Carter's, Inc. (CRI) Earnings Call Transcript & Summary

Good afternoon. My name is Bill Reuter, and I'm the high-yield retail and apparel analyst here at Bank of America. We're here to talk about something which almost everyone thinks is fun, which is newborns, young children, and that's with Carter's. We have Mike Casey, the CEO; Richard Westenberger, the CFO; and Sean McHugh, the Treasurer. No one wants to hear from me, they want to hear it from Mike, so I'm going to pass it over to him.

Hey Bill, thanks very much. Good afternoon, everybody. Thanks for making time to get together. I've got some very brief opening remarks for those who may be a bit less familiar with the Carter's story, and then we'll have plenty of time for Q&A. So as you may know, Carter's is the largest branded marketer of young children's apparel in North America. We own the largest share of a $30 billion market in the United States, we have nearly twice the share of our nearest competitor. We own 2 iconic brand names that, my guess is most of you have heard of and you probably have warned and if you have children or grandchildren, you've certainly purchased for your family: Carter's and OshKosh B'gosh. Both brands have served the needs of multiple generations of consumers for more than 100 years. Carter's is the dominant apparel brand for newborns with nearly 4x the share of our nearest competitor. OshKosh beautifully complementary brand. That's why we bought it back in 2005. Skews a bit older, whereas Carter's skews younger, known as the dominant baby apparel brand. Oshkosh is a playwear brand, including the iconic Oshkosh overall. Both brands have extended their product offerings to serve the needs of newborns up to about a 10-year-old child. We focus on essential core products, the must-have products that consumers purchase in great frequency in those early years of life: Bodysuits, wash clothes, towels, bibs, blankets, pajamas and playwear for those children. Children rapidly outgrow these outfits in the early years of life. Our brands are known as traffic drivers. That's why we have these wonderful relationships with Target, Walmart, Kohl's, Sam's, Costco, the off-price retailers because they realize that our brands are traffic drivers. Families have a need to replace these wardrobes frequently in those early years of life. There's a need to go out and shop. And when they shop for their children, they're inevitably buying some things for themselves and the rest of the family. Over many, many years, we've built this wonderful multichannel model. We started as a wholesaler. We were a domestic wholesale manufacturer. This is why we're completely in [ Georgia's ] where all the top years ago. We had all of our manufacturing here and then, of course, it evolved to sourcing from Asia. Our brands are sold in about 20,000 store locations in North America. We're the largest supplier of young children's apparel to the largest retailers in North America, and Target, Walmart, Amazon, Kohl's, Macy's, are some of them. We are the largest specialty retailer focused exclusively on young children's apparel. Years ago when our business was largely focused on wholesale, we also had outlet stores like most domestic manufacturers had to work through regulars, overruns. So we had outlet stores, and then we evolved out of outlet stores into strip centers because strip centers were very much like the outlet store locations. Very profitable store model. And then a little over 10 years ago, we launched our own eCommerce platform. It has been our fastest-growing, highest-margin business. And it's grown to be the largest eCommerce platform focused exclusively on young children's apparel. Very profitable international business. So if you're following you've got a wonderful wholesale business, retail business, direct-to-consumer and then international. International this year will probably be around 13% of our consolidated sales. Brands sold in over 90 countries and 2/3 of what we define as international or multichannel operations we manage up in Canada and Mexico. These were licensees that built these beautiful businesses, multichannel model businesses. And when they got to a certain scale, we acquired them. We also do business with the multinational retailers, Amazon, Costco and Walmart, and then dozens of other wholesale relationships throughout the world. On track record of good growth prior to the pandemic, 31 consecutive years of sales growth. This is not a hot-and-cold business, because what we do for a living -- you have new customers, beautiful new babies being born every day, #1 brand they think about is Carter's. So we had 31 consecutive years of sales growth, long track record, strong operating margins in cash flow generation, very strong balance sheet and substantial liquidity. Pandemic, we're emerging from the pandemic, I believe, a stronger company. Made a number of structural changes in our business to weather the storm that I think will serve us well in the years ahead. During the pandemic, we cut our SKUs by about 20%, focused on fewer, better, higher-margin product choices. Ran leaner on inventory somewhat intentionally. And then when stores closed, unintentionally, we had to cut back a lot of second half 2020 inventory commitments, and that served us well. By cutting back on inventories, we cut our off-price sales in half, reduced the clearance sales significantly, focused on fewer, better, higher-margin stores. We doubled the number of store closures. Of stores coming up for renewal on the leases, we're not providing a service level to margin-rich e-commerce customers. Or if they weren't taking some -- taking advantage of some of these buy online, ship to store, pick up in store, curbside pick-up in store, we said don't renew it. Let's open up in a better location that's going to provide a high service level to the e-commerce customers. And then because we were leaner on inventories, we focused our marketing investments on brand building, developing kind of this virtual relationship with consumers, with virtual summer camps, virtual sing-alongs, virtual baby shower. So we focused our marketing less on promotions and more of the emotional content of raising children and all these structural changes and others drove a significant improvement in price realization and higher profit margins. So outlook for the business is good. If you tuned into our most recent earnings call at the end of October, outlook for the business is good. We're projecting a strong finish to the year, also planning good growth in sales, earnings and cash flow next year and the years ahead. That's a summary based on forward-looking statements. There are risks inherent in the business, and those risks are disclosed in our SEC filings. So hopefully, that overview, as brief as it is -- I could go a lot longer, but I was told to be brief, so we have plenty of time for your questions this afternoon.

