns 34% of the outstanding stock in this company. Blackstone still has a 13% stake.

I want to note before we move forward, in this second go-around in the public markets, what has their stock performance looked like? Up or down? Now, listeners, I'll take a millisecond for you to guess. The answer is: shares are down about 42% cumulatively. We will get into the whys of that in just a moment.

Sciple: Yeah. That's why folks might be viewing this company as a value stock. For a little bit more context, Michaels is the largest crafts and specialty retailer in North America based on store count. 1,262 stores in the U.S. and Canada. We talked about whether we craft. They define their market as, over 53% of U.S. households participated in at least one crafting project during 2018, so, a robust market there.

When you look at some of the numbers here with this company, it can pop out on some traditional value metrics. If you look at their forward price/earnings, it's about 4X. Their gross margin is higher than what you would expect from the typical store-based retailer. But the big number that really popped out to me, and why I wanted to talk about this company today, is looking at their free cash flow. If you look at their free cash flow from last year, they had about $300 million. If you take that number and divide it by their market cap, which currently is $1.5 billion, that gives you a free cash flow yield of about 20%, which is extremely strong relative to the broader market. When you look at investing in a company, you can generally get a decent picture of what you can expect your returns to be over time by looking at that free cash flow yield, then adding in what your expected growth in free cash flow is over time.

As we've talked about with Michaels, it's in a market that's probably mature, so you can't expect free cash flow to grow in a really significant way over time. At the position that the company is valued at today, the market is clearly expecting that free cash flow yield to decline over time. However, if we can identify some trends that say that will be stable over time, there's a real chance that this stock is overvalued.

Asit, you've had a chance to look through some of these free cash flow numbers and those types of stats coming out of Michaels. What's popped out to you about this company when you take a high-level look?

Sharma: I love the margins. Gross margin of 35%. Free cash flow, again, as you stated, that pops out at me. For listeners, those of you who are unfamiliar with this term, free cash flow is operating cash flow -- the cash the company generates from its operations -- minus the physical assets that it buys during the year, or any small acquisitions. So, you subtract equipment, fixed asset purchases from this operating cash, you get free cash flow. After that, whatever money is left over is to pay your debt service, to maybe pay investors in the form of a dividend, or reinvest further in the business, that's all gravy. So, the company has this high free cash flow yield. That popped out to me, as well.

I like the stability of the sales, given this really bad retail environment. Comparable sales this year in fiscal 2019 are expected to be flat versus the prior year. That means that the average store in the company's store base isn't going to increase sales at all. But, compared to many physical-store-based retailers -- listeners, you probably heard the news a couple of days ago that Forever 21 is the latest retailer to declare bankruptcy -- I'll take flat comps. I don't think that's such a bad number. It shows that, at least the sales are stable and can be improved. So, that also jumps out at me.

Net margin, they average in the low to mid-single-digits. That, again, is pretty decent for a retailer in this day and age.

Now, some of the stuff that's not so appealing is that debt on the balance sheet. Before we talk about the debt, though, I do want to point out -- if we look at the asset side of this company, if it's a stable company with very stable operating cash flows, you'd expect, over time, if the cash flows are rising even slightly, the company would be building up a big cash balance. But, like many retailers, Michaels has most of its assets in its inventory. It's got these 1,200-odd stores that Nick told you about. It constantly has to buy inventory. It has its balance between payables to its vendors, cash that it needs to pay down its accounts payable, and this big inventory balance. The inventory as of the last quarter was $1.25 billion. I'll return to that number in just a bit during this segment.

Now, debt. Debt's at $2.7 billion. Nick, you and I were crunching what this means when we talked earlier today. Versus its equity, you really can't get a read, because Michaels has negative equity. It's got a shareholder deficit. This is from losses that it sustained years and years ago. Over the course of decades, it's actually built a shareholder deficit. For those of you listeners who like to hear the debt to equity, we can't give you that number. We can say that the company is able to cover its interest obligations. Its times interest earned ratio is roughly 4X. That means that net earnings cover the interest burden about four times over during the year. That's sort of thin, but on the other hand, I've seen worse.

Final note about the debt. If you look at a very widely used metric, which is debt to EBITDA -- that is, debt before interest, taxes, depreciation, and amortization -- that ratio sits at around 3.5X. That's another number that we crunched just before taping today. That's actually moderate leverage, although, relative to its own balance sheet, it's got a big debt load that needs to be addressed. If you look at what this means in the big picture, the leverage is moderate. It's acceptable. It's a problem that can be solved. One of the questions that we'll toss back and forth is, does the company want to solve this debt problem?

What jumped out at you, Nick, about the balance sheet?

Sciple: Taking a look at the balance sheet, as you said, that high leverage number obviously pops out to me. You expect to see that from a company that has been brought public in recent years by private equity. But, to the extent that we should be concerned about the debt, it comes back to that free cash flow number that we talked about before. At the current amount of cash that the company is turning out, we shouldn't be too concerned about their ability to at least sustain their interest payments on the debt, and that sort of thing. But, where it does become a concern is if we see the business continue to deteriorate over time, and we see that cash flow begin to drop.