Tilly’s Suffers From Strategic Problems And Is Not Cheap Despite Low Multiples (NYSE:TLYS)

Tilly’s (NYSE:TLYS) is an American apparel retailer focused on adolescents and young people.

The company had a difficult 2023, with same-store sales falling significantly compared with 2022 and even more with the 2021 pandemic boom period.

On the positive, the stock does not seem overvalued compared to mean-reverted profitability, and the company has no debt and almost $100 million in cash. On the negative side, the brand does not seem to have any specific competitive advantages in today’s retailing world, and its decade-long CEO has recently left after recent merchandising failures.

I prefer to pass on Tilly’s, as a play on a potential recovery seems mostly already discounted on the stock, and I’m not excited about the company’s future.

Company introduction

Tilly’s was founded in 1982 in California and went public in 2012. The company’s founders still control about 15% of total stock and exercise control via a two-class structure that gives them 10 votes per share, compared to 1 vote for the exchange-traded shares.

The company has 260 stores in California (100), Florida, Texas, Arizona (20 each), and 29 other states.

The company’s core demographic seems to be adolescents to very young adults, both boys and girls. The products are in the surfer-skater area, and the company’s stores seem to follow the same vibe.

Tilly’s strategy seems to delve around a good assortment, moving more than 20 third-party brands (none of which represent more than 5% of sales) and its own brands (which collectively represent 30%) of sales.

The company prides itself on its merchandising strategy, with new inventory reaching stores weekly and store managers having discretion over which products to order. With most stores concentrated in California, this seems a viable strategy.

In terms of digital, about 20% of the company’s sales are online. The company’s website and Instagram are relatively unimpressive.

The website is licensed (from Salesforce), many products lack a model photograph, and the grid seems unordered. Traffic has consistently decreased from 2 million a month at its peak during the pandemic to less than 700 thousand today. Critics of the website are not great, with 1 star in Sitejabber and 2 stars in Trustpilot. Critiques point to the company’s chunky and failure-prone website experience with payments and exchanging gift cards and returns. This compares negatively to 3 stars in Yelp, where the in-store experience is also included.

The Instagram and TikTok pages seem conventional, with few followers, less than monthly website traffic, and no campaigns with influencers or KOLs.

Overall, Tilly’s strikes me as a conventional retailer that follows the traditional merchandising-traffic model with some e-commerce. I do not get the impression that Tilly’s meaningfully engages customers as a brand.

Challenging year

Before the pandemic, Tilly’s was doing just fine. The company posted consistent growth, almost doubling revenues since IPOing. Its margins were not super high for a retailer, maybe indicating a lack of competitive advantage. Despite this, operating margins were relatively stable, averaging 5%.

Like most apparel brands, Tilly’s then went through a period of record revenue during 2021 and early 2022, only to decrease later.

The extent and duration of Tilly’s revenue decrease, almost reaching pre-pandemic levels, is more particular. Some apparel retailers were able to weather the post-pandemic challenges a little better. One such example is Hibbett (HIBB), which serves a similar demographic.

Management has commented that the company’s main challenge is that its target customer’s disposable income is shrinking because of inflation. However, it has also admitted (for example, on its latest earnings call) that it has had a series of merchandising flops, with articles that are not as appealing while others are undersupplied. I believe the comparison with Hibbett evidences that Tilly’s problem is more intrinsic than external.

The problem has been compounded at the bottom line via SG&A expenses that have been sticky to the downside. SG&A is about 50% store payroll; another $25 million represents advertising expenses. Store rent, fulfillment, and merchandise costs go into CoGS, so they don’t leverage the SG&A account. That still leaves about $75 million (or more than 10% of sales) as unallocated corporate expenses. This number seems excessive.

Recovery and valuation

Tilly’s current market cap is about $220 million, which net of about $100 million in cash and short-term investments results in a $120 million enterprise value.

We could add back the $200 million in lease commitments that the company has to the enterprise value, but that would also require to add back the lease costs (around $65 million in yearly payments) to operating income. I find this inconvenient and not very useful.

Pre-pandemic, the company was able to generate an average of $26 million in operating income. If we used the 5% average operating margin of the pre-pandemic period on today’s earnings of $650 million, it would result in $32 million in operating profits. Both cases are enticing compared to an EV of $120 million.

Therefore, Tilly’s seems very attractive if it can recover some of the profitability it enjoyed during the pandemic. Can the company do that?

Last month, the company announced that its decade-long CEO would be stepping down, and that the company would be temporarily helmed by the co-Founder and Chairman. This could prove an inflection point, but I would not bet on it, specially before seeing any strategic changes.

The company’s gross profits margins are slowly going back to the long-term average 30%, after heavy discounting to get rid of inventories at the beginning of the year. However, SG&A expenses are still above the long-term average gross margins. This indicates that the recovery should come from either sales leveraging (reducing SG&A to revenues) or via a decrease in SG&A.

On the revenue side, I would not invest based on an optimistic economic scenario, first because the data does not seem to indicate that, and second because it would be betting on the economy and not the company. The company has shown problems to grow in this context, which might be indicative of competitive and strategic problems, rather than macroeconomic ones. I don’t feel impressed by the company’s physical or e-commerce operations.

On the commercial side, the company faces more than 100 lease decisions in fiscal 2024. It could abandon several unprofitable stores and recover some gross margins (via lower leases) and some SG&A margins (via less store payroll). Tilly’s could also improve its corporate expenses, and reduce some of the $75 million in unallocated costs mentioned in the above section.

In this case, I prefer to wait and see signs of improvement before committing capital.

My conclusion is that although Tilly’s multiple to average earnings is attractive, and that the company has a strong balance sheet to weather a prolonged economic downturn; the company’s stock is not attractive at these prices because the brand seems to be undergoing competitive and strategic challenges. Until these are solved, or at least the problems are identified, one should not bet solely on operating margins returning to the mean.

For that reason, I prefer to temporarily pass on Tilly’s, at the expense of missing a recovery on the stock price, until more information is available.