Retailer and wholesaler of party supplies Party City’s (NYSE: PRTY) fate depends, to a large extent, on the Halloween season. This is especially true given the company’s relatively high leverage, with much of the debt trading below par.
However, there are reasons to think that the company may have a good Halloween season, making the stock potentially misvalued at current levels. However, equity trades as a heel and should be sized accordingly.
Here is the operating result of the business (with my adjustment for exceptional charges and depreciations during the calendar years 2015-2019). It should be noted that 2019 was a bad year even after adjusting for impairments and that was beforecovid.
Party City operating income before Covid by year
|$272 million||$274 million||$280 million||$278 million||$117 million|
source: SEC filings, author’s analysis
Now, as we turn to debt, it’s worth noting that the company pays around $100 million in annual interest costs today, so the debt burden, while high, may be manageable in a historical context. $23 million of debt is due in 2023, but significant refinancing is not required until 2025 (see below).
Debt below par
That said, bond investors don’t necessarily have confidence, if you look at Party City debt, a lot of it is trading below par, as you can see from the delta between gross carry and “fair value” below (this snapshot is from June 30, 2022).
Then 2022 should be relatively low on Management tips for the second trimester, the company expects about $2.2 billion in revenue. That’s in the low end of the 2015-2019 period, where the company typically had sales of $2.3 billion to $2.4 billion. Then they expect EBITDA of $170-200 million, which is, again, in the low end of pre-Covid history.
I have also visited various Party City stores and they are currently well stocked for Halloween with a number of high margin products that are looking good. However, this may have come at the cost of high transport and storage costs for the third quarter.
Risks and Valuation
Still, the business may be a little less risky than it seems.
|2022 EBITDA (middle)||$185 million|
|interest charges||$100 million|
|capex (net of allowances for leasehold improvements)||$70 million|
|tax (20%)||$37 million|
|Free cash flow 2022||-22M$|
The start of 2022 has been difficult in terms of higher freight and helium costs and a difficult first quarter due to omicron. As I wrote before, freight and helium may have squeezed gross margins by 3%. That, in very round numbers, is perhaps another +$60 million for FCF, bringing the company closer to $40 million FCF in a normalized year. Indeed, even taking the numbers all the way to the top of the forecast and being a little less aggressive on taxation, Party City achieves FCF balance without too many heroic assumptions.
A stub of equity
Therefore, investors should be clear that Party City is trading as a stock heel, ahead of the major debt rollover in 2025. It is, to some extent, at the mercy of credit markets, this which is not a good place to be in the current rate hike. environment.
Still, it’s not too hard to see a scenario where, with strong trading in the fourth quarter, Party City goes from distressed air to just defiance and FCF closes in on around $40 million or so. a stronger than expected fourth quarter this year, a more robust 2023 free of major headwinds such as cargo and helium. If the market were willing to put a 15x multiple on $40 million of FCF, that would imply a valuation of $600 million, or about $5.31 per share. If the company can achieve several quarters of strong transactions, this assessment may even be conservative. There is still time between now and 2025.
Finally, I believe Party City has a certain degree of rift. Helium balloons are hard to buy on Amazon (AMZN) and buying all the little items you need for a party is easier in their stores than online. I think Amazon has clearly taken some of its business (like Halloween costumes and other higher priced items) and will continue to do so, but Party City may be better positioned than many other retailers given its niche positioning in the party space.
- The main risk for Party City is leverage in both directions. First, their debt is high and it is uncertain whether they could refinance on similar terms in 2025.
- Second, part of their business has shifted to Amazon and their cost base remains largely fixed.
- Like most retailers, they need a strong fourth quarter and, in particular, Halloween needs robust execution, although the current drop in gas prices and the absence of a deep recession (for now ) can be a favorable wind there.
- Even halfway through the forecast, the company could be negative in FCF this year.
Party City is probably a little cheap, but a few missteps and their need to refinance much of their debt in 2025 will put more pressure on equity. There is likely an upside with moderately good execution that takes them to a positive FCF this year or in 2023, which could provide a basis for equity and debt markets to view the company more optimistically. Yet time is running out as the need to refinance approaches.