Great. That was very helpful. So first of all, everyone in the audience, if you want to use your interface to ask questions, I will have them, ask them of the team. I will ask some here to get us started on our own. So the first question is about demand. Apparel across the board has seen huge amounts of demand as it's generally viewed as discretionary. I don't view your products as being quite as discretionary as a lot of apparel categories. How do you think that your categories either benefit from an uptick in discretionary spending versus being a more consistent story that's more based upon need in terms of apparel?

I think it's more of the latter. Again, there's no naked babies in the world, naked babies. There's a need for our products. And we're in every major location where people are shopping for kids' apparel. And when you find out you're expecting, by and large, it's the first purchase that you're going to make for your beautiful new baby on the way. And the beauty of our business, again, what we focus on are those essential core products, the things families with young children go through in multiple quantities in those early years of life. There's multiple changings in those early days, weeks, months of a child's life where your multiple change -- out changes in each day. So we focus on the things that consumers need and want. And so that's why I think we've had the consistency in our performance over many, many years. You'd be hard-pressed to find somebody else that's had 31 consecutive years of sales growth. I think you'd be hard-pressed to see find another company that's built the strength of our multichannel model as we have evolved from a wholesaler to then opening up our own stores, in many cases, right next to our wholesale customers. And then I can remember years ago, one of our largest customers said we're okay with your stores opening up, competing. But if you guys go online, that's going to be a problem. Well, then we launched our e-commerce platform. And every time we did that, everything grew. So even when we were focused mostly on department stores many, many years ago, Target called they say, "Listen, we're charge, and we need the Carter's brand because that -- we view it as a traffic driver." So we can't give you the Carter's brand, but how can we help you? So we developed a brand just for Target. And at the time, many of our investors were worried, "Well, what's that going to do to your business at Kohl's and Macy's?" Because years ago, this was back in 20 -- this was in 2000, everybody viewed Target like they view Amazon today. Like years ago, they thought Target was going to put everybody out of business. They didn't. When we launched Target, everybody grew. Kohl's and Macy's grew. 2 years later, we launched with Walmart. And people were like, well, Walmart, what's that going to do to your business with Kohl's and Macy's? What's that going to do with your business with Target? Everybody grew. And then in more recent years, Amazon approached us to say, we want the Carter's brand. We, well, can't give you the Carter's brand, but we'll replicate the successful model with Target and Walmart for you. My point is that all these major retailers see the beauty of our brands and see the essential need families have for kids' apparel, particularly the dominant brand in kids' apparel. And it provides relevancy to their private label brands. Every major retailer has their own private label brand. But when those brands sit side by side with our brands, one, they have that choice. And depending on what the end use is, they have a good choice. Our brands are typically priced a bit higher, those brands. But those are 2 good choices. But a big part of our business is gift-giving. And more often than that, the data would show, more often than not the consumer spends an extra buck or 2 to bring a gift from Carter's or Baby B'gosh.

