Value Investors Club / Charming Shoppes (CHRS)

Description

In December 2006, we pitched AIPC (then under ticker PLB) on VIC as a stock with big upside, partially b/c of a turnaround being led by Jim Fogarty of Alvarez and Marsal (A&M), of whom we thought highly. After 15 years leading turnarounds on A&M's behalf (including two years at AIPC/PLB, which is up 5x from the price of A&M's warrants), Fogarty resigned and became the permanent CEO of Charming Shoppes (CHRS) in April 2009. He has significant turnaround experience in the apparel industry, having helped restructure Levi's and Warnaco (WRC), and we now like CHRS as a long with more than 50% upside, b/c:

1. It's a niche retailer w/a good market position at a trough level of sales that was poorly managed for years.

2. The new CEO is a turnaround specialist, w/big options and a proven track record.

3. Street estimates are too low. We have visibility into an EBITDA ramp from 65m (consensus) to 150m+ without assuming that sales improve.

4. The stock has been forgotten, is poorly covered, and new management should market the story next year.

5. They just raised more than expected in an accretive credit card transaction that was not appreciated by the market.

6. They have initiatives in place to drive sales that we believe are likely to succeed.

Target Price

$7.50 (56% upside) - 1-year target, based on 6x $150m 2010E EBITDA.

$9.50 (97% upside) - 2-year target, based on 6x $190m in 2011E EBITDA, from some combination of upside to the cost savings, which we think is there, and/or up to a 5% bounce in SSS (w/a 40% incremental margin), which we view as very reasonable, given their sales initiatives. This would imply a valuation of 14x EPS, but would still be on a SSS base more than 20% below 2006 levels.

The Business

CHRS is a mall- and strip-mall based retailer of plus-sized clothing for women. It has 3 concepts that span the age and price point spectrum from value to better. It is the #2 national player in plus-sized clothing w/10% of the market (WMT #1 w/13-15%). This is a real company, w/about $2.2b in sales and 2200 stores.

The 3 business units are:

1. Lane Bryant - 50% of the biz; about $1b in sales; and peak EBIT margins were 8% when they bought the biz from LTD in 2001. Think Macy's for the plus sized woman middle to upper middle 35-55 year old target customer. 881 stores.

2. Fashion Bug - 35% of the biz; focused on the value-oriented, lower income customer; the 30-40 year old woman. (They were in the girls and young women's businesses, but just got out of them over the last two quarters.) 868 stores.

3. Catherines - 15% of the biz; Focused on the bay boomer customer in her late 40s-60s, who doesn't earn as much as the LB customer, but may have more disposable income, b/c the kids our out school. 30% of this business is also size 28 and above (for very large people). 465 stores.

They also have 44 outlet stores.

The risk is that CHRS sales have been meaningfully slowing since 2H 2007, and Fashion Bug in particular is notably struggling. This unit could be a drag on resources and time, and it is possible that it can't be fixed. However, given that they are generating good cash and trends seem to have stabilized, and some of the catalysts are already being implemented, we'd be surprised to see it head much lower. In addition, they have improved the balance sheet considerably through the sale of their credit card business and by using cash flow to buyback 50m of the convert.

Cap Structure & Value

Price (11/3/09): $4.81

FD s/o: 118.9m

Mkt Cap: 571.9m

Convert: 223.3m (have bought back 51.7m of it in the 50s; used to be 275m issue; trading at 71; converts at 15.38)

Other Debt: 33.9m

Less:

Cash on B/s: 117.1m

CC Unit Sale: 136m (net proceeds from selling their credit card biz in a non-dilutive transaction)

EV: 576m

SSS 2005 2006 2007 2008 2009E 2010E

Consolidated 3% 1% -5% -12% -9% -2%

Lane Bryant 4% 1% -6% -13% -9% -3%

Fashion Bug 0% -1% -4% -11% -11% -5%

Catherines 10% 4% -3% -12% -6% 0%

We think the following Street estimates are clearly low, and this is discussed in the catalyst section below.

