Is Roots Corp. a Buy After Solid Q3 2017 Earnings?

Everything about its Q3 2017 earnings report suggests Roots Corp. (TSX:ROOT) is a buy. So, why am I not convinced?

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Fool.ca contributor Joey Frenette recommended that investors buy a half position in Roots Corp. (TSX:ROOT) before announcing its earnings December 5, arguing that the iconic nature of the Roots brand in Canada will keep it from the retail graveyard.

“If you’re a believer in the power of the Roots brand, I’d recommend buying half a position before earnings with the intention of buying the other half should earnings come short of expectations,” wrote Frenette. “If earnings are a beat, then you may want to wait for a pullback before buying the second half of your position.”

Well, Roots earnings were excellent, sending its stock as high as $10.85 in heavy trading — its highest level since falling below $9 in early November.

Frenette is reasonably enthusiastic about the company’s future. While I don’t have any doubt it will remain a player in Canadian retail for years to come, I was very skeptical about the IPO.

Has Q3 2017 changed my mind? Let’s have a look.

The three main numbers

Same-store sales grew 10.1% in the quarter over last year, gross margins increased by 180 basis points to 54.9% from Q3 2016, and adjusted EBITDA rose 20.5% to $16.3 million.

Any time you can deliver double-digit growth in all three of these areas, you’ve done well.

Let’s consider how both Aritzia Inc. (TSX:ATZ) and Canada Goose Holdings Inc. (TSX:GOOS)(NYSE:GOOS) did in their first quarterly reports as public companies.

Aritzia’s second quarter of fiscal 2017 saw it grow same-store sales by 16.9%, gross margins increased by 160 basis points to 35.9%, and adjusted EBITDA rose 20.4% to $19.8 million.

Canada Goose’s fourth quarter of fiscal 2017 saw revenue increase 21.9% (it only opened its first two retail stores in the fall of 2016, so there were no comparables), gross margins increased by 950 basis points to 54.4%, and its adjusted EBITDA loss increased by 50.0% to -$11.4 million. However, on an annual basis, it had an adjusted EBITDA profit of $81.0 million, 49.2% higher than a year earlier.

So, given the different times of year for all three going public, it’s a bit of an apples-to-oranges comparison.

Nonetheless, each of the companies’ first reports was reasonably solid, so I don’t think one can say too much about Roots that’s negative at this point.

It did what it needed to in the third quarter, and its stock is rebounding as a result.

My two concerns

As I stated in mid-September before Roots issuing its final prospectus, I was concerned about its debt and its valuation.

At the end of July, its debt was $122 million. At the end of October, it was $112 million or 8.2% lower. That’s a good sign, and it’s only 20% of its enterprise value, so as long as it continues to grow same-store sales, I’m not quite as concerned as I was before the IPO.

As for valuation, I had a problem with a multiple of 12.1 times its 2019 adjusted EBITDA estimate of $68 million. However, that was based on pre-IPO valuation speculation that put its enterprise value at $823 million.

At an enterprise value of $554 million, the multiple is just 8.1 times its 2019 estimate. That’s much more appropriate given its growth.

Bottom line on Roots stock

Now that I’ve had a chance to digest Roots’s latest financials, everything Frenette said about the company is 100% on the mark.

My only concern with the company would be its U.S. expansion. Except for Lululemon Athletica Inc., Canadian retailers haven’t done a great job south of the border, where there are a lot more retail square feet per capita. That can go sideways in a hurry.

But for now, I’ll give Roots stock the thumbs up.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Will Ashworth has no position in any stocks mentioned.   

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