Spruce Point Capital Management Issues “Strong Sell” Opinion On Burlington Stores (NYSE:BURL) And Sees 20% – 40% Downside

Executive Summary

Burlington Stores

Spruce Point Is Cautious On Burlington Stores For The Following Reasons:

Burlington (“BURL” or “the Company”) Is An Old School Retailer Now Being Spun As A Sexy New Growth Story Amidst An lntensifying and Ultra Competitive Retailing Environment

  • Burlington Stores (formerly Burlington Coat Factory) is an “off-price” discount retailer based in Burlington, NJ that sells men’s and women’s clothing, home furnishings, and accessories. It competes with the likes of TJX Companies (T.J. Maxx, Marshalls), Ross Stores, and countless other retailers offering shoppers a discount to the M.S.R.P.
  • In January 2006, Bain Capital privatized Burlington by acquiring control for $45.50 per share, valuing the company at $2.0 billion, or 7x EBITDAR and 15.6x P/E according to the proxy
  • Under pressure from a series of struggling retail investments (e.g. Toys R’Us, Guitar Center), Bain Capital seized the opportunity to re-IPO Burlington in 2013. Its IPO prospectus touted various growth opportunities to excite new investors including: a) Improve merchandising, b) improve the shopping experience for its mostly female customer base, c) refresh existing stores and grow to 1,000 locations, and e) invest in technology + supply chain initiatives to inc. inventory turnover, and improve operating leverage
  • With its share price up 330% since its IPO, Burlington has benefited both from low income shoppers searching for deals, and management’s aggressive financial and accounting tactics to engineer “beat and raise” quarters. However, in the brutally competitive retail business fortunes can change fast, and we believe investors are under-appreciating risks being signaled

Burlington Has Been Touting impressive Comparable Store Sales (“CSS”), Gross Margin, and EPS Gains, While Shrinking Same Store Inventory. We Don’t Think It Can Last. Spruce Point Has Identified Numerous Financial Presentation, Accounting, And Business Issues That Could Be Signaling A Slowdown In Future Financial Results

  • At IPO. Burlington touted the advantages of its large stores (8ok sgftl. Now, the story keeps changing; it repeatedly talked down its optimal store size format (50-6ok, now 40-5ok). In our opinion, this may create and apples-to-oranges problem for its comp store base, may allow it to juice its comps by reclassifying modified or relocated stores as new, and changes its unit economics
  • As an indicator of potential strain, recent sales growth rates have rapidly diverged from accounts receivables growth This type of divergence is a classic red flag. Burlington also bought-in its fragrance category, which allowed it to boost its comps
  • Burlington presents its gross margin, a key performance indicator, in a non-standard way, by excluding store occupancy costs and depreciation of certain fixed assets. Burlington used to disclose its occupancy costs in SG&A but has repeatedly made changes to SG&A disclosures, and is now completely obscuring occupancy costs making it hard to evaluate trends
  • Our recent store visits left us with the impression that stores were unoptimized. With comp store inventory declining, existing and new competitors rapidly entering the discount segment, Burlington may be challenged to sustain recent performance.

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Burlington’s Inventory And Financials Signalling Potential Strain

In Our Opinion, The Crux of Burlington’s Financial Stains Can Be Seen By Closely Evaluating Its Inventory Accounting, Pack and Hold Inventory Strategy, And Inventory Turnover

  • The Company uses the retail inventory method, which is open to significant management iudgment and estimates including merchandise markon, markups, markdowns and shrinkage (aka loss of inventory from theft) which significantly impact the ending inventory valuation as well as the resulting gross margin
  • Shrinkage estimates reversed in Q4’1 5 for the first time ever, resulting in a $3.5m hit to gross margin. We’ve identified a troublesome rise in reports of theft and violence at Burlington locations which suggests more reversals may occur
  • Burlington always touts its ability to improve inventory turnover as a key driver of sustaining and improving its financial performance. Burlington uses a non-standard inventory turnover calculation, stopped disclosing turnover inclusive of warehouses where pack and hold inventory resides, and recently stopped disclosing the annualized guarterly metric mid 2015
  • Pack and hold, an inventory management strategy to buy discounted merchandise and hold it for future periods, rapidly surged post IPO. In our opinion, the strategy provides management opportunity to manage gross margins and boost turnover. m identified a misstatement of its pack and hold inventory value in Q3‘15: at best an error, at worst accounting manipulation