You actually touched upon my next topic, which is the original transition from wholesale to retail. Throughout the retail evolution, you have gone through a period where you're planning on closing stores, and now you're planning on opening them. Can I guess -- can you talk about what has entered into that transition? And then what types of locations you're looking for these, whether it's outlets, strip malls, full-price retail?

Yes. So again, just a quick history. We had outlet stores years ago, like most domestic manufacturers had outlet stores. But we made a lot of money in our outlet stores. We used to call our outlet stores ATM machines because they had a very high return on investment. Very little investment in CapEx and inventory, but we recognized only about 5% of kids apparel was bought in outlets. So we said, why don't we take that same model and bring it closer to the consumer? And everything was the same: Timing of delivery, pricing was the same, experience was the same. Everything was the same but for location, and it worked. It worked beautifully. And so we were in this store growth period. So we transformed our company from what was largely a wholesale operation. More of our business now is direct-to-consumer. And we did that, Bill, because we felt as a long term to have a direct-to-consumer business, we have more control over the brand, a better presentation of brands. This is all we do for a living. We don't have a men's business; we don't have a women's business. We don't have a housewares business. All we do is kids' apparel. We've been doing it for not us. But we -- as a company, we've been doing it for over 150 years. So we wanted to have more control of the brand, and it works beautifully because the more we opened up stores, the more we focused on the e-commerce platform, it became a point of inspiration for our wholesale customers, because they would marvel at the success. We had the CEO of one of our largest wholesale customers say, "Listen, I listen to your earnings calls, and you continue to say e-commerce is your fastest-growing highest margin business. That hasn't been our experience. We'd like to learn more." And that CEO came to Atlanta. We met with them, took them up to our multichannel distribution center in North Atlanta, walked our stores together and showed them the kind of how we manage the business. And the reason why we have such a very profitable e-commerce business, we have a very low return rate. We've been making white body suits for 100 years, blanket sleepers, wash clothes. It's not a mystery what you're going to get. You're not going to put a white body suit on your baby, and you say, this isn't at all what I thought it was going to be. You know exactly what it's going to be. So we have a very, very low return rate. That's the returns for men's and women's apparels and shoes for Zappos, the return rate for some of those product categories are well north of 50%. Ours is a fraction of that. And so -- so anyways, we were in the store growth mode, direct-to-consumer mode with e-commerce. During the pandemic, our retail team took a look at stores coming up for renewal, like they do every year, some portion of 20% or more of our leases come up for renewal every year. And they looked at to what extent were the stores up for renewal providing a high service level to our margin-rich e-commerce customers. So we're focused on that omnichannel customer, that consumer who views the stores and online is one. So we've added -- we've invested in these capabilities where you have the convenience of shopping at home and then completing your transaction, say, "Hey, can I kick it up at the store?" And it will ping you on your cell phone and say, it's ready. You can pick up your online purchase in a couple of hours at a store located close to you. Or if you don't really need it today, just we'll shift the product to the store, you could pick it up in the store. Every time that happens, that's a margin-accretive transaction. Another big investment we made is in RFID capabilities so that if you're a family in Seattle shopping with us, we can see to what extent that store -- one of our beautiful stores in Seattle has what you just ordered, and we may fulfill that purchase from one of our stores in Seattle. You'll get the product quicker than from shipping it from Atlanta, and it's less expensive. It's a margin-accretive transaction. If a store coming up for renewal, those didn't have a big e-commerce penetration. We said, close it, close it. Because the way of the world is going to be more online shopping, this kind of beautiful combination of the online and brick-and-mortar experience. So that's why we decided to close the lower-margin stores that are not providing a high service level to the e-commerce customer, open up a store in a more densely populated area where it's more likely that, that consumer will shop. The stores we're opening, there are plenty of good choices. It's a very good real estate market because some retailers did not make it through the pandemic well. Some of our competitors didn't make it. So we're taking a look at some of the real estate locations. There are good outlet centers. We are the dominant -- our brands are #1 and 2 in kids apparel in the outlet centers. Prior to the pandemic, we were going down a path of malls. We always stayed away from malls because we -- strip centers were more like outlet centers. But then when some of our competitors didn't make it, we said, let's take a look at some of those real estate opportunities. And we looked at well over 1,000 mall locations, and most of them said we would have no interest in because the economics weren't attractive, the returns wouldn't be good. But we said there's probably 300 to 400 good mall locations worthy of consideration. We're in about 75 of them today, some of our best-performing stores. Especially now that people are reconnecting and getting back into the stores, if you followed some of these trends, reporting in the Wall Street Journal over the Thanksgiving holiday, the stores are people going back in the stores. I've been to visit to our store visits. It was hard to find a parking spot on a Tuesday, like on a Tuesday morning, the parking lots were full. This was prior to the Thanksgiving holiday. So we got good at closing stores during the pandemic. The direction we've given in our retail team now go after those better real estate opportunities that enable a high return on investment. People, 2/3 of kids' apparel is bought in stores. And to have the strength of an e-commerce platform and the beauty of the presentation, the convenience of being able to pick up the product in the store located close to their homes, that's a wonderful combination. So you'll hear us talk more about what is the door go growth plan in February. That's when we articulate what we think is possible going forward. But my guess is our store growth plan will be better than what we articulated at the beginning of this year. It will be -- and we see new opportunities to open up stores closer to densely populated towns where there's a high mix of families with young kids.

