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Quick -  name three successful mass market retailers who spend virtually zero money on advertising. 

Other than perhaps Costco, how many could you name?

I am now going to describe a highly successful international retailer who you have likely never heard of, but who has some of the most incredible economics you have ever seen in the retail industry.  To top it off the company is run by an experienced and profit focused management team, has 50%+ inside ownership, an exceptionally high dividend yield for a billion dollar plus market cap (~6%), great magic formula numbers (pretax return on capital of 100%+, pretax earnings yield of ~15.0%), and has a very long runway of growth ahead of it (10+ years).  Once you are finished reading the writeup you will also be able to name one successful retailer aside from Costco in response to the opening question.

Bijou Brigitte (BB) serves the mass market for fashion jewelry.   We think this is an attractive industry for the following reasons:

1.  Margin-rich (BB has averaged gross margins of ~85% for the past three years)

2.  Speed-to-market - ie. much shorter lead-times than apparel - can deliver the hottest fashion trends to market quickly

3.  Can cover down-trending businesses w/trending ones - companies that are not multi-faceted are challenged in this way ie. when denim is out-of-style or -season, Levis cannot make up the sales through other product categories.  Same goes for Hot Topic and goth, ANF for preppy.  Accessories retailers can react by simply shifting the composition of their businesses.

4.  Mass appeal which enable economies of scale for large players - less fashion-forward people can participate in the current trends, so product would be viable in the Midwest US or small town Europe, just as with people in NYC or LA (in contrast to skinny jeans which some of you may have noticed are less than flattering on the less than skinny portion of the population).

5.  Accessories are an easier sell for many reasons:
- people with smaller budgets can use accessories to update their wardrobes at minimal cost. 
- not as big of an investment as apparel, so less thought goes into the purchase. 
- if a customer has gained weight, clothes might be unflattering, but jewelry and handbags can still be fun to buy.

6.  Inventory is less of a challenge, one-size fits-all – accessory retailers do not have to buy as deep into each style.  Fewer skus per style and less inventory on-hand will help keep turn rate high.  Don’t have to worry about becoming broken in sizes like in apparel.  Apparel needs to own a minimum of a full size run, or else be forced into an early markdown (just to give you an idea of size range per style: kints - 5 sizes; wovens - 7 to 12 sizes; denim - up to 26 sizes).

7. Tried, tested and proven resiliency - one trend may go out of style, but others soon come in to take up the slack.  Whether it be pendants this year, bohemian necklances or Sarah Jessica Parker Sex in the City big gold hoop earrings, there is always some type of accessory that is in style.  Next time you go for lunch, look at the grandmother, mothers, daughters walking the streets…they are all wearing accessories of one type or another whether it be earring, bracelets, rings, or fashion watches.  It has always been this way, and given the dress-up habits of my 2 and 4 year old girls I suspect it won’t ever change.  This anecdotal and non value added comment is supported by the very resilient historical sss figures of Claire’s over the years, which lends evidence that a customer is more likely to stop buying $100 ANF jeans before they stop buying $5 trinkets. 

8.  If you are successful and establish yourself as a destination store, both BB and Claire’s have proven you don’t need to spend money on advertising to attract customers.  This is a big help to margins.

Advantages of large chains vs mom&pops:
1.  Bigger buys = lower costs
2.  Ability to transfer goods in which performance differs regionally

To address the obvious, this is also an industry that has low or virtually no barriers to entry.  However, we will offer up the clique that retail is a devil in the details business, particularly so for a dedicated accessories retailer for the following reasons:

1.  Very sku-intensive, meaning more work for the buying office to buy all the different styles, monitor performance, etc (BB has 9k SKUs)

2.  Presentation is a challenge - with all that merchandise, fixtures can quickly become very messy, and thus, visually unappealing.  Also, without mannequins to wardrobe, it takes a certain knack to put together attractive displays…more difficult to romance the merchandise via elaborate sales displays.

3.  IT can be rather tricky as one rolls out many stores due to complexity of sourcing and distribution given large number of sku’s.

All of the above challenges may be easily overcome for a small chain of 5,10 or perhaps even 50 stores, but to build up a business similar in size to that of Claire’s or BB strikes us logarithmically more challenging and time consuming.

