Which Children's Retailer Will Get The Biggest Piece of the Parental Spending Pie?

The stage seems to be set for success in the children's toy and clothing markets as more families than ever have two incomes, resulting in increased discretionary spending. Parents aren't the only ones buying the children clothes and toys, of course--aunts, uncles and grandparents do so as well, especially around the holidays. The Children's Place (NASDAQ:PLCE) gives kids the opportunity to be fashion forward, while Build-A-Bear Workshop (NYSE:BBW) appeals to a child's playful side. Target (NYSE:TGT) settles right in between by offering both clothing and toys.

The Children's Place plays up its profit
Claiming to be the world's largest pure-play children's specialty retailer, The Children's Place shows that selling to children --- or rather their parents -- can be a profitable undertaking. The company operates 1,123 stores that include 36 in the Middle East, and it expects to open stores in Israel in 2014. That seems to be a risky move given the unsettled political situation in that part of the world. .

The company's business strategy is to offer a distinctive clothing line and accessories that are only available at The Children's Place store and website.

Sales in 2013 slipped a bit from the third quarter of 2012 to land at $492.7 million. The Children's Place's gross margin declined to $201.8 million, or 41% of sales, but the company tightened its belt and scaled back selling, general, and administrative expenses to 25% of sales compared to 26.3% for the third quarter of 2012.

Jane Elfers, President and Chief Executive Officer, explains it this way: "We achieved the high-end of our earnings guidance as a result of strong execution of our important back-to-school period, and the continuation of disciplined expense management across the organization."

She seems to be right, as revenue dropped and the gross margin as a percentage of sales increased. The Children's Place generated operating income of $61.6 million for the third quarter of 2013, which compares with $53.5 million in 2012.

Building a company one bear at a time
Who would have thought that teddy bears could be the basis for establishing 400 retail shops in the United States and abroad, as well as creating an interactive website? The founder of Build-A-Bear Workshop, Maxine Clark, certainly did.

This retail concept is unique. First the child chooses a bear -- other animals are available as well. The animal is stuffed at the stuffing station, fluffed at the fluffing station and -- well -- you get the idea, all under the child's supervision. While the bears are priced within a $10 to $30 price range, the clothing, shoes and accessories made to fit the animals can run up the bill to nearly $100. And no child wants a poorly accessorized bear running around.

Build-a-Bear Workshop may have a knack for building bears, but it's not so skilled at building a profit. While the pre-tax loss for the third quarter improved to only $1.1 million in 2013, which compares to a loss of $4.5 million in 2012, the company continues to leak stuffing. Build-a Bear lost a total of $7.1 million on a pre-tax basis for the first nine months of the year, which again is an improvement from the nine-month loss of $13.9 million in 2012.

While revenues increased on a comparable store basis, the company saw a decrease in revenue from the third quarter of 2012 as a result of closing 31 locations. The company expects to close an additional 10 to 25 under-performing stores in 2014.

Build-a-Bear's CEO and Chief Bear President, Sharon Price John, said in the third-quarter press release that the company is attempting to improve margins and operating efficiencies. Gross margin did improve from 36.5% to 40.1%.

However, the company still has a way to go in improving operating efficiencies.  Selling, general, and administrative expenses were 42.2% of sales for the third quarter of 2013, while cost of goods sold was 63.5%. That means the company lost $2.10 for each $100 of sales.

Missing the target
A visit to any one of the 1,778 Target stores shows that it has well-stocked infant, toddler, children, and tween's clothing departments. All apparel -- including apparel for adults -- accounts for about 20% of Target's annual sales. Toys and electronics are included in the hardline category, which accounts for 18% of sales. The selection of toys varies depending on how close it is to the holidays, but the stores always have toys. Target calls itself an upscale discounter which appeals to families who want quality at budget-friendly prices.

Target's third-quarter sales reached $17.3 billion, an increase of 2% from the third quarter of 2012. The gross margin decreased to 30% of sales, or $5.2 billion, compared to $5.3 billion for 2012. Selling, general and administrative costs increased $149 million from the third quarter of 2012.

The company changed the way it accounted for contributions from vendors by including them as a reduction in cost of sales rather than a reduction of selling, general and administrative costs as the company had in previous years. Even with this change, the cost of goods sold increased as a percentage year over year, and selling general and administrative expenses remained about the same. Net earnings for the quarter fell to $341 million--a decline of $296 million from last year or 53.5%.

Now let's talk about the elephant in the room. Will parents feel comfortable shopping at Target when up to 40 million credit and debit cards were hacked between Nov. 27 through Dec. 15, 2013? If you've got your calculator out that's an average of 2 million cards per day. I question whether parents, or other shoppers, will trust Target, which would definitely affect the company's future results. You have to ask why Target didn't notice the problem earlier -- it took over two weeks for the breach to be discovered. As of the date of publication of this article, Target has given no explanation as to how the breach happened.

To invest or not to invest?
As much as I love the concept of Build-a-Bear, I would have to decline to invest in it. The company has an uphill climb to get itself profitable and it doesn't seem to have a handle of what new locations have the best revenue potential.

As for Target, I'd have to say no as well. The company's performance is OK, but what bothers me is that credit and debit card breach. It could result in class action suits, fines, restitution for reissuing cards and penalties -- up to $90 per card in penalties -- that's a total of $3.6 billion, or about $0.6 billion more than Target's net earnings for 2012.

My first choice to add to my investment portfolio would be The Children's Place based on its dedication to managing expenses, its proprietary merchandise line, and the company's growth potential. All kids need fashionable new clothing, but they may not need well-dressed bears.