Party City (PRTY): A Short Story
A brick and mortar retailer that is pinning its future on balloon sales. Really.
Party City Holdco Inc. (NYSE: PRTY): Short
Recommendation: Sell PRTY short in advance of Q3 earnings (est. November 8th), add to position as near-term catalysts begin to crystalize and long-term, solvency outlook becomes increasingly dire.
Summary
Supply chain troubles and high costs cutting into the all-important Halloween and Q4 shopping period
Lackluster turnaround plan with considerable operational and commodity risk
High debt levels, associated interest rate exposure, and concern around refinancing capacity
Management compensation with reliance on subjective “adjusted EBITDA”
Inability to mitigate or adapt to changing retail landscape brought by the continued shift to big box stores and ecommerce
Thesis
Despite being a long ailing business that flirted with bankruptcy and dissolution during the depths of the 2020 COVID-19 lockdowns, Party City has seen its stock appreciate 24x since its pandemic low, with an 20% return YTD, besting the Russell 2000. The market- perhaps enamored by the Company’s new management, turnaround plans, and marginally de-levered balance sheet- is ignoring negative short- and medium-term catalysts that will put downward pressure on the business’ operations and stock price, while also overlooking Party City’s painfully obvious structural decline in and incompatibility with the modern retail world that will ultimately render the firm worthless.
Background
Party City (the Company) sells “decorated party goods” (balloons, Halloween costumes, festive tableware, party accessories, etc.) across retail (74.5% sales) and wholesale segments (25.5%). The Company operates 90% of its 831 stores with franchisees managing the remaining 10%. In July 2019, Party City appointed Brad Weston as CEO. Weston quickly began implementing a turnaround plan that focused on modernizing stores, emphasizing balloon sales, lowering prices, and improving staff training.
In July 2020, COVID-19 related financial distress led the Company to engage in a debt exchange that lowered overall leverage, pushed the bulk of maturities to 2025 and 2026, reduced cash interest expense, and provided $100M in cash through new issuance.
Immediate Downside Risks
Typical of many retailers, Party City relies on the Q4 holiday period for a disproportionate share of annual sales, with approximately 33% of revenues generated during this time. A notable 20% of revenues come from Halloween related purchases during the September and October months. After disappointing in Q4 2019 with negative $205M EBITDA (pre-COVID!) and a lackluster, negative $18M EBITDA (buoyed by $74M of one-time non-cash losses on assets held for sale) in Q4 2020, Party City needs a win this year to prove to investors and its very generous creditors that its turnaround efforts are working. Doubtful. There are two main reasons the Company is in for a rocky Q4:
1. Low inventory and poor selection
Supply chain crunch: 70% of all SKUs come from outside of North America. There is little more to say about supply chain bottlenecks that have been plaguing the world for the better part of a year. Shipping container space is hard to find and rates are astronomical. The count of ships awaiting entry to the Ports of LA/Long Beach peaked at an all-time high of 73 on September 19th- around the time Party City was importing inventory for the crucial Halloween shopping period. Management has put a brave face on during its earnings calls and conferences, but has also revealed that they have taken the extreme measure of chartering their own ships.
Lean inventory management: Beginning in 2020, Party City began to dispose of leftover seasonal inventory to reduce store clutter, targeting a 20-30% lower baseline level (~$100K less per store). Perhaps prudent from a SKU and turnover management perspective, this means that the Company has drastically less inventory cushion (margin of safety) to fall back on should shipments not make it to the shelves before the end of the Halloween shopping period.
2. Intense cost pressures
Staffing: Party City plans to hire 17,000 temporary employees for its Halloween and winter holiday shopping seasons. As is wildly obvious to anyone who has tried to checkout at a grocery store in the past year, labor is scarce with wages soaring. The Company will be competing with other, far better capitalized seasonal businesses and massive logistics firms for talent. It will certainly not come cheap.
Ship charters: As mentioned, ordinary, commercial shipping is at its most expensive in recent history. Charters are usually smaller, 1000-container ships that can unload at smaller ports to avoid the LA/Long Beach back up. Costs, however, average twice as much per container unit than with the typical, larger vessels used.
Inflation related price increases undermining Party City’s value proposition: In 2019, the Company aimed for price reductions on 30% of its SKUs to “(rebuild) trust with the customer on price” and move away from a promotional structure. This will be near impossible to uphold as input costs continue to skyrocket.