Switching gears a little bit. Everyone's curious on manufacturing disruption. Are you concerned about facility closures? There's obviously rising cases of COVID in Vietnam. Can you talk a little bit about your diversification around by country? And then what you're seeing or what you think is going to happen?

Yes. So the biggest market we have is Cambodia. So that's probably -- I think that's more than 30% of -- yes, I think it is about 30% of where we source product. The next biggest market is Vietnam, it's around 20%. So those 2 countries about 50%. Cambodia is in good shape. China is in good shape. China, everybody, including Carter's has been deemphasized in China for a lot of reasons, even before the pandemic. China was kind of in this mode pre-pandemic. We want people in China worked out on higher-value services. They were trying to deemphasize apparel. They'd rather have them working on airplane wings or technology and that type of stuff, we get it. So we were -- even our China-based suppliers, we're investing in plants in Cambodia, Vietnam, Malaysia, for us. And so I would say Cambodia, China is in good shape. Everyone else has actually done well. I mean years ago, you talked about Bangladesh that was a high, high risk for all the reasons that were reported, safety, all that. But Carter's and other good companies invested in Bangladesh, that alliance for worker safety. And Bangladesh was neck-and-neck with Vietnam and the second largest producer of apparel, exporter of apparel from Asia. But Vietnam was rocked because Vietnam has had a strict COVID restrictions. And I don't know if we were ever actually shut down in Vietnam. It just wasn't full production. And some of our suppliers are getting people back in. Some parts of Vietnam aren't back to full production. They're seeing high rates of absenteeism and because people just can't get into the plants because they're restricted from. But I think with the passage of time, with the access to the vaccine, I think the United States donated over 1 million doses of the vaccine to help, because they understand the importance of Vietnam to the U.S. economy. I think it's going to be bumpy. I would say our shelves are full. If you went into our stores today, you've got plenty of Christmas PJs, you've got plenty of good choices. Is the mix ideal? Did some of the bottoms come in and not the tops that we designed to go with the bottom? Sure, there's some of that. But I would say demand has been robust. We've had -- I've been in enough of our stores in recent weeks, plenty of good things to choose from. And where we are now is, we're coming to the tail end of the fall and holiday season. We're working with our -- our wholesale customers to say, listen, yes, you wouldn't -- you don't have -- you're not going to have a typical 13-week selling cycle. Maybe we have some portion of whatever 6 weeks, plus or minus. So we're going to ship in the 6 weeks that you're going to sell through at a good sell-through, a good margin. We'll either pack and hold or we'll absorb, we'll work it through our own stores. Pack and hold meaning, bring it back next year because they love the product. It's just that you just don't have the full selling cycle. There's no -- the risk, and we're going to avoid this, is ship it all in but then it doesn't sell well. And if you're clogging up off the floor, with too much of the old, you're not making room for the new. So we're pretty good at this. I mean, I think the biggest challenge is behind us, I mean we went through a very difficult time, we learned all kinds of new skills on how to deal with store closures and lockdowns and all that jazz and order cancellations. I think we weathered the storm extremely well in 2020. We're having a very strong recovery this year with some of the changes we've made in our business. I think the path forward is going to be a little -- the recovery is going to be uneven; the path is a bit bumpy. But I would say today, I think things are stabilizing. And I think what we're going to see is once we get beyond this kind of holiday demand -- there's always this kind of window. There's like these things -- a little bit of a breather for our suppliers. Once we get into that post-holiday January, February time period, Chinese New Year period, that will enable some to catch up on some things that they were running behind on, get a head start on Spring. We actually moved the Spring production up a couple of weeks to get ahead of some of these delays. Certainly with the West Coast ports. West Coast ports are clogged for a lot of reasons. But everybody's scrambling to get everything in before the holidays. After the holidays, I guess as some of that congestion will clear, I don't think we know enough about this new virus. That's the new wrinkle this past week. But suffice it to say, we know more about how to deal as -- the world has more knowledge of how to deal with some of these variants than we did in March of '20. So my guess is we'll work our way through it. It's kind of an uncertain time. But all I know is one thing about Carter's, beautiful babies are being born every day. So the demand will continue to be there. Our challenge is to make sure we do a good job supporting it. And we went from a $3.5 billion company down to a $3 billion company in '20. We came roaring back to a $3.5 billion company this year and a more profitable company. 2019, we earned about $400 million in EBIT. This year, it will be closer to $500 million. This is a stronger company. We've all used the expression this past year, silver linings in a lot of respects. But in terms of -- we learned a lot. We've developed new skills. We tried new and different things because we had room to do those new and different things, and we've learned how to run a more profitable business.