Perhaps that is the reason Claire’s has been the only name of critical mass in the US for so long and was bought out at a fancy multiple (11x EBIT) by Apollo last year (worth noting Claire’s has a more developed store base and less growth opportunities than BB).  OK, maybe it was just because Apollo could just get a ton of cheap debt, but I digress.

The typical unit economics for BB are as follows:

Initial capex           E100k

Initial inventory     E50k

Initial investment   E150k

Avg store sales based on 2006 data   E400k

Approximate 4 wall EBIT margin        40%

ROI  - ~100%

Payback – ~1 year

These numbers are not exceptional to 2006.  In fact, the return on net assets for the organization for the last three years is as follows:

BB’s ~950 stores are currently represented in Germany, Netherlands, Austria, Spain, France, Italy, Greece, Hungary, Poland, Portugal and to a much lesser degree the US and UK.  Management has opened between 100-140 stores during each of the past 4 years. 

The company has been successful in every market it has entered.   The company recently opened 2 stores in the UK, a market management believes has potential for 400 stores.  On continental Europe management believes there is potential for another 1,000 stores.  In the US, where Claire’s operates circa 2,000 stores, BB opened its first 2 stores last year. 

After positive feedback in the US, management expects to accelerate the pace of the US expansion with an ultimate target of 1,000 stores down the road.  We would agree with management that the concept is proven, and echo management’s public statement that BB has “enormous expansion potential internationally” (Annual Press Conference Release, 2007).

In light of the vast opportunities for expansion, management is focused on maximizing the value of the model in a disciplined and measured fashion.  The team will open new stores as quickly as they can find suitable locations, but no quicker (think of Buffett and his desire that his insurance companies don’t write policies just for the sake of writing policies).  If management can’t find attractive locations they will scale back the opening schedule so as not to compromise the economics of the business model.  For 2007 they have guided to a slower than historical pace of 80 net openings.  Perhaps next year will be more, perhaps it will be less, perhaps the same.  Ditto for 2009, 2010, 2011, etc.  Management cannot tell you with certainty how many stores will be opened each year, but they have built up the people and infrastructure to handle 150 per year.

Not surprisingly given management’s focus on the long-term, there is no coverage by any global brokers, and the name can largely be considered below the radar if you talk with European retail analysts.  This is in stark contrast with the public perception of BB among its addressable market, whom regard the retailer as top of mind for the purchase of fashion jewelry.  Think a sophisticated and well presented Claire’s (without the Dora the Explorer earrings), but catering to an older and more sophisticated customer.

With such a long-term outlook management has little concern for whether like for like sales are +3% or -3% in any given year.  Unfortunately for the momo investors, after three years of double digit lfl’s, the wheels fell off in 2006 with negative 2% lfl’s.  To add insult to injury the company had the audacity to further report negative lfl’s of 3.2% in the first quarter of 2007 and negative 3.6% in Q2 2007.  We suspect 5 years from now very few people will be talking about or even remember what 2007 or 2008 lfl’s were, but time will tell.  

Rightly or wrongly we have made a bet the current level of sales per box is more or less sustainable, and that is core to the investment thesis.  As a data point Claire’s Europe averaged sales per square foot of USD791, USD862, USD892 in 2003, 2004, 2005 respectively.  Based on some rough estimates and discussions with management (sales/sqft are not formally disclosed), we believe BB is running at levels a little below those of Claire’s (our estimate is about USD800/sqft in 2006).  Management believes sales/sqft are sustainable, and if anything will go up over time rather than down. 

We believe the current share price reflects expectations of negative lfl’s (similarly sales per sqft declines) for the remainder of this year as well as the next two years.  If that is the case the stock is probably fairly valued at present.  If management manages to start generating positive lfl’s at any point in the next few years we think the stock is too cheap. 

Some may find it worth nothing that this exceptionally conservative management team noted in the second quarter press release that “Although the negative sales trend was still clear in April, business development has been positive since June, so that a better result can be expected in the third quarter”.  This business has notoriously little visibility, but from our research we have found nothing to suggest the business is suddenly broken.  Competition has steepened over the past few years as more and more department stores and apparel retailers have begun to realize the attractiveness of the accessories market, but we don’t see the limited offerings of general merchants permanently displacing a specialist retailer such as BB.