In Our Opinion, Another Big Area Of Concern ls Burlington’s Store Unit Economics Appear To Be Deteriorating

  • After its IPO in 2013, Burlington stopped disclosing the unit economics of its stores, which it said cost an average of $1.6m $1.8m for a typical 8ok sqft location ($21 .25/sqft at the midpoint). In Q1’16, Burlington recently stopped making the affirmative statement in its SEC filings that a “vast majority of existing stores had positive Adjusted EBITDA”
  • With less than 1% of sales coming from ecommerce, store location and physical sales are critical to its success. It appears that in recent years, the Company has been opening stores at locations of failed retailers (Kmart, Sears, Filene’s Basement)
  • A recent FOIA reguest to obtain a building permit for a new 5ok sqft location in Delaware supports our view that unit economics may be deteriorating. Based on conservative assumptions of inventory spend, pre-marketing costs (which accounting rules dictate must be expensed but Burlington doesn‘t disclose), we estimate per sqft costs have increased 17%-45%
  • Burlington received large EPS and cash flow benefits from landlord incentives that were increased after its acquisition by Bain, and may have been facilitated by its larger store format and slack in the commercial real estate market in the post-financial crisis period. Burlington‘s move towards smaller stores, may taper the benefits of these lease incentives. Its accounts are signaling a slowdown of EPS and cash flow benefits from incentives. Accrued deferred lease incentives are now declining, and net operating cash flow benefits from rent incentives recently turned negative

Spruce Point Has Uncovered Hard Evidence Suggesting Earnings Manipulation

Spruce Point Has Obtained Bona Fide Documentary Evidence Which Suggests Aggressive Accounting at Burlington, And May Explain Why Its Audit Committee Recently Adopted a Clawback Provision Covering Acts of Fraud

  • Our suspicion that Burlington’s accounting appears aggressive were heightened when in Q1 ’16 the Company reported a $2.5m benefit from the sale of a NJ tax credit (is the Company signaling a slowdown of income, or aggressively managing earnings?)
  • Spruce Point filed a FOIA request with the NJ Economic Development Authority, the gov’t agency that granted Burlington a $4om tax incentive to maintain and create jobs in NJ. To our disbelief, we found that Burlington legally sold the credits to Citigroup in August 2015 (Q3152, yet booked the transaction to income in Q1 ’16. This appears to be an extremely aggressive interpretation of GAAP, which usually dictates recording transactions in the period they occur
  • In our opinion, Burlington’s motivation appears clear: it needed to beat aggressive earnings estimates for Q1 ’16. The tax credit sale boosted its EPS by $0.02 cents, resulting in a quarterly beat by $0.04 cents and sending its shares up 7% by noon that day
  • Coincidence or not? In February 2016, Burlington’s Audit Committee added a compensation Clawback provision for management, “in the event of a financial restatement or significant financial harm to the Company arising out of willful actions, including without limitation fraud or intentional misconduct to cover fraud and financial misstatement.”

Significant Recent Turnover In Management, While Remaining Members of Burlington’s Management Team In Key Financial, Accounting and Operational Roles Have Worked At Retailers Plagued with Accounting and Operational Issues