Shifting gears a little bit to some financial questions. I guess the first is thinking about a leverage target. I'm not sure whether the company currently has the leverage target, do you maintain one? And then a little bit around that, what do you think about in terms of your capital allocation policies? How are you thinking about using your free cash flow over the next year?

Sure. Sure. Well, to answer your primary question, we've not had a specific leverage target that we've articulated, and we've not had a specific target to which we've operated. And our position over the years has been to have a strong balance sheet. We've been historically, I would say, moderately levered. The business has been owned by private equity several times. In those days, the business was highly levered. It was a beautiful model for that because the business is very cash rich. So that debt was put on the books and then paid down over time, so it created a lot of value for those owners. The business does throw off a lot of cash. In 2019, we had nearly $400 million of operating cash flow. We think as we go forward into next year, we're going to be back in that, kind of, more historical pattern of generating significant operating cash flow and significant free cash flow. So the first priority is to invest behind our growth alternatives, our growth opportunities, which we think we're pretty fully doing. We're pretty fully supporting the investment needs. There's nothing that people have brought forward a good business case internally that we haven't been able to find. So we're not cash constrained in any event. We did put on some leverage at the beginning of the pandemic, not knowing how deep and severe that the COVID situation might be. Our forecast didn't indicate that we needed additional financing, but this prudence being what it was, we felt like it was the right time to put some additional capital on the balance sheet. As we've come through the pandemic, to Mike's earlier comments, we've made these what we call structural improvements to the business. So we have meaningfully improved the profitability of the business. So on less revenue, we're meaningfully more profitable and generating, again, a lot of cash flow. So right now, our thinking is as we get into next year, we're likely to take some of that pandemic debt off the balance sheet. Pre-pandemic, we were a little less than 2.5x levered counting or incorporating our lease leverage because we're a retailer. We've got big obligations to come from those leases. So it's important to remember those as well. But we're a little less than 2.5x. That's been a comfortable place to be. My guess is that we'll operate somewhere between 2 and 2.5x. Still lots of flexibility to pursue anything that we would like to. We have been, I think, a good distributor of excess capital. So over the last number of years, we've distributed most of our free cash flow to shareholders. Most of that in share repurchases, we do have a recurring dividend that we suspended during the pandemic, we've now restored it to the pre-pandemic level. Our intention would be to grow that dividend with earnings over time. And then to the extent we have additional unallocated cash, we would look to distribute that via share repurchases. So that's broadly how we think about it.

