J. Jill Stock: Fairly Valued, I Wait For Lower Prices (NYSE:JILL)

J. Jill (NYSE:JILL) is an American apparel retailer focused on mid to high-income women above 45.

Among the positives, the company has an interesting brand concept, loyal customers, a balanced omnichannel approach, and an attractive demographic to surf the current macroeconomic waves. Its execution has led to great margins and excellent returns on capital employed.

On the negative side, J. Jill is leveraged and should hopefully prepay debt to increase payments to equity and reduce risk. I also disliked some related-party transactions around pandemic financing.

Overall, I believe the stock price (adjusted for future dilution) currently reflects a fair valuation. I do not think these prices represent an opportunity, and I prefer to wait for better entry points. One such point could present itself after less than spectacular 4Q23 earnings.

Brand And Value Proposition

J. Jill operates 245 stores in premium malls and lifestyle centers.

The company’s value proposition is high-quality, high-end priced, simple, basic clothing for middle-to-high-income 45-65 year old women.

One thing I like about J. Jill is that this value proposition is consistent.

Its designs are not extravagant, focusing on basics, luxury casual wear, and some trend/fashion-following colors. It offers a good assortment of sizes; some influencers mention that its sizes are slightly bigger than normal. This is all pointed to more conservative, older women.

The company is strong on service, with a concierge service in stores, almost immediate human-agent communication on its website, and a small, intimate store footprint (average store size is 6 thousand square feet, with some of them of only 2 thousand square feet). The store concept is not crazy innovative, though, as seen below.

Pricing is high, with t-shirts starting at $50, blouses at $80, and jackets at $100+. These are not very competitive against Amazon or Zara, which are also good at basics. The company’s gross margins (now close to 70% and historically around 65%) reflect these high prices.

In my opinion, the price point is interesting from a psychological perspective. It could be that the average J. Jill customer wants to differentiate at a price point inaccessible to younger women. Identity and differentiation are important for both men and women during the middle age crisis.

As an example, last year, the company launched a sub-brand called Pure Jill at price points that are 30% higher on average, with good repercussions. This indicates its customers are comfortable with the company’s prices.

The 45-65 years demographic concentrates on disposable income, with children leaving home and advanced careers. According to J. Jill, the average customer has $150 thousand in disposable income, and only 25% have children at home. 70% of their customers are college graduates.

There are some indications that the company’s customers are loyal. The company claims that the average customer has been buying at J. Jill for 10 years. The comments on social media (particularly Facebook and YouTube) are really good. 52% of the company’s sales occur with their private label credit cards, from which the company derived $4 million in royalties in FY22 alone.

Omnichannel

J. Jill had an upper hand in DTC selling because the brand sold a lot via printed catalogs. Today, 45% of their sales occur outside of stores, mostly on the Internet, but the company still spends the same on printed catalogs and advertising as in digital advertising ($15 and 20 million, respectively).

Traffic trends in services like Semrush show that the company’s e-commerce website consistently increases organic traffic, now at 2.7 million monthly visits.

A quick visit to their website shows good execution. The site has most digital assets covered by models (not plain pictures), sometimes in several colors and sizes. It allows filtering by shape, color, style, and size. Customer service is quick, with a live agent attending to a request in less than five minutes during workhours (I tried this myself).

Execution

One of the most interesting points about J. Jill has been its execution after the pandemic.

The company had a few problems before the pandemic (with a previous CEO) after it faced falling revenues and margins because it transitioned out of catalogs to quickly into digital offerings. This probably led to closing stores throughout the pandemic and post-pandemic boom instead of opening stores like many competitors.

Today, the company’s margins are higher than ever. Part of it is generated by gross margins way above the historical average, and another part by lowering SG&A.

The company has consistently closed stores since before the pandemic, and despite that, its sales have proven relatively resilient, increasing sales per square foot and cost leverage. With 140 leases maturing between 2023 and 2025, the company has much space to continue rightsizing its store footprint without paying high lease abandonment costs.

It operates with half the footprint and employees of recently covered Tilly’s and Citi Trends but generates similar revenues and much higher margins.

One of the good points of J. Jill’s demographic is its resilience.

The 45-65 demographic with no children and $150 thousand in average annual disposable income probably has financial assets, does not pay rent, and has job security. They are much less exposed to inflation and a recession.

J. Jill’s revenues have not suffered at all from the inflationary bouts. Consider that between 2020 and 2022 the company closed 15% of its stores.

This execution has led to extremely good ROCE, as seen below. In my opinion, this is one of the best gauges of asset profitability because it eliminates the effect of leverage that is present in ROE or ROA.

Leverage And Control

The company’s weak points are its high financial leverage and concerns around third-party transactions. The two are related.

Tower Brooks, a PE company that owns 62% of the stock, controls the company. TB acquired J. Jill in 2015 and IPO’d the company in 2017.

J. Jill went public with a lot of debt, partly used to pay hefty dividends. This classic PE move is criticized because it is a form of financial engineering that increases risk. Whereas the leverage risk is ok for a PE firm, imposing it on all shareholders is not a sign of great governance.