  • Numerous recent resignations of key executives for vague reasons include: CFO Todd Weyrich in Jan 2015 for “personal reasons” while guidance was increased, EVP and Chief Merchandising Officer quietly resigned via 8-K filing in March 2015 to “pursue other interests” and long-time General Counsel Paul Tang quietly departed in July 2015, replaced by Janet Dhillon
  • CEO Kingsbury’s track record deserves close scrutiny. He was CEO of Filene’s through 2006, which suffered declining sales each year. At Kohl’s he was quietly removed from store operations, administration, and merchandising. Kohl’s delayed its SEC filings in 2011 and restated results to 2008 for a material weaknesses and issues with “complex” lease accounting. What role, if any, did he play with leases as head of store ops and admin. and why does Burlington also have aggressive operating leases?
  • CFO Marc Katz previously was CFO at A.C. Moore, a retailer that disclosed substantial inventory accounting and supply chain challenges. Its earnings restatement resulted in the company changing its FY 2006 results from earnings to losses. Katz is joined by other key A.C. Moore executives such as Mike Metheny (EVP of Supply Chain) and Dennis Hodgson (SVP and CIO)
  • Burlington‘s Chief Accounting Officer’s John Crimmins record is also tainted by accounting scandal. Crimmins was Timberland’s Corporate Controller, Chief Accounting Officer, and later promoted to CFO. In April 2007, Timberland delayed its Q1 earnings, and its audit committee said its financials from 2001-2006 could no longer be relied upon

Burlington’s Share Price Has 20% – 40% Downside Potential

With Burlington’s Share Price Near All-Time Highs, And Bain Capital Cashed Out, Management is Selling Stock Fast

  • In addition to the recently added clawback provision noted earlier, a subtle change to management‘s Annual Incentive Plan for 2016 also may signal the unsustainability of its earnings growth:
    • To illustrate, the incentive compensation has historically been determined 50% by comparable store sales and 50% by Adjusted Net Income. In Feb 2016, the Board approved replacing the “Adjusted Net Income” portion of the Financial Component with “Adjusted Net Income per share.”
    • The change in definition is important because Burlington has implemented two share repurchase programs in 2015, allowing it to repurchase a total of $40om of stock. In effect, management can mask a declining earnings growth rate by accelerating repurchases and earning a bonus for repurchasing shares!
  • A total of seven insiders have sold shares this year and reaped $27m in proceeds:
    • CEO Kingsbury and EVP Supply Chain Metheny implemented 1ob5-1 stock sale programs in March 2016 (shortly after the clawback provision), followed by the EVP of HR also initiating a program in June
    • Other key insiders selling include Katz (CFO), Seeger (EVP of Planning & Allocation and MIO), and Hand (EVP of Stores)

Burlington’s Shares Are Priced For Perfection Without Incorporating Fresh Concerns We’ve Highlighted

  • Burlington current trades at approx. 11x and 21x 2017E Adj. EBITDA and EPS, respectively, and is among the most levered retailer at approximately 2.5x Debt/ 16E EBITDA. However, adjusting its financials for nearly $2.5 billion in off-balance sheet leases, we estimate its true Adj. Debt/ EBITDAR to be closer to 4.ox – dangerously high for an undifferentiated apparel retailer
  • Wall St. sell-side analysts see 24% upside to an average price target of $90/share. Analysts’ are wildly optimistic that it can grow EPS 20% next year through continued CSS growth, and EBITDA margin expansion of 40 – 5obps – almost blindly taking management‘s word and extrapolating results into the foreseeable future without even raising any of our concerns
  • Analysts’ try to draw comparisons between Burlington and best-of-breed retailers TJX and Ross Stores in justifying its rich valuation and price targets. However, Spruce Point believes that Burlington’s vast operational inefficiencies and margin gap will be difficult to reach in the absence of substantially more capital investment. Not surprisingly, Burlington is guietly ratcheting up spending for “supply chain” initiatives, which are susceptible to aggressive cost capitalization which embellishes EPS
  • Burlington‘s valuation multiple is stretched and trading near an all-time high and discount none of the fresh concerns we’ve raised about the sustainability of its recent performance and the integrity of its accounting and financial reporting practices. By normalizing Burlington’s valuation and trimming estimates, we see a share price range of $45 – $60, or 20% – 40% downside

Burlington Stores

Burlington Stores

Burlington Stores

Burlington Stores

Article by Spruce Point Management

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