The key risk as we see it is that further expansion by chains such as Claire’s and European competitors (e.g. Six, Accessorize) saturate the market leading to lower sales per box for all players.  From our research we believe BB skews towards older customers than Six or Claires such that in general terms it is more likely for BB to capture the occasional core customer from these chains than vice versa.  Big picture the easiest way to describe this is that a 30 year old woman is less likely to shop at Claire’s than a 13 year old is likely to shop at BB.  This viewpoint is somewhat reaffirmed by Claire’s use of Icing by Claire’s (often in the same mall as a regular Claire’s store) that targets the slightly older and more sophisticated customer.  Lastly, we speculate that it will be the smaller chains or independents that feel the most pressure in a more competitive  market, leading to ultimate closure of some of the more peripheral players.

As for the actual managers in question, the company is family run. The father was the original founder, the son the current CEO.  We have had telephone discussions or in person visits with the founder, the son, and the CFO (who is not a blood relation but given the similarities in philosophies one could easily be mistaken otherwise).  Each key individual “gets it”.  The company has not produced the margins and ROC they have by accident.  They have built the organization (IT, infrastructure, human resources) with the intent of delivering sustainable returns for the long haul.  Management owns 50+% and have told us explicitly they will never sell a single share.  Compensation is very reasonable, options nonexistent. The CEO (son) has told us “This is the last job I will hold until I die” and is managing the business with that in mind.

As for commitment to shareholders, we suggest you look at past dividends as data points.  The company has historically had a high dividend payout ratio via a combination of regular and special dividends.  Management has told us explicitly the dividend is going up and not down.  Management has told us explicitly they have absolutely no intention of becoming a bank (e.g. hoarding cash).  If the company EBIT develops as we believe, the company will have no choice but to ramp up the dividend such that it is not inconceivable that in 2009 the shares will be yielding ~7%+.  That being said, we expect next year’s dividend to be E7.00-7.50/share, which implies a current yield of ~5.5-6%.

Before presenting the current EV, I will ask you take a moment to be intellectually honest and ask yourself what you would pay for a business with the previously described economics, long runway to open additional high ROIC stores, run by a management team that is looking to add value with every cent they spend.

The current EV breaks down as follows:

Share price       E124

S/O                  8.1m

Mkt cap           E1,000m

Cash                E156m (end of Q2 2007)

EV                   E850m

Since 2006 was the last full fiscal year, I present the current valuation based on 2006 actuals:

EV/EBITDA                                        6.3x

EV/EBIT                                              6.5x

EV/FCF excluding growth capex          11.3x

EV/FCF including growth capex           13.5x

We do have an internal model, but to make thinks easy let’s just assume we have flattish earnings expectation for 2007/2008 vs 2006.  As a data point, 1H 2007 net income was E33.4m, down from E34.3m in 1H 2006.  2007 results have been negatively impacted by an increase in German VAT (up to 19% from 16%), while looking forward 2008 will benefit from a reduction in the corporate tax rate in Germany.

We believe the prior multiples suggest good value, as does the dividend yield.  At these prices one could optically argue you are paying around 10x for forward looking FCF excluding growth capex, which suggests you are getting future growth for free provided the runrate in earnings from the present store base is sustainable.

The downside of the name is that like many retailers the visibility on quarterly revenue is limited at best. To preserve margins at the current level our model suggest you need 2-3% positive lfl’s, which coincidentally was the same figure quoted by Claire’s management on their recent conference call for bondholders.  

On the upside, the financials could not be cleaner, management is completely transparent when you speak with them, they are very gracious hosts if you take the time to visit, and they are truly committed to sharing the rewards of success with shareholders by increasing the dividend. 

Overall it strikes us that there are minimal expectations in the current price and one may be pleasantly surprised at some point over the next year or two.  If things just muddle on with +-2% lfl’s you still have a high single digit FCF yield even after deducting for growth capex.  For an unlevered stock with a decent dividend yield and a billion dollar plus market cap, that strikes us a reasonable risk/reward situation.

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