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3 Reasons Why This Retail IPO Is a Buy

By Mark Lin – Jul 3, 2014 at 6:00PM

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This company's share price closed almost flat on its first day of trading. With lackluster investor sentiment, is this stock still a buy?

Source: The Michaels Companies

The Michaels Companies (MIK), the largest arts and crafts specialty retailer in the US, started trading on the Nasdaq last week. It has been a strong performer in the specialty retail sector in the past few years, as it grew its revenue and operating income by four-year compound annual growth rates of 4.1% and 11.3%, respectively. Michaels also registered positive comparable-store sales in each of the past five years.

It's also possible to compare Michaels with The Container Store Group (TCS 4.22%), another specialty retailer which was listed in November 2013.

Attractive industry
Many consumer product categories have been affected by changing consumer preferences and digital disruption. Products such as sodas and physical books have seen their sales adversely affected by increased health consciousness and the advent of e-books, respectively. It's a relief to know that the future of the arts and crafts industry looks promising for now.

Firstly, crafting isn't a fad. Almost 50% of crafters have been involved in craft projects for over a decade, based on research from The Craft & Hobby Association. In addition, crafters buy crafting supplies close to twice per month.

Secondly, crafting isn't just your grandmother's hobby--in fact, it appeals to multiple generations. According to Michaels' internal estimates, a fifth of its customers are male and more than two-thirds of them are below the age of 55.

Thirdly, crafting and craft supplies don't cost an arm and a lef; the median household income of Michaels' customers isn't excessively high at approximately $81,000. In addition, crafters' relatively low price sensitivity is validated by Michaels' stable 40% gross margin over the past three years.

Source: The Michaels Companies

Private brands
Most retailers are at the mercy of their suppliers because they don't sell their own house brands to improve their bargaining power. Michaels and The Container Store don't make such mistakes.

The Container Store generates about 50% of its revenue from exclusive products, and its Elfa product line manufactured by its Swedish subsidiary accounts for approximately 25% of its revenue.

The Container Store also claims that its Elfa line of shelving and drawer systems is among the most popular and profitable products in its portfolio. This ensures that The Container Store doesn't have to accept unreasonable product price hikes from its suppliers, or fear that customers will walk out the door when it loses any of its suppliers.

Along the same line of thought, Michaels places a strong emphasis on exclusive private-brand products; its internally developed portfolio of 11 private brands represented 48% of its fiscal 2013 sales. Its portfolio includes brands such as Artist's Loft, ArtMinds, Celebrate It, Creatology, Craft Smart, etc.

The strength of Michaels' private brands is validated by the fact that it was the sole arts and crafts retailer on Interbrand's 2014 list of Best Retail Brands in the US in 33rd place, ahead of other well-known retailers such as J.Crew and Banana Republic.

Wide product assortment
With consumers increasingly concentrating their purchases at big-box retailers because they have better prices and wider product ranges, most specialty retailers are losing market share to their bigger competitors. This isn't happening with Michaels. Michaels stocks approximately 36,000 SKUs which cover the full gamut of arts, crafts, scrap-booking, floral, framing, and home decor.

In contrast, arts & crafts supplies tend to account for a relatively smaller portion of the SKUs carried by mass merchandisers. As a result, crafters will still turn to specialty retailers such as Michaels to meet their needs.

At the other end of the spectrum, small independent retailers don't have the scale to compete effectively with Michaels. With a footprint of more than 1,000 stores across 49 US states and Canada, Michaels can achieve higher cost efficiency by spreading its fixed advertising and distribution costs over a much larger revenue base than its smaller peers.

The results speak for themselves; Michaels reduced its selling, general, and administrative expenses as a percentage of sales by 130 basis points from 2009 to 2013.

Similarly, The Container Store works very hard to keep its merchandising 'fresh' for its customers. It adds approximately 2,000 new SKUs to its assortment every year.

Foolish final thoughts
The retail environment is becoming increasingly competitive and it's difficult to pick retailers as investment candidates. Michaels caught my eye because the arts & crafts industry has attractive characteristics and Michaels' private brands and wide product assortment give it an edge over its rivals.

While the arts and crafts market isn't an explosive growth market, a loyal and resilient customer base makes Michaels an attractive defensive play. Trading at 9.5 times trailing twelve months EV/EBITDA, Michaels is attractively priced.

Mark Lin has no position in any stocks mentioned. The Motley Fool recommends The Container Store Group. The Motley Fool owns shares of The Container Store Group. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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