Cato Stock: Operations Are Eating The Deep Value Play (NYSE:CATO)

Cato Corporation (NYSE:CATO) is an American apparel retailer.

The company’s stock is a deep value battleground because of its low EV and strong balance sheet coupled with dismal last-decade operational results.

I analyze Cato’s brand value proposition in this review and discuss some operational challenges. The brand seems outdated, the value proposition is not ideal for apparel retailers in the current context, and operational efficiencies are low.

On the deep value debate, I recognize the company’s dividend potential because of its cash holdings. However, I also see the potential for large cash losses if revenues continue falling, which would quickly close the valuation gap for the negative.

I settle for a Hold rating for Cato and wait for signs of operational improvements. The dividend argument does not generate a return per se.

Brand analysis

Cato has been around for a long time. The company was founded in 1946 by Wayland Cato and his two sons. One of the sons lived to the age of 100, passing last year. His son, John Cato, owns 51% of the company stock and has been Chairman, CEO and President since 2004.

Cato’s value proposition is assortment, trend, and low prices. Its target customers are female juniors, meaning adolescents. The company describes its positioning as between department and discount stores.

Cato was highly successful for some time with this approach, reaching $1 billion in revenues and more than 1,500 stores at its peak in 2017. Today the company’s store footprint is still massive at 1,250 square feet.

Since then, the company has been in a downturn. I believe the problem concerns positioning, plus a lack of work on the brand and the offer.

Reviewing videos on social media, Cato is described by fashion influencers 30/40+ years old as their teenage dream during the 1990s, the golden era of the mall. Back then, good assortment and low prices were the name of the game.

The problem is that assortment and low prices are the game of the Amazons, Walmarts, Shein, Temu, and many other giants. It is a challenging game because scale gives you a huge advantage.

Further, the company aged with its 90s customer demographic without renewing the branding or the products. Cato says on its 10-K that its customer segment is junior, but its Instagram account models are all above 30.

A look at the picture below, from a recent YouTube video, gives an idea of the low quality of the store presentation. All the inventory is exposed, the fixtures are not great, there is no prioritization, and the style does not seem to be pointed at female juniors.

Pricing is still really economical, with tops for $18/25, jeans for $20/30, or jackets for $30/40. The problem is that in a globalized world like today’s, having good quality and low price pieces is not a competitive advantage anymore.

Cato’s e-commerce efforts are small, with online generating about 5% of sales. Social media accounts have less than 100 thousand followers, the website takes a long time to load and is a little old. I liked their ‘Ways to Wear It’ section, where they recommend outfits for a specific piece, but the design is a little simple.

Bad execution

The fact that despite its large size and being a leader at some point, Cato has been losing so much market share already points to problems in management.

This is also palpable when looking at the operational efficiency of the company.

Cato classifies all store rent costs in CoGS, and only corporate expenses and store payroll in SG&A. From the chart below, we can observe that (besides the pandemic-induced volatility) Cato’s gross margins have been relatively stable despite the store closures and falling sales. The company has been able to arrest this portion of operational leverage.

However, SG&A to revenue ratios have consistently increased because the company has been unable to reduce SG&A consistently despite closing stores. Part of it is labor costs have increased more than 50% since 2019, according to the company proxy statements (median worker compensation section). However, store payroll only represents $114 million (7.6 thousand workers multiplied by $15 thousand median income) of the company’s $250 million TTM SG&A expenses. The rest is corporate overhead. This should be trimmed to allow the company margins to expand.

Deep value numbers

The picture painted up to this point is pretty grim.

However, Cato has many bulls, which focus on the company’s balance sheet. As of 3Q23, the company has nearly $120 million in cash, no debt, and only $100 million in lease liabilities. A market cap of $125 million leaves Cato’s EV at close to $0. This means the investor could theoretically buy Cato, pay himself $120 million in dividends, and keep running the company for free.

Cato has consistently returned capital to shareholders in the form of dividends and buybacks. For FY22, it paid $30 million to shareholders in these two formats.

There are two views of the Cato deep value play.

One is company liquidation, selling some assets like its distribution center in North Carolina and paying dividends to shareholders.

The problem with this view is that liquidation creates liabilities not in the balance sheet, like lease abandonment or severance payments. Cato’s average lease term is two years, meaning the company could walk out of many stores without triggering lease-abandonment losses. However, closing stores also requires severance payments, with many of Cato’s employees having average tenures of more than ten years.

The second view is turnaround coupled with high dividends. Some people believe that Cato can continue paying dividends, eventually repaying the current share price in dividends. Still, in the meantime, there could be changes to the company that turns around its operations, creating a second engine of returns.

I like this idea, but the problem with the thesis is time. Cato’s languishing has reached the point where the company’s operations are not generating cash anymore but rather consuming it quickly, as seen in the 3Q23 report.

Despite Cato’s target demographic of value-looking customers being more affected by inflation, the company has not yet faced a severe contraction in consumption. It is losing cash today.

The problem of the turnaround plus dividend bull thesis is that the company might need to spend its cash vault to keep its operations running, eventually closing stores and paying severance.

For that reason, I prefer to wait on Cato.

I want to see substantial strategic changes to branding, product selection, and complementary digital efforts. Also an increase in corporate expense efficiency. Without these, the deep value play is invalid because the shareholder is not paid to wait, and time is not on his side.