Description

I recommend CWTR as a short. They have a number of business problems that are not discussed in the analyst community, the Chairman is aggressively selling stock, management has a poor track record, and it has fully priced in a turnaround that I think will fail.

As I was finishing this up write-up, the CEO (Dan Griesemer) abruptly resigned. There was no explanation or quote from him in the press release. The founder/chairman (and former CEO) will assume the CEO position. I do not think that Griesemer was anything special, but I think Pence has the potential to run the company into the ground. He was overly aggressive in expanding the company before and ran it with very little inventory discipline. The company said that the board was not happy with the speed of the turnaround, so they asked Pence to step back in to "accelerate the timeliness for this growth".

Business Description:

Coldwater Creek Inc. operates as a multi-channel specialty retailer of women's apparel, accessories, jewelry, and gift items primarily in the US. It focuses on women aged 35 and older. The company operates premium retail stores, merchandise clearance outlets, and day spas. It also offers products through its e-commerce website as well as through catalogs. As of March 27, 2009, the company operated 349 retail stores. It was founded in 1984 by Dennis and Ann Pence in Sandpoint, ID.

Business issues:

1) Very Competitive Industry

Apparel retailing is an inherently difficult business. There are no real benefits to scale, customers can switch easily and have full price transparency, and there is limited intellectual property (they can copy you a season later) unless you have a strong brand. I would argue that CWTR's brand value is very limited based on their reliance on promotions and historically poor returns on capital.

Also, there is plenty of capacity in the "missy" segment. CWTR's most direct competitors are Chico's, Ann Taylor Loft, Talbot's, Christopher & Banks, and mid-market department stores.  We have seen relatively few closures across these companies, yet demand is down significantly. This excess supply should weigh on returns in the segment.

2) Dubious Retail Model

After having success with their catalog business, CWTR decided to enter the retail segment in 2001. Retail growth stories tend to get priced very well because of the high ROE potential. CWTR was no different. They opened stores aggressively and touted mid-teen margin potential by pointing to CHS' margins. However, CWTR never achieved the level of productivity or efficiency of CHS (which by the way was unsustainable because of the low barriers to entry). In fact, I would argue that CWTR's retail expansion was barely (if ever) NPV positive. The segment arguably hit 7% operating margins at the peak. At that point the company ROE was ~19%. Retail is a more capital intensive business than catalog / internet (more investment in inventory and store build-out), so I think it would be hard to argue that CWTR's retail segment achieved anything better than a 15% ROE in its best year and probably has not recouped its cost of capital.

The first set of tables allocate "Corporate Expense" based on revenue.

This second set of tables allocates "Corporate Expense" by revenue in 2004, then has Direct's allocation growing at 5% with the rest allocated to Retail with the logic that Retail was the growth segment, so it was requiring all the added resources.

3) Poorly conceived leasing strategy

Next, I believe that CWTR took a very aggressive approach to their leasing strategy. In effect, they went to landlords and said "We want to go into the mall, but we want you to pay for the buildout. In return, we'll pay more rent down the road". You can see this on their balance sheet and cash flow statement in the line "Deferred Rent Liability". This deferred rent liability arises when the landlord gives the tenant an allowance to build out the store. That cash becomes PPE and the liability is amortized as a reduction in rent expense over the life of the lease. This means that cash rent is greater than income statement rent. I haven't found another retailer with anywhere near as significant of a deferred rent liability. Leasing agents point out that in order to get this significant allowance, CWTR has to agree to weaker tenant rights. For example, they might not have (or have weaker) kick-out or co-tenancy clauses. This puts CWTR at a disadvantage, because they cannot exit underperforming stores as easily as CHS et al. In fact, CHS is closing 20+ stores per year despite better sales productivity and profitability than CWTR.