That's very helpful. And then historically, the company has been very conservative with regard to M&A. You have done some small tuck-ins here and there. I guess, has anything changed in terms of your view about opportunities given that a lot in the environment has changed over the last year or 2?

We'd actually love to add another brand or 2 to the portfolio over the next 5 years. It is slim pickings though, then because of our position in the market, we're usually the first person to get a phone call. We've looked at a number of things over the years and things -- the brand names that you would know. And even those who bought them, came back to us to sell them soon after they bought them. So it's -- we're really good at kids' apparel. So that's why some people take this on, and they say, this was -- this is a -- it's a challenging business. It's a complex business to manage. And -- we focus on kids' apparel. We've often thought it's often been suggested something outside of kids' apparel. And then we really ask ourselves interesting opportunities. And I have to tell you, we've looked at some things that when we passed on them. A year later, we look back and say, thank God, we passed on it, right, for a lot of reasons. We just said, you get smarter as you get older and with more life experience you said, glad we passed on some things. I'm glad we didn't get some things that we were interested in, that we couldn't bring the company to the altar, as much as we dated and try to encourage them to combine. There are some things that we look back said, looking back sometimes you get lucky that you didn't get some things that you thought would have been good additions to the portfolio. But we want to make sure we acquire brand names that are worthy of sitting side-by-side with Carter's and OshKosh B'gosh. Those are 2 awesome brands that have multiple generations and have a good experience with. But we look for something in kids' apparel, something with a track record of growth. We're not looking to take on some huge turnaround. And we're looking for a good management team that wants to stick with us. Carter's kind of place people come, and they spend the bulk of their career. Most people I work with, this is the longest run they've had in their careers, and it's been a very successful experience, good experience for them. I'm honoring people next year with 30, 40 years with the company. A good friend of mine retired after 57 years. That's what Carter's is. It's just this wonderful culture, experience, career experience for many, many people. And we're looking for something that would be accretive to earnings near term. It's just -- we're not looking for something that's going to lose money, and we're hoping year 5, it starts to break even and start making money. So we've looked at a number of different things. But with that said, we continue to look. And because of our position in the market, the -- we're often -- we had something this past week or someone reached out to the third time to say, "You sure you don't want to get together? Because we think we have an interesting position in the market." But our bankers provide wonderful ideas to us. And so we have the capacity. We have the interest and capacity to make an investment in a good brand that would add to, strengthen our business. Our business is much more interesting because we own OshKosh, Canada, Mexico, Skip Hop. So we're interested in adding acquiring brands or businesses, and we'll continue to look. We'll continue to search. But we have to -- we have high standards for an M&A because you have to, because it -- but we understand the risks of M&A as well. For now, we're going to stay focused on the core business, because there's more money to make in the core.

I guess we have time for one more. As credit investors, we're obviously always thinking about what can go wrong. Private label is always a risk. I guess how do you think about those risks particularly in light of the fact that you do have these exclusive relationships with your largest customers such as Target and Amazon you've laid out today. I guess, is that a concern?

Well, private label has gotten very good. The big investment in private label was during the Great Recession. So in the Great Recession, all the major retailers focused on offering a high-value component in kids' apparel. That period was very good for us because what they did is, they entered out all these other tertiary brands, and they said, "Listen, there's going to be fewer, bigger, larger, stronger retailers. We need fewer, bigger, stronger suppliers," and that was Carter's benefit. Again, Bill, our brands add legitimacy. You want side-by-side in person. Again, a big part of our business is gift giving. And you can bring a gift to the home or to the shower from Wonder Nation or Okie-Dokie, or Jumping Bean or Faded Glory, or you can pay $1 or $2 more and bring a nice gift from Carter's or Baby B'gosh. Our track record would say more often than not, people -- because look at our share, more often than not, people buy partners and OshKosh B'gosh, because they know it's going to be a great experience. And it says something about the gift giver, right? But in your relationship with the giftee, what kind of brand you bring to the house.

All makes sense. Well, thank you so much for spending some time with us. I wish everyone a happy holiday. Thank you for all the effort you're doing.

I wish you the same. Bill, thanks for hosting us. Take care.

Thank you all.