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Back in 2018, I had a call with a pair of executives from 1-800-Flowers.com (FLWS). And while there was some quality information on the call, what struck me most was the broad sense of optimism coming through. That and, to be honest, a bit of scoffing (albeit very polite scoffing) when I told them I owned a position in their rival, FTD Companies.

Those executives weren’t lying. FTD would go bankrupt the following year (it was one of my biggest mistakes ever, even with the salvage of some value on the way out), and FLWS would continue an impressive run. In fact, long FLWS / short FTD, without exaggeration, was one of the best direct-comp pair trades in history:

Vince Martin @okieinvestor

Has there even been a direct-peer pair trade that worked out as well (or as poorly) as $FTD / $FLWS ? I certainly can't think of one that's even close (five-year chart, btw)

1:25 AM ∙ Mar 31, 2019

With FTD going through a painful restructuring, 1-800-Flowers.com cemented its dominance in the space, and FLWS stock continued to roar. By early November of last year — bear in mind, less than six months ago — FLWS had pulled back modestly from summer highs, but still had been a 13-bagger over the previous decade:

source: YCharts

And then the bottom fell out. Since its close on Nov. 8, FLWS has plunged 61%.

The Simple Case for FLWS Stock

The downside catalyst really has been a single quarterly report, though as we shall see it was a truly ugly report. Market sentiment toward small-caps no doubt hasn’t helped, either (though, by the common $2B-$10B definition, FLWS was actually a mid-cap when the decline started).

So far on Overlooked Alpha, we’ve focused on potentially unjustified sell-offs. That’s not much of a surprise in a market that’s sent a good number of small- and mid-cap names plunging: the median small-cap, per a finviz.com screen, is about 28% off its 52-week high. No doubt many of the decliners needed a pullback, given where valuations reached last year, but that kind of broad weakness always creates individual opportunities.

The simple case for FLWS supposes precisely that kind of opportunity: a nervous market sending a quality name too far down (and potentially way too far down) after a bad quarter driven by temporary factors. And FLWS’ valuation at the moment does look it’s gone too far down.

Relative to FY22 (ending June) guidance, which was pulled down after the Q2 report in late January, FLWS trades at just 5.4x on an EV/EBITDA basis. P/E is 14x; backing out ~$1.50 in net cash on the balance sheet, the multiple drops to 12.5x. The price to free cash flow multiple is a bit less attractive, though that multiple for FY22 also is impacted by temporary factors.

What the market is pricing in from here is essentially zero bottom-line growth, or something close to it. That seems far too conservative.

What History Tells Us

The fundamental bull case near the lows can be highlighted by a look at FLWS’ last decade-plus worth of performance:

FY12-FY21 multiples use average share price (from 7/1 to 6/30, roughly in line with fiscal year), year-end shares outstanding, and year-end balance sheet figures. FY22 at midpoint of updated guidance post-Q2 and current share price of $13.40

Two things stand out here. First, valuation is exceptionally low against historical levels. And bear in mind that those historical multiples come from average prices (prices at the end of most years were higher, which would elevate those multiples.

Pre-pandemic, paying 5.4x EBITDA and 14x EPS for FLWS would have created a market-beating investment — even with the huge plunge over the past five-plus months. That hardly guarantees that paying those multiples now is a market-beating investment

Second, at least relative to guidance, investors aren’t paying those low multiples against profitability that seems exceptional. Margin history suggests that FLWS overearned during the pandemic — and there’s no doubt some truth to that. (Further helping the bull case, however, is that the story isn’t quite that simple, as we shall discuss.) But FLWS is trading at 5.4x EBITDA using guided margins that are the lowest in a decade, and a full 100 bps below the 10-year average pre-FY22.

That, too, doesn’t guarantee that FLWS is now a market-beating investment. 1-800-Flowers.com is just one of hundreds of companies facing fears of precisely this kind of margin erosion in an inflationary environment. But, here too, there’s some support for the bull case.

The fundamental case for FLWS right now is that the stock is priced at depressed multiples to compressed margins. Assuming just one of those factors changes, the stock should rally.

The Big Plunge

So why is FLWS stock down so far? Small-cap weakness definitely was a factor. FLWS turned south with the Russell 2000 in November, though it did underperform that small-cap index during the pullback:

source: YCharts. 6-month chart

But the big pressure came from the sell-off following fiscal Q1 results in late January. 1-800-Flowers.com went public in 1999; it declined 61% in 2000 and 60% in 2002. (Oddly enough, it rallied 278% in 2001.) There was a 56% decline in 2008 as well. And yet, the 28.5% decline on Jan. 27 was the stock’s worst single-day performance ever.