Party City is entering the vital Q4 period with weak inventories, higher costs driven by both COGS and SG&A line items, and a reversal of its lower priced “trust building” customer acquisition strategy.
Below are photos from a trip to a Party City in West Los Angeles on October 19th- peak Halloween shopping period. Staff was non-existent, aisles were a mess or had large empty areas, costume selection was lacking, and there was a, frankly, bizarre amount of prime shelf and floor space dedicated to fog machines and the liquid needed to run them. The entire experience did not inspire confidence.
Poor Turnaround Prospects
In addition to the aforementioned cost increases and destruction of the value proposition, Party City’s reinvigoration plans face several challenges.
1. There is no “winning in the balloon category”
The Company wants to add “store within a store” balloon shops (at an estimated $250K per location) to emphasize its higher margin balloon offerings and drive customer foot traffic. Putting aside the non-trivial execution, operational, and cost risks, this initiative also exposes the company to helium gas commodity price risk. During the latest helium shortage, Party City reported a 10.6% ($9.2M) reduction from 2018 to 2019 in wholesale metallic balloon sales because they were unable to source the gas. Tying even more of the Company’s profitability and customer acquisition strategy to an unpredictable, volatile commodity is myopic and dangerous.
2. Crippling debt load
While the 2020 debt exchange allowed Party City to avoid bankruptcy, the Company still has a staggering $1.46B in debt obligations. $678M in loans are expected to be rolled in 2022, but there are no concrete plans for refinancing $299M in 2025 corporates or $969M the following year. Management targets a 3x leverage ratio- a world away from Party City’s current debt to TTM EBITDA of 19.7x. As solvency becomes a more immediate issue, short term financing may dry up and operations negatively affected as suppliers and wholesale customers cut ties with the Company.
3. Management compensation
Executives including the CEO and CFO do have ample (restricted) stock-based compensation, theoretically aligning them with the long-term interests of the Company. However, it is worth highlighting that up to 100% of base can be paid out as a cash bonus for achieving certain adjusted EBITDA targets. Adjusted EBITDA is already a notoriously subjective, squishy, and easy to manipulate metric. For context, Party City’s own calculated 2020 EBITDA was negative $531M, but its adjusted figure- which includes add backs such as $88.4M for inventory disposal, $7.2M for corporate development expenses, and $73.8M for “COVID-19”- was a rosy $95.5M. EBITDA also inherently ignores interest expense, which should be of particular concern to a company with so much debt and so little free cash.
Given COVID disruptions, 2020 cash bonuses were based on H2 adjusted EBITDA- which, conveniently, came in just above the 100% payout threshold:
Secular Deterioration and Demise
Without fully rehashing a tired yet true trope: physical retail is facing a secular decline. Specialty stores, such as Party City, are facing the dual threats of ecommerce and big box retailers. Certain retailers might have in-person shopping advantages that cannot be easily replicated online or at a Target (e.g. trying on Lululemon clothes, “experiencing” the latest iPhone, getting advice on wood adhesives from a Home Depot salesperson, etc.). Party City has none of this. Brick and mortar locations cannot match ecommerce in terms of selection (~10% of sales come from ecommerce, but Party City simply cannot hope to compete with Amazon or Walmart in this channel). Most of the items sold are designed to be used once and discarded: no one makes serious, thoughtful purchases at Party City that require consultation or expert knowledge.
Put bluntly: why would anyone with an Amazon account bother getting off the couch to go to a store with a poor shopping experience, weak inventory selection, and no promise of low prices to buy a chintzy pumpkin Halloween costume and 20- person disposable utensil table set?
Bull Case
While Party City in its present iteration will inevitably fail, there is a possibility the Company limps along for years thanks to low rates-enabled cheap financing and a resilient consumer determined to spend down savings accrued throughout the pandemic. Sitting on a short position throughout would be expensive, frustrating, and plainly prove the thesis wrong (proper timing is essential). Management could use this borrowed time to implement their turnaround plan, downsize and renovate existing locations, and make Party City the preferred budget-conscious, one-stop-shop for casual party needs. More unlikely options that have potential share price upside include splitting the wholesale and retail business or pursuing a merger.
