Description

My name is Chico's.

Company background: CHS is a specialty retailer of women's apparel targeting the boomers. Company operates about 1080 stores under 3 concepts -- Chico's, White House Black Market, and Soma.

I assume most people on VIC are familiar with the retail space and have heard of CHS. CHS was a great growth stock from '96 to '05 under the leadership of original founder couple and subsequent CEO Scott Edmonds. The company posted double digit SSS and 30%+ EPS growth for almost a decade. Unfortunately, the success also laid the seeds for an equally spectacular collapse, which saw two years of negative SSS and margins going from industry-best 20% to losing money. Stock plummeted from $48 to $2. Since then the company had a complete reshuffle of top mgmt team, from CEO to CFO to top merchants at all 3 concepts. Company has undergone an impressive turn-around, and stock recovered nicely before pulling back 40% after a "disappointing" Q1 report and typical summer retail massacre.  

Improving supply/demand: First, on demand. A few years ago, many company presentations across industries had a page describing how they would serve the baby boomer generation. Well, the boomers are finally here, and the demographic wave should be very favorable for Chico's in the next few years, since the sweet spot of their customers are 55 years+. In addition, during the recent downturn, women have pulled back on their apparel purchase much more than teens, kids, and men. Most of the industry had negative SSS from '06 to '09, and while it is dangerous to argue there is "pent-up demand", I think it is safe to assume current consumption is not above normal. Of course, we can debate whether US consumers are finally tapped out this time, but that is too philosophical a question, and I will resort to Peter Lynch's motto of "don't bet against US consumers".

On supply. The success of CHS had once attracted such memorable new concepts as "Janeville" by Gymboree, "Forth & Towne" by Gap, and copy-cats like Coldwater Creek. Today, the 10-15% sqft growth days are long gone, and most companies in the industry have either stopped expansion or closed stores.

Still good store economics: Even after CHS had seen sales/sqft fall from $1100/sqft at the peak to $600 currently and margin from 20% to 10%, it is still one of the best in the space of missy apparel retailers, vs. ANN/CWTR/TLB all hovering around $300/sqft. This is purely my personal opinion from following the space closely for the last few years, but I think CHS's competitors are a weak bunch, led by the likes of Trudy "I fail everywhere I work" Sullivan at TLB, Kay "One concept must suck at any given time" Krill at ANN, and Dennis "I used to the richest guy in Idaho" Pence at CWTR. I do not have a strong view on the current mgmt team at CHS, but I would note the new CEO and CFO have hit most of the operating goals since they took over. In fact, most people (myself included) were laughing at their goal of $1 EPS power outlined in early '09, when the stock was trading at $2 with $1+ in cash/share. It looks much closer to reality now.

Opportunities in both sales & margins: CHS currently has about 1100 stores. It probably can open another 350 stores (100 Chico's in small markets, 150 WHBM, and 100 outlet stores across both concepts). In terms of store productivity, while $1100/sqft is history, even improving from $600/sqft to $750/sqft would be meaningful sales increase. And obviously there is the free option of Soma, which if successful could be a meaningful growth concept, although I put a very small probability on it.

On margins, unlike many of its peers, CHS is not at peak merchandise/gross margin. Its current gross margin (ex occupancy) is still 400-500bps below prior peak. Inventory had trended below sales growth, although it is worth monitoring as mgmt had planned to boost inventory in 2H to drive sales. Mgmt is embarking on some sourcing initiatives, which should also add some upside in the out years. Online sales also hold some promise as it generally gets higher margin once sales hit critical mass. Lastly, Soma is still losing money (my estimate is 5-10c), and if it gets folded, the core Chico's/WHBM's margins are likely higher than currently reported. Net net, CHS is at 10% op margin at current run rate, vs. 20% prior peak.

Putting everything together, I think CHS can do $1 EPS next year on 13% op margin (well below prior peak of 20%). In a best case scenario, company can do $1.25 EPS at 15% op margin on $2.2B sales in '11 in a best-case scenario.

Valuation

Why the opportunity: Stock ran up significantly in '09 and early '10 to a high of $16, and arguably was ahead of itself, fully pricing in the $1 EPS power number. CHS then reported a "disappointing" Q1, where mgmt invested the upside into TV marketing. Investors abandoned the stock, and there were a couple of downgrades this week, citing reasons like slowing momentum, incremental promotion, and BP oil spill. I do not have a strong view on the NT results, although dept stores like M & JWN have generally reported decent SSS in recent months. I think the street is too myopic on near term earning momentum while completely ignoring the balance sheet, FCF and valuation. To me, the story hasn't changed too much in 3 months, but stock at $9 is a completely different proposition from stock at $16.

I realize 6 months sounds like a long time in this market, but if we fast forward 6 months, this stock will have close to $3.5 in cash, and trades at single digit EPS/FC ex-cash at below average margin. I think the stock has $5-6 upside (12x '11 + cash) and $1-2 downside from here. I do realize the stock had traded a lot lower during '08, although the same can be said about most other stocks, and CHS has $2 more in cash/share, which has to count something.

Risks:

• SSS fell off a cliff and heavy markdowns return.
• Economy double dip. Though I'd think the transports like the truckers would be better shorts than retailers at this point.
• Mgmt blew the cash on some stupid acquisition. Acquisitions have been rare in specialty retail space, and there are actually a few success stories (WHBM by Chico's, and the couple by DBRN).

Catalyst