And, to be clear, it was an ugly report. After Q1 FY22 earnings in late October, FLWS reiterated full-year guidance for revenue growth this year of 10% to 12%, along with modest compression of Adjusted EBITDA margin (an outlook of 5% to 8% absolute growth). EPS was guided roughly flat against FY21’s adjusted figure of $1.84 (owing to higher depreciation and tax).

After Q2, however, the outlook was slashed across the board. The projection for revenue growth dropped ~3 points to 7% to 9%. Guided Adjusted EBITDA was crushed. The implied figure after Q1 was $227 million; the updated range is $140-$150 million.

Implied margin expectations came down 330 basis points, to 6.3% from 9.6%. Implied guidance for the second half suggests a 260 bps compression — and a 62% reduction in underlying profit. Free cash flow guidance went from over $100 million to down sharply year-over-year — and, per the Q2 call, possibly even negative.

The post-earnings sell-off in FLWS wasn’t a case of the market misunderstanding a quarter, or overreacting to a trivial miss. Year-to-date performance hasn’t been that bad, but the slashed guidance clearly seems to change the story here — at least in the near- to mid-term.

The Case Against FLWS Stock

Indeed, there’s a way to argue that the sell-off in FLWS to $13-plus is completely rational. (To some traders, there’s clearly a case to go further: per finviz.com, short interest still is ~17% of the float, though only about 6% of shares outstanding

FLWS’ margins in retrospect clearly seem to have been boosted by the pandemic. A company with literally zero margin expansion in the six years between FY13 and FY19 saw a 340 bps boost (more than half of the 6.6% base) in two years. Yet as recently as late last year, the market was pricing that expansion as sustainable, given that valuation multiples (notably, 7-8x EBITDA) were roughly in line with previous years.

From this perspective, the sell-off before the Q1 report was the market playing catch-up in understanding post-pandemic risk. Investors reduced the multiples assigned to FLWS, just as they did with so many other stocks in so many other pandemic-affected sectors (indeed, with so many other stocks of all stripes).

The plunge after the report, and the further decline since (FLWS has dropped another 11% from its post-earnings close) are a sign of the market pricing in not just a return to normalcy, but potential erosion from pre-pandemic levels.

After all, there is substantial pressure on FLWS’ cost structure. On the Q2 call, chief financial officer Bill Shea cited:

• marketing costs that “were significantly higher than planned.” In the Q&A, Shea pointed to digital marketing rates that “were at historic lows” in 2020;

• ocean freight rates at “five to ten times historical levels”, costing some $28 million in the first half, most of it in Q2 (the key holiday quarter);

• hourly labor rates in-house up more than 25%;

• shipping costs which “escalated beyond what we were able to pass along to customers”.

These inflationary impacts don’t necessarily reverse. On the labor front, Shea admitted as much in the Q&A of the call:

Labor and some of the challenges with access to labor and labor rates, I think we're at a new normal. So there's -- it's $18 an hour, that's up 25% over what we paid last year and probably up 30% to 40% over where we paid pre -pandemic. So there are some ongoing challenges that we have.

There’s another problem on top of this. Before the pandemic, 1-800-Flowers.com struggled to really grow. Profits jumped in FY15 after the successful acquisition of fruit delivery specialist Harry & David, but stayed stuck until a big spike in FY20. That lack of growth was the core reason why I ignored management’s optimism on the call four years ago.

As I noted in a piece on Seeking Alpha in 2019 several years back, two analyst questions got to the core of the issue. Here’s Linda Bolton Weiser from D.A. Davidson on the Q4 FY18 conference call:

Thank you. That’s helpful. And then -- so thinking longer term here, I mean FTD has been having problems for a couple of years now. It just hasn't been all of a sudden, it's been a gradual deterioration of their business. And if you look back at your FY16 EBITDA, I think you did about $86 million of FY16 EBITDA. And here we are next year expecting 7% to 10% lower than that, a couple of years later, three years later your EBITDA is about 7% to 10% lower than a few years ago. So granted your top line growth is accelerating pretty steadily, so that’s good, but it strikes me that you're spending more to get that top line growth. So you’re getting the growth, but your profitability is deteriorating...

