This article is excerpted from Tom Yeung’s Moonshot Investor newsletter. To make sure you don’t miss any of Tom’s potential 100x picks, subscribe to his mailing list here.
Retail Investors Are Loving Value Stocks…
It’s been a phenomenal time to be a value investor. Since 2021, value stocks have quadrupled the returns of growth stocks.
Many of Moonshot’s picks have ridden that wave, with firms like Volt Information Sciences (NYSEAMERICAN:VOLT) doubling almost overnight. Some energy picks have performed even better.
And finally, retail investors are beginning to notice.
In March, data firm VandaTrack found that individual investors were net buyers of travel companies, with cheap stocks like Delta Airlines (NYSE:DAL) and Carnival Corp (NYSE:CCL) leading the way. Oil and mining stocks have also seen much investor love.
Value investors can thank luck and history for the recent run-up. Value stocks severely underperformed between 2015 to 2020, creating pockets of excessive cheapness. And the Fed’s gradual rate rises have created a “Goldilocks” environment for value. It’s slow enough to keep consumer demand strong, yet fast enough to incentivize institutional investors to rotate out of “high-duration” growth stocks that suffer as rates rise.
It’s created a tasty porridge that’s just right.
…But Deals Are Getting Harder to Find
Much like a good meal, however, markets can have too much of a good thing.
In this case, rising asset prices have made deep-value stocks less cheap. Retail investors are now finding themselves picking between expensive tech firms or moderately-priced value stocks.
Buying up GameStop (NYSE:GME) shares at $4 is a thing of the past.
Or is it?
In today’s Moonshot issue, I’m going to take a bit of a flyer. Rather than talk about “safer” Moonshots, this e-letter will cover a stock that’s much more like GameStop in early 2020.
It’s a mall-based retailer…
Wall Street hates it…
You probably haven’t stepped foot in any of its stores since 2018…
And three bears might show up at your doorstep to tell you it’s gone bankrupt…
And yet its shares are also absurdly cheap. And much like other meme stocks, it’s built a lot of customer goodwill over the years.
Party City (NYSE:PRTY).
Party (City) Like It’s 2015
I’ll admit… when Party City went public in 2015, I wasn’t convinced it was a good bet.
At the time, the company’s $17 share price implied an enterprise value of $4.1 billion — a heady value for a retailer where 85% of its products are available online.
The remaining 15% of in-store goodies weren’t exciting either.
Balloons… Cheap candy… Last-minute Halloween costumes…
Not exactly a wellspring of opportunity.
At first, investors didn’t seem to care. The 2010s were a phenomenal year for stocks, and Party City would quickly rise 30% in its first month of trading. For a brief moment, it seemed as if PRTY would keep the celebration going — helium balloons and all.
But then things started to unravel.
Within a year, shares had dropped 35%. And by the time the Covid-19 pandemic hit in Q1 2020, its stock had fallen to $0.30.
You could hardly buy a piece of candy for that.
Cheap Candy Meets Cheap Stocks
But in recent months, Party City has managed to survive… and thrive.
In February, the firm announced blowout 2021 figures. Same-store sales for the year had jumped 34%, erasing more than half of the company’s pandemic-related decline. Gross profit also increased a stunning 4.8% — driven mainly by the divestiture of its low-margin international operations.
One insider even doubled down on his shares. Between April 6 and 8, 10% owner Clifford Sosin added another 1.95 million shares to his 18.05 million holdings.
And he’s an investor to watch.
According to data compiled by TipRanks, Mr. Sosin has averaged a 161% return by trading the companies he already owns. It’s a hallmark sign of a successful Insider Track play.
Four Reasons to Celebrate
Four bull cases are emerging for Party City.
- Retailers are learning to compete against e-commerce.
Some companies were quick to adapt to online competition. Tractor Supply (NASDAQ:TSCO) has pushed its shares up 1,730% since 2010 by focusing on smaller communities with few retail options. Others like Dollar General (NYSE:DG) and Dollar Tree (NASDAQ:DLTR) carved out a niche in low price-point goods that are harder to ship profitably.
The Covid-19 pandemic would eventually force lagging retailers to innovate or go bankrupt. Party City has been one of the survivors.
- Party City is expecting a sudden return to profitability.
Party City’s operating costs are largely fixed, so any improvement in gross income generally flows straight through to profits.
Wall Street analysts expect the company to bring in 82 cents per share in 2022, a 21% improvement over 2021 earnings.
Bondholders have also been getting excited. In February, Fitch upgraded PRTY’s credit rating from CCC to B-, a rate that reduces its implied default probability from 40% to 10%.
- PRTY shares are cheap… especially if you ignore debt risk.
PRTY stock is currently priced at 5x price-to-forward-earnings, placing it in the same league as home builder D R Horton (NYSE:DHI) and dry bulk shipper Genco Shipping (NYSE:GNK). The latter has a 12% dividend yield.
Once you ignore debt risk, PRTY looks even cheaper. Its 0.18x forward price-to-sales puts it in the bottom 1.5% of U.S. companies by that metric. GameStop’s shares would have to drop 90% to $15 to achieve a similar valuation.
- It’s easy for retail investors to understand.
Finally, there’s the meme stock potential.
Redditors generally gravitate to easier-to-understand companies like AMC Entertainment (NYSE:AMC) and GameStop, giving Party City a distinct advantage in attracting retail-based investors. Hype around enterprise-focused firms like Palantir (NYSE:PLTR) and Blackberry (NYSE:BB) tend to be shorter-lived.
The Risks of Deep Value
Cautious investors, however, will be quick to note Party City’s woes.
Much like other private-equity spinoffs, PRTY is loaded with interest payments like a resident out of med school. (The company’s accountants probably have about the same amount of cheer).
Its $1.3 billion debt now costs almost $100 million per year to service — a scary prospect for a firm that generated only $78 million in net income last year.
And things could get worse. As rates rise, the company may find fewer reasonable options for refinancing its bonds due in 2026.
The company also operates in a mature, low-growth industry. Similarly cheap stocks like JC Penney and FYE have gone bankrupt instead of turning around.
Finally, Party City’s long-term returns are unexciting at best. Return on invested capital (ROIC) has averaged 7.8% since 2016, barely covering its 7.2% cost of capital. An investor holding PRTY shares for twenty years will be disappointed.
But much like GameStop in 2020, Party City’s low valuation is creating the potential for super-normal returns. And with retail investors seeking the next deep-value investment, Party City gets my vote for “most likely to be the next GME.”
Retail Turnarounds are Hard
In 2016, the board of vitamin retailer GNC unceremoniously ousted Mike Archbold as CEO.
It was a decision at least a year in the making. The firm had run a massive share buyback program, decreasing its outstanding shares from 68 million to 86 million, but per share earnings of 94 cents still left investors unimpressed. And discount retailers from Walmart to Amazon were continuing to chip away at GNC’s customer base.
But any Main Street investor would have known that the retailer’s problems had started years before.
That’s because the protein supplement fad had been declining since 2011. It was only a matter of time before that reality would show up in GNC’s financials.
Many other speciality retailers face the same issues. When firms become so specialized, it becomes an uphill battle to adapt.
FYE… Blockbuster… Guitar Center… Pier 1 Imports… Retail failures are far more common than turnarounds.
So the next time you see a retailer with declining sales, remember that even a pivot to NFTs might not save the firm.
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On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.