The table below attempts to show how this line works in the cash flow statement. There are three components to the "Deferred Rent". (1) Tenant allowance receipts that increase the liability and are a source of cash, (2) amortization related to straight-lining rent escalations (this is a very small portion and I lump in with the other amortization), and (most importantly) (3) amortization of prior tenant allowances received.  One can see from the last column below that cash rent exceeded rent expense by approximately $12m in FY 2009 and has been steadily increasing (I believe the 2006-2007 decline is related to straight-lining). Also of note is that this will be the first year that this is a net cash drag to the company rather than a source of cash (-3.6m through Q2). Not coincidentally, operating cash flows have deteriorated markedly in 1H FY 2010 from $68m to $18m (by more than Net Income has fallen).

A look at the balance sheet confirms this number. The liability stands at ~$135m. Applying the remaining lease life of 6.7 years results in a cash rent expense of $20m greater than the income statement expense. This is very significant for a company that has ~$950m in sales and had peak operating margins of ~8%.

4) Inventory issues

More immediately, CWTR has inventory issues despite what they say publicly. Management touts their lean inventories and cited them for the Q2 sales miss (7/23 press release). However, they continue to reference in-store inventories rather than total inventories.  If inventories were as lean as they say, merchandise margins wouldn't continue to face significant pressure (GM down 600 bps yoy - 450 bps of which was merchandise margin in Q2).

As you can see in the table below, COGS growth has trailed inventory growth in recent quarters and never fully worked off the dramatic inventory growth experienced in 2007/2008. This implies flat to falling inventory turns. At the same time, inventory growth is starting to re-accelerate. It was up 11.2% yoy at the end of Q2 and is planned to increase further at the end of Q3 and Q4 in anticipation of improved sales (as per management guidance on the conference call and inventory purchase commitments of $230m v $198m a year ago - from Q2 10Q). If sales don't improve markedly, this will put further pressure on gross margins (though Q4 will probably improve slightly because of the depressed level last year).

The comment that their sales shortfall was due to low inventories becomes more of a stretch when contrasted with CHS whose inventory was down 9.6% coming into the quarter and generated a sales increase of 3.6% (vs. CWTR sales -6.7% and inventory +2.8% to start the quarter).

5) Broken full price selling model

They have destroyed their brand (what there was anyway) and trained the customer to wait for discounts. This is a tempting strategy when times get tough, but in high GM businesses, one has to have the discipline not to rely on price to drive sales. This is evident in their reliance on promotions in magazines and their own catalogues that offer significant discounts for volume purchases as well as the "up to 70% off" signs in front of stores. This is a tough cycle to break because convincing customers that the goods won't be discounted if they wait a few extra weeks requires willingness to hold out and compelling product.

6) Potential cash crunch

I am not predicting that this will happen, but I think there is the potential for a negative liquidity spiral at CWTR. Currently, their guidance is to end the year with $100m in cash. My estimate of year-end cash is laid out below.

Given the inventory build in the face of weak sales, my EBIT and NWC change estimates could be generous (it assumes about breakeven in 2H). If things are materially worse than I have projected, vendors could get concerned about the company's ability to pay them and require tighter terms. Days payable are historically high at 54 days and accounts payable are $103m. If terms tighten to the low 40's (still within historical range and would go lower if vendors were truly worried), $20m goes out the door. CWTR has a revolver available, but the company is already drawing LOCs against it ($27m / $75m available).

Insider selling:

Chairman Dennis Pence instituted a 10b-5 under which he has sold 250k shares per week. He has sold approximately 2m shares (out of ~14.3m at the beginning of the program).  

Management quality / Company communications:

As for Pence and his team's management prowess, I would point to their aggressive retail expansion before knowing what the ROI was on retail stores and the opening of Coldwater Creek Spas, which have been a drag on resources and a small drag on profitability.  They also like to cite the great real estate deals that result from their desirability as a tenant (the checks clear?). Leasing agents tell a different story. CWTR was basically willing to go into any space because they were aggressively pursuing square footage growth to please the street and meet their growth targets. At the pace they were growing, they couldn't be picky and ended up in lots of subpar locations in "B" and "C" malls as well as under-occupied lifestyle centers. Their June 2009 presentation says that "Virtually all stores are cash flow positive on a four wall basis".  The CFO wouldn't confirm this after the Q2 call when I asked him why CHS was closing stores despite their better productivity and profitability.