And Benchmark’s Dan Kurnos a year later:

...then let's just address kind of the elephant in the room on the forward guide, especially EBITDA, which is what's hurting you today. So, you guys have made several hundred millions of dollars of investments in tech in the last few years. Obviously, you guys have taken significant marketing share and accelerated your revenue. There's no doubt about that. You've got FTD, kind of, in pieces now, although there are some obviously, concerns that Nexus [Capital Management, which acquired FTD’s core assets] will be maybe a more rational and reasonable player against you guys. So just how do we view the long term, sort of, balance between growth? Do we return to a improving or a leverage situation you guys used to generate about, 30 basis points to 70 basis points of margin expansion a year?

The clear risk here is that FLWS sees a return to pre-pandemic top-line growth (low-single-digit on an organic basis, ~flat underlying margins), plus a “new normal”, as Shea put it, in post-pandemic costs. It’s that risk that bears would argue FLWS is pricing in at the moment.

Why FLWS Stock Is Worth The Risk

Those risks are legitimate. And it’s not difficult to be a bit gun-shy when making a case for any stock being “cheap” fundamentally, given how rarely it seems that pure value cases have played out well over the past ten-plus years.

All that said (and this is a terrifying sentence to write given that history), given valuation, 1-800-Flowers.com doesn’t need to grow much, if at all.

The midpoint of guidance suggests EBITDA this year of $145 million. D&A should be ~$50M this year; interest ~$7M, and the effective tax rate 23-24% per guidance (so ~$20M). Capex is going up to a guided $60-$65 million this year (and probably stays somewhat elevated in the mid-term, particularly given efforts to drive automation and mitigate labor costs).

So normalized free cash flow still should be in the range of $55 million, suggesting a P/FCF multiple of about 15.5x, and about 14x backing out net cash and associated (modest) interest income.

That’s a multiple that incorporates little in the way of growth. But it’s also a multiple being calculated against a free cash flow base that may well be depressed — not elevated.

Because while CFO Shea was talking up the impact of (probably sustained) inflation on costs, he also highlighted a large number of enormous impacts that simply aren’t sustainable. Again, FLWS took a $28 million hit from ocean freight just in the first half, which accounted for ~40% of the delta between EBITDA guidance post-Q1 and post-Q2. Freight rates will not stay that elevated for that long.

One delayed shipment in Q2 cost $8 million of wholesale orders; labor issues at a supplier created another $4 million hit. $6 million in inventory had to be written off after other delays led to order cancellations. Despite those pressures, and higher prices, FLWS still grew revenue high-single-digits in the first half and expects a repeat performance in 2H.

Some of the inflationary pressures seen at the moment will work themselves out. Some will be mitigated by automation. (Bear in mind that FLWS isn’t purely a flower company at this point; over the past three full fiscal years, nearly half of segment-level profit has come from Gourmet Foods & Gift Baskets. Automation can help, going back to when FLWS installed cookie icing machines a few years back.) And on the flower side of the business, inflation creates a larger competitive advantage for scale, even if further pressure on independent florists could present a headwind for the BloomNet wire service business (~15-20% of total profit the last three years).

FLWS’ loyalty program continues to grow. It’s done a nice job in M&A, building out a solid portfolio of businesses beyond flowers, and driving a coherent strategy for cross-selling between those properties (highlighted by the recent buy of livestreaming platform Alice’s Table). The investments made pre-pandemic contributed, at least in part, to the strength of results during the pandemic — and they can contribute to growth going forward as well.

Capex likely will come down over time (it was in the $30-$35M range before the pandemic), and FLWS has some balance sheet flexibility with ~$100M in net cash. (That figure may come down in 2H, but inventory build will reverse in FY23; the spend is not going to perishable items, per management.) On top of all that, some of the one-time pressures in FY22 — notably ocean freight — are going to reverse at least a bit. Performance YTD — flat volumes, per commentary, against a hugely difficult comparison — suggests demand is intact and that the company has the ability to take pricing where needed (as it has year-to-date).

Broadly speaking, the market is acting as if a) FY20-FY21 performance was a complete outlier and b) FY22 performance is the new normal. I’m far from convinced either is the case — and at this valuation, a successful long position only needs the market to be wrong on one front for the stock to rise from here. (Worth noting as well: analysts stuck by the stock after the post-earnings sell-off, and the average price target suggests more than 100% upside.)

It may take some time for the thesis to play out. But Q3 earnings on Apr. 28th offers a chance for “better than feared” results that coud lead to a bottom. That aside, the sell-off to date seems like an overreaction. FLWS deserved some kind of haircut, but this decline seems like too much.

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