Every quarter, I take a look at opportunities that I initiated coverage on with high upside. Citi Trends (CTRN) has seen its share price decline almost 10% since I last looked at it, and though the company had a disappointing Q3, I believe shares look undervalued, with 35% upside from current levels. Let’s look at what caused the Q3 miss, capital allocation, and Citi Trends’ prospects heading into Q4.

Q3 Miss: Dropping the Ball in Women’s

Overall, Citi Trends’ third quarter was slightly below estimates, with total revenue down 0.9% y/y to $176.9 million due to a calendar shift. Comp sales were below plan at 0.6% y/y growth, stalling out from the 4.6% growth YTD comp growth rate. Nevertheless, the Q3 two-year stack sits at 8%, which is in line with TJX’s (TJX) Marmaxx 2-year stack of 8% and slightly ahead of Ross’ (ROST) 2-year stack of 7%. Overall, the trend is healthy, but it is worth understanding what caused Q3 weakness.

During Q3, Citi Trends had preliminary reads on fashion that turned out to be wrong. The ladies category declined 7% y/y versus 6% growth in Q3 ’17. The beauty of the Citi Trends model is that the company does not carry such a significant inventory load that it is strapped with unsaleable product for months or quarters at a time. Rather, management quickly liquidates product in order to bring in more productive inventory. In fact, Citi Trends’ confidence in getting trends right going forward explains why the company’s guidance remains unchanged, and its November comp trend puts Citi Trends squarely in the ballpark of 1-2% comp growth.

From a profitability perspective, Citi Trends dealt with freight cost issues that have afflicted the entire industry. Gross margin during Q3 declined 80 basis points to 37.8% of sales, with 70 basis points of the decline attributable to higher freight costs. YTD, gross margin is flat, and I think the company could see some upside if they are able to better address freight going forward.

SG&A expense was up 40 basis points y/y to 34.9% of sales, though it was virtually flat on an absolute basis. The increase was mostly due to a calendar shift, and YTD, SG&A has actually declined by 10 basis points y/y to 32.8% of sales. Management expects that 2-3% comps will be able to deliver SG&A leverage in future years; so returning to comp growth is critical to driving earnings expansion.

Overall, operating margin is up 50 basis points YTD to 2.9% of sales. Q4 is the most material quarter to drive profitability, and if Citi Trends meets comp guidance, we should see operating margin either flat or up slightly for FY18, as the company still must lap lower freight expenses in Q4 ’17. Management noted that over time, they expect 2-3 annual comp growth to eventually drive an operating margin of 5%, which I also believe is possible.

A New Huge Buyback

As I noted in my initiation, Citi Trends is pursuing the capital allocation playbook made famous by TJX and Ross – grow comps and buy back stock aggressively. Citi Trends tapped out its Q1 ’18 authorization, repurchasing 135,936 shares in Q3 for a bit over $4 million. Unfortunately, this equated to an average price of $29.81. Unfortunately, management has not exercised price restraint with regards to buybacks thus far.

Luckily, the Board of Directors authorized another $25 million share repurchase program, which would equate to over 9% of shares outstanding at current prices. Additionally, Citi Trends has ample liquidity to materially boost buybacks in Q4, as the company entered the quarter with about $71 million in cash and short-term investments. Management clearly does not seem particularly adept at timing buybacks, but the company should be able to retire a significant amount of stock at an attractive price.

Capex spending remains under control, totaling just $13.6 million through the first three quarters of 2018. Management continues to close underperforming stores while growing the store count slowly.

Shares Look Cheap, Buybacks Could Provide EPS Upside

For the full year, Citi Trends is guiding to $1.66-1.71 per share in earnings. This equates to an earnings multiple of roughly 12x, well below the likes of TJX and Ross, which trade for 18-20x earnings. Of course, both companies are better run, larger, and better businesses, but Citi Trends occupies a unique niche and has proven to grasp the off-priced model.

At current prices, shares trade well below my intrinsic value estimate of $28-32. I believe comps should be solid given management’s guidance came nearly a full month into the quarter, and I anticipate some EPS upside if management is able to repurchase a significant chunk of stock. Citi Trends trades at an attractive multiple, and I believe business should be fairly resilient in the event of a recession.

Disclosure: I am/we are long ROST, TJX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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