Cato Corporation – Slam Dunk or Value Trap?
After COVID-induced shutdowns hammered brick and mortar retailer Cato Corporation in 2020, results have come roaring back. Even after a 75% appreciation so far this year, the business stills looks extremely cheap after stripping out excess cash.
Cato owns potentially valuable hidden real estate assets to boot, providing a further margin of safety. Is the situation too good to be true?
Background
Founded in 1946 Cato Corporation is a sleepy retailer of women’s clothing. The company operates around 1,300 locations across 33 states and is run by CEO and Chairman John Cato who controls 45% of the voting stock. Cato generates essentially all of its revenue from brick and mortar locations, and generally serves lower income and rural areas. About half the locations are positioned in the same strip as a Walmart, which serves as an anchor for their clientele.
Cato primarily sells private label women’s clothing targeted at junior and plus-size shoppers. Basically the strategy is to sell low-priced apparel in strip shopping center locations to people who are already out running errands. Not exactly the most exciting business model, but they’ve been doing it for 75 years and it’s what they know.
The number of stores has remained largely flat since 2002, rising less than 1% per year. Total number of stores peaked in 2016 at almost 1,400 and was just over 1,300 as of the end of 2020.
Source: Company filings, author
Cato is a no-growth business but it does generate a decent amount of cash. From 2002-2019 eps grew at just 1.2% annually (so negative after inflation). In recent years the company has paid out ~75% of earnings in the form of dividends. In 2020, when stores had to shut down for the pandemic, the company slashed its dividend from $1.32/sh to $0.33/sh.
Source: Company filings, author
Fortunately for shareholders, the company has always maintained an exceptionally conservative capital structure with a hefty net cash balance. Excess cash has averaged around $180M for decades. The company lost money in 2020 but thanks to the capital structure was able to avoid a terrible outcome for shareholders, weather the store shutdowns, and pay or renegotiate its operating leases.
Investment Appeal
Andrew Walker recently did an interesting interview on his “Yet Another Value Blog” podcast with guest Mike Melby from Gate City Capital. Mike pitched Cato as an investment and laid out compelling reasons to own the stock, most of which centered around the rock bottom valuation and potential to realize value from hidden real estate assets. I decided to do a little digging after listening.
The bull thesis for the stock is pretty straightforward and goes something like this:
Cato holds roughly $10 per share in cash ($186M) and income tax refund receivables ($30M) compared to a ~$16.80 share price. Additionally, while the business leases virtually all store locations, they own 350 acres of mixed-use development land and 150 acres of industrial property. This land is not needed to run the business and looks like a “hidden” asset.
Kuddos to the guys at Gate City who have done extensive homework on the land, as it does not show up in SEC filings but can be found via property tax records. Cato is currently partnering with a developer to build out the land which sits in a desirable location in the Charlotte metropolitan area. It appears to be fairly early in the process, but so far the developer has built a headquarters for RoundPoint Mortgage and is in process of developing a grocery store, shopping center, and hotel.
Melby estimates, based on comps in the surrounding areas, that the 350 acre parcel, including the equity interest in the already built mortgage building, could be worth around $55M. The 185 acres might be worth another $9M based on similar land currently on the market. I don’t have any insight into South Carolina property values but the estimates Melby laid out seem very reasonable based on comparable real estate transactions and current listings in the area.
Cato also owns its headquarters and a distribution center in Charlotte, but I wouldn’t assign any excess value to those given the business needs those properties to operate. In theory those properties could be monetized in a sale leaseback or liquidation type scenario, but I’ll leave those aside for now.
So, altogether the company has $10/share in cash and equivalents and $3/share in “hidden” real estate assets meaning investors get the core retail business for less than $4/share. Cato earned $1.46 in 2019, the last normal year of operations before COVID hit. If the company quickly returns to 2019’s performance then the core business trades at less than 3x earnings.
If you believe the next couple of decades will look like the past couple, then the retailing business will continue trundling along at 1-2% growth, implying a fair multiple of 11-13x earnings (using a 10% discount rate). Capitalizing earnings at 12x gives you a fair value of ~$17.50 for the retail business, or around $30 for the stock including all of the assets mentioned above. This compares to a $17 share price today, or 75%+ upside.