With the early failures mentioned in the previous section and the pandemic, J. Jill was about to go bankrupt in 2020. The company was able to refinance its main credit facility at LIBOR + 5%, which is not crazy high for its situation.

At the same time, a consortium that included Tower Brooks lent $15 million to the company in a subordinated loan to be repaid in 2024. However, the debt’s principal was $20 million, which already represented a 10% yield on the debt without interest payments. The loan also paid LIBOR + 12%, and the lenders received 3.5 million penny warrants (exercise price 1 cent, so basically free shares).

These terms were terrible, and maybe it was the only way to save the company then, but they seem to have hugely benefited the lenders. The loan was repaid last year. The lenders lent $15 million and received $20 million in principal, plus close to $9 million in interest (considering LIBOR of 1% for 2021, 3% for 2022, and 5% for 2023) and 3.5 million free shares (worth $14 million in 2020 when the loan was established). Those are great returns.

The reporting of the loan was not great either. Finding information about the warrants is difficult in the company’s 10-Ks, with no specific section dedicated to it, and the company showed the loan net of capitalized discounts, which underestimated the loan’s principal. When the loan was repaid, J. Jill had to recognize $13 million in prepaid capitalized principal as losses, almost the entire sum of the original loan.

The company has repaid the subordinated loan, and the primary loan has been refinanced and partially repaid. The company owns $157 million, $150 million of which belongs to a term loan that matures in 2028 and yields SOFR + 8%. This loan amortizes between $8 to $12 million annually and can be prepaid. The company also has access to an ABL facility for $40 million, of which $7 million has been drawn.

This means the company has to pay about $20 million in interest expenses yearly, with SOFR rates at 5%. If the company doesn’t make prepayments and SOFR remains at 5%, the interest payments should decrease by about $1.3 million annually.

For debt to be accretive, the return obtained on assets (ROCE) has to be higher than the interest paid for the debt. This is true for J. Jill, using the figures shown in the previous section (ROCE close to 19% versus the interest of 13%). This means that ceteris paribus, repaying the debt would decrease ROE.

However, debt is a risk factor, particularly for an apparel retailer already suffering from operational leverage. Further, the company could repay the debt, reducing ROE but increasing net income and FCF, and then increasing ROE by repurchasing stock.

I want the company to go in that direction in the future, but management comments point to more flexibility, maybe considering acquisitions. I wouldn’t say I like that road.

Management incentives might not be aligned with those of shareholders, given that bonuses are based on adjusted EBITDA (not considering operational or financial leverage or returns on capital).

How the bonuses increase with adjusted EBITDA means that managers make 25% of each additional EBITDA dollar after a certain threshold. Still, shareholders pay the risk of higher debt and operational leverage. This should change because it is unacceptable. The company’s CEO made $10 million between FY21 and FY22 in compensation and bonuses, plus another close to $5 million for the CFO. This is excessive.

Valuation

J. Jill’s market cap and enterprise value numbers are misleading. They are calculated based on 10 million shares without considering the penny warrants almost guaranteed to be exercised. That would move the share count to 14.5 million, or a market cap of $362 million. Add $92 million in net debt to reach about $455 million in enterprise value.

As always, with a leveraged company, we must ask ourselves where the breakeven point is.

Generally, adjusting SG&A is complex for retailers, and this can be modeled as fixed costs of around $340 million. We considered $20 million in interest payments (assuming no prepayments and no more debt from the ABL facility).

I prefer to err on the conservative side for gross margins and use 67.5% instead of the current 70%. The average of 65% is influenced negatively by the pandemic and early mistakes, so it is a bit punishing from the company’s current perspective.

That would result in $533 million as a breakeven point, under which the company would not cover interest. That is a 12% revenue decrease from the current $600 million. This is not exactly a wide margin of safety. If we use the company’s current 70% margins, the breakeven point moves to $514 million.

With margins of 67.5% and revenues of $600 million, the company can generate operating income and pre-tax profits of $65 and $45 million, respectively. With 30% taxes, these translate into a NOPAT of $45.5 million and a net income of $31.5 million.

Compared to the company’s adjusted market cap and EV of $362 and $455 million, these result in a P/E of 11x and EV/NOPAT of 10x.

This does not seem excessive when balancing the company’s excellent operational execution, good customer demographics, and consistent branding with the negatives of excessive and misaligned compensation, high leverage, and somewhat conflicted governance.

However, I would prefer a higher margin of safety (lower stock price). First, to compensate for the higher risk of an apparel retailer that is operationally and financially leveraged. Second, to generate a higher return if things go well and to compensate for the bad governance.

I prefer to wait for lower stock prices. One such opportunity might present during the 4Q23 results. The company already guided for flat revenues and EBITDA of only $11 to $13 million. According to the company, this is significantly below last year’s $15 million and is aided by this quarter’s one extra week, adding $2 million in EBITDA. Without that extra week, the comparison would be more grim.

If the results generate disappointment and fear of bad times ahead, the stock could correct meaningfully, resulting in a better entry point. In the meantime, I would like to see a better compensation scheme in the proxy and more commitment towards prepaying debt in earning calls.