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Risk-Reward With The Michaels Companies

- By Jonathan Poland

Head to instagram and see that arts and crafts are big business with anyone looking to create fancy decorations, sugar cookies or real art work needing supplies at stores like Michaels and Aaron Brothers, both owned and operated by The Michaels Companies (MIK). The company's stock has had a rough time in the last few years, down almost 60% since 2016.

But, looking at the fundamentals, the stock looks rock solid and cheap. Shares are priced at 4.8x forward earnings, which are expected to reach $2.50 in 2020. The market cap is just 40% of total annual sales, which have steadily climbed every year since it went public in 2014, reaching $5.2 billion in the last 12 months. Gross margins are a respectable 38%. So is operating cash flow, and the company spends less than 50% of its net income on capex.

The problem is the debt, now approaching 150% of its market cap at $2.7 billion.

Here's a number that matters: $2.4 billion. That's how much the company has earned since 2011, using much of that money to buy back over 32 million shares, further boosting earnings per share.

Compare that to the service company where a lot of the creations made with products from Michaels are being sold -- Etsy.com -- and Michaels looks even more like a bargain. Etsy has a market cap of $8.5 billion, almost 5x the size of Michaels; however, it generates just 25% of the income and 10% of the sales. Of course, Etsy is a platform, and it's still growing. If only retailers would understand that they could become more technology driven, platforms like Etsy wouldn't carry nearly the same valuation. But, in this market, they do, and that makes Michaels' stock worth taking a position in.

Michaels may be a slow growth story, but the story has a long way to go before it's over. It has a strong social media game with over 5 million followers across its main accounts, helping keep brand equity high. Management continues to buy back shares to improve ownership returns for investors. Sales and profit continue to rise. Michaels is looking to open 10 new locations a year for the next few years, as well as improve comps on current locations. Yet, the company doesn't have to invest heavily in store design like other retailers, which should keep margins high because artsy types frequent its stores to enjoy a hands-on experience, making it somewhat less susceptible to the traffic falloffs of other retailers.

At the current profitability, if there's no further growth, the company will earn over $3.2 billion in the next decade, easily enough to pay down the long-term debt. And with the stock priced as though the business will be gone in less than a decade, what's more likely to happen is that by this time in 2021, more people will be creating more cool stuff using products sold by Michaels, and it will hit earnings expectations of $2.53 per share, at a value of 10x to 15x, putting shares in the $25 to $35 range.

Disclosure: I am not longor short Michaels.

This article first appeared on GuruFocus.