CWTR had to restate earnings in early 2006. This $0.06 restatement was out of $0.50 initially reported earnings. They also were basically able to report the income twice-analysts certainly weren't backing this out of EPS going forward.

http://phx.corporate-ir.net/phoenix.zhtml?c=92631&p=irol-newsArticle&ID=1306648&highlight=

Restatement of 2005 Earnings

"The company also announced that it would restate its fiscal 2005 financial statements to correct the manner in which it accounts for non-refundable marketing fees received from its credit card issuer in conjunction with its co-branded credit card program. As previously disclosed in the company's prior SEC filings, these fees were recognized as revenue during the period in which a customer's co-branded credit card was issued and activated. Going forward, revenue associated with the marketing fees will be deferred and recognized over future reporting periods. As a result of the restatement, net income per share for fiscal 2005 will decrease by approximately $0.06. Net income per share for the second, third and fourth quarters of fiscal 2005 will decrease by approximately $0.01, $0.02 and $0.03, respectively. Net sales for fiscal 2005 will decrease by approximately $8.5 million. Net sales for the second, third and fourth quarters of fiscal 2005 will decrease by approximately $1.3 million, $3.3 million and $3.9 million, respectively. The deferral of these marketing fee revenues will have a positive impact on financial results when they are recognized in future reporting periods. Marketing costs incurred in connection with the program will continue to be expensed in the periods in which they were incurred. Additionally, this restatement will not affect the company's cash position."

Also, the company has historically been aggressive in its markdown reserves.

http://image.coldwatercreek.com/pdfs/2006AR_1.pdf

Page 27 under "Inventory Valuation"

"As a percentage of gross inventories, our reserve for obsolete and slow moving inventory was approximately 0.4 percent and 2.9 percent as of February 3, 2007 and January 28, 2006, respectively. The decrease in inventory reserve as a percentage of gross inventories primarily relates to our retail segment and is the result of actual write off experience being lower than estimates and better inventory management, including the successful disposition of slow moving inventory during fiscal 2006."

This number is no longer disclosed, but a 0.4% reserve for apparel seems quite aggressive. This provided them approximately $3.1m of pre-tax income in 2007 ($127m inventory * .025 difference in reserve) and is generally a low number for apparel retail (high single digits is more common, but reporting is spotty). The following year experienced a "one-time" write-off of obsolete inventory.

I can't say whether they intentionally mislead investors in their accounting or not, but I think it is part of a pattern of aggressive accounting (credit cards and inventory), business (leases and growth), and communication (in-store inventories and margin expectations) practices.

Valuation:

My valuation approach is pretty simple:

Consensus sales and earnings for 2011/2012 are $1.0B/ and $.05/$0.14. I'll eat crow if they do 7% operating margins in the next couple years. These estimates do not reflect that approximately 2% margin benefit they receive from the amortization of deferred rent liability.

Peers all trade at large multiples of consensus earnings on the basis of normalized earnings (2011/2012 P/E to consensus: CHS 24x/19x, ANN 53x/31x, ANF 36x/20x - ANF being another retail turnaround). I think the difference here is that CWTR has structural problems that impede getting back to normal.

Capex cannot really be deferred for long, so earnings are a good measure of sustainable cash flows for specialty retailers. The company previously peaked at 8.4% operating margins and has subsequently experienced significant declines in direct and same store sales, making those levels of profitability difficult to achieve again. The company has already cut $100m of costs (including marketing), and there appears to be little room to further cut costs. In fact, some of the marketing is coming back on line (catalog circulation increasing).

At 350 stores out of a potential 550 (according to management), there is some room for growth, so one might argue for a high teens multiple. However, as discussed above I think the ROI on retail investment doesn't justify it (even at peak margins, the company ROE was 19% and retail is a lower margin, more capital-intensive segment), so I would attribute little value to growth opportunities.

Summary:

In short, I believe CWTR is a broken business where earnings overstate cash flows and management has a poor track record. Despite this, a full recovery is priced into the stock.

Catalyst