In addition to the apparent mispricing of the core business, Cato has a near-term catalyst in the form of dividend reinstatements. Pre-COVID the company paid a $1.32/share dividend, but took the prudent step of halting the payout during the uncertainty of 2020. The dividend was recently reinstated at a lower level of $0.44/share, but it stands to reason that the old payout levels could quickly be reinstated as pressure from the pandemic eases. If and when Cato resumes 2019’s payout levels the stock will yield around 8% from today’s price. It will begin to show up on the screeners of dividend seeking investors as trailing financials catch up with economic reality. Oftentimes this juicy yield will push up share prices and investors who get in ahead of the announced increase benefit from a great yield-on-cost and a rising share price when the dividend hike is made official. Kontoor Brands benefited from this dynamic after it was spun off from VF Corp. in 2019 and again when they halted and subsequently reinstated the dividend last year.
Source: Company filings, author
If you buy into the sum of the parts valuation above and believe that the market will close the gap to intrinsic value in any meaningful way, then investors could be looking at pretty solid returns. Total returns could exceed 100% over the next several years when including probable dividend payments.
Risks
It might seem like a layup to buy a stock whose core business appears to be trading at 3x earnings, and it may in fact be that simple. There are, however, a few ways that this theoretical valuation never comes to fruition.
The biggest problem with an investment thesis that hinges on realizing value from hidden assets and excess cash is, drumroll…you have to actually realize the value from those excess assets sooner or later. This seems obvious, but I think it’s often overlooked in situations like this. It’s sloppy to assume that the excess cash is going to find its way into minority shareholders pockets via increased dividends or buybacks before taking a look at capital allocation tendencies. This is why seemingly reasonable sum-of-the-parts valuations so often fail to prove out in practice.
Over the last twenty years the company has always carried a ton of excess cash on the balance sheet. Since 2010 cash has averaged over $220M per year, and I don’t have any reason to believe John Cato is willing to part with a significant portion of the excess cash. There’s nothing wrong with this, by the way, as his conservative structure can be thanked for getting the company through COVID. It just means that returns on equity are going to be more depressed than they otherwise would be and shareholders seem unlikely to realize the value of the excess cash. An activist investor is unlikely to persuade Cato to become less conservative as he effectively has majority voting control. John Cato controls 45% of the vote and it’s impractical to think essentially all of the remaining investors would take the time or effort to side with an activist.
Turning to the real estate, you need to have conviction on both the value of it, the time to realize the value of the developments, and that shareholders will benefit from increased distributions if and when the land is sold. That’s a lot of ifs, and real estate development is notoriously difficult and fickle. I’m not saying investors won’t realize sizeable returns from these hidden assets, but I’ve been underwhelmed before banking on quick realization of illiquid real estate assets.
Finally, low-end retailing is generally a brutal game to play, and just maintaining “no-growth” is not guaranteed for an undifferentiated retailer like Cato. I would certainly lean towards betting that the business will continue to maintain historical levels of earnings for the foreseeable future – private label women’s clothing located near Walmart anchor locations does not seem ripe for disruption – but there is not a competitive advantage that I can find in Cato’s model. If the business loses its way and starts seeing sales contract and has to close locations (like it did from 2016 to 2019), you can kiss any hoped-for multiple re-rating goodbye.
Takeaway
Cato is an interesting situation. It undoubtedly looks cheap, maybe extremely cheap if you can get comfortable with realization of value from hidden assets and excess cash. If I controlled the cash flows and distributions of the company and could buy 100% of it at this price I certainly would be happy to do so. Buffett famously did things like this in the early days and diverted cash flows from so-so businesses into higher return opportunities. The big issue with this one is that Mr. Cato controls capital allocation and, while he hasn’t done anything horribly wrong, I don’t really see a quick monetization of excess assets anytime soon.
Matt and I always say that if price is the only thing we like about a stock, we pass. There is some special situation-y element to this with the looming dividend hike and value realization from the real estate, but the core business is just not high quality enough given the uncertainties. It seems unlikely that investors do poorly from recent prices, and a normalized ~8% dividend yield puts a soft floor under the stock. If any number of things go well (asset sales, increased dividend, modest growth in retail business), returns could be exceptional for a number of years for equity holders. Buying Cato’s stock really comes down to investment style and the level of comfort with the Cato family’s ability to effectively allocate capital. Investments of this type can work well and are interesting, but they aren’t really our style.
All of that said, regardless of investment style, this was pretty clearly a slam dunk at under $7/share in mid/late 2020.
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