Street Estimates 2009 2010 (FY1/2011)

Sales $2,294m $2,113.5m

EBITDA 64.7m 114m (NOTE: only 1 estimate for both years)

EBIT -60.8 11.1m (2 estimates for 09, -109m and -12.5m; note consensus for 2010 is a 0.5% OM)

EPS -63c 14c (range of -87c to 4c for 09)

Capex 24m 30m (guidance for this year is 24m net of landlord leasehold improvements)

EV/Sales: 0.25x 0.27x

EV/EBITDA: 8.9x 5.1x

EV/EBITDA-capex 14.4x 6.9x

2010 FCF

EBITDA: $114m (consensus)

Interest expense: 5m

Taxes: 9m (NOL now, but on a normalized basis assuming 25m of EBT and 35% tax rate)

Capex: 30m (Fogarty very good at squeezing capex; he will only grow capex if he has to and sales showing a pick-up; but this is a bare bones level)

-So, 12% FCF on less than 1.5% margins w/sales down 25-30% over four years, so big leverage if sales return, as we think they will, but are not baking in.

This year they have generated 47m of CFFO-capex and fcf should be about 40m ex-changes in WC.

Target Price Rationale

$7.50 - 1-year target

$9.50 - 2-year target

The Company has a cost savings plan that they indicate will generate $125m in cost savings for the year. They will not provide disclosure on how much of this has been recognized YTD, but we estimate it to be about 55m, assuming that 75% of SG&A is fixed and 25% is variable, which we believe is correct given their high store base and large amount of fixed selling costs. This implies that there is another 70m of costs savings as a tailwind to the back half of the year. YTD EBITDA is 57m. Add to this another 70m in cost saves plus another 20m in initiatives should really ramp in 2010 as discussed below (15-20m from additional rent savings and store closures + 3-4m from sourcing + 1-2m from some IT initiatives that will not have been annualized), and EBITDA can get to $150m w/o sales growth. That gets us to a $7.50 stock at 6x EBITDA. That basically assumes about a 4% ebit margin and would also be 10x FCF. There may also be some additional upside to this, b/c the variable part of SG&A has also been falling year to date and should continue to do so in q3 and q4.

To get to higher levels, you need sales to rebound, which we think will happen as discussed below. This could propel them to the mid-single digit EBIT margin that the CEO claims is reasonable for a business like this. A 5% bounce in SSS w/the cost saves would propel them to a 6% EBIT margin, which would get to about $190m in EBITDA, say in 2011. This would equate to a $9.60 stock at 6x EBITDA (assuming D&A keeps dropping), or $8 at 12x EPS or $9 at 10x FCF (using 35m in capex vs. 20m run-rate now). Basically at a 6x EBITDA multiple, each 1% of OM is worth $1 in the stock. Again, to get to these margin targets SSS need to grow. There are initiatives in place (discussed below) that make this reasonable (not to mention the cycling of some bad years), but given the amount cost cuts they have in the pipeline and given the turnaround experiences of the management team, you don't need to bank on it to make a very nice return here. Lastly, keep in mind that if sales do show some bounce, it won't trade on current numbers or 2010 numbers, but on 2011.

Catalysts (in order of easiness):

1. Accretive credit card transaction announced in August was not appreciated by the market. CHRS sold their private label credit card business to Alliance Data Systems for $136m net, more than initially guided to. This transaction closed on 10/30/09 and essentially recognized the value of an asset on their balance sheet that we were not giving them credit for, b/c there was uncertainty as to whether they would be able to get value for it. This effectively reduced the valuation in our opinion. They have stated that the sale will be non-dilutive to EBITDA, as the buyer will be able to run the business better and their fee stream from the buyer will be about the same as they were generating themselves. Also a ton of investor focus, and hence company time, had been focused on managing the credit card program, so with that gone, it should free up management time.

2. New CEO is a butt-kicker, who helped turned around Levi's, Warnaco (WRC), and AIPC. He spent the last 16 years as a turnaround specialist at Alvarez and Marsal, before deciding to leave A&M, and become the CEO of CHRS. Note that he has significant experience in the apparel industry. He received 2m options at CHRS, 1m of which are time based and 1m of which are performance-based. He is super focused on cash generation and on profitably growing the business, and someone we truly think you want to bet with. In listening to their earnings calls his understanding of the blocking and tackling needed to successfully grow the biz (as discussed below), becomes evident.

3. Re-marketing the business to Wall Street (starting in 2010). This includes getting more and better coverage. For instance, the biggest sellside firm that covers the stock didn't even write a note after earnings in August. Its basically been forgotten. While we do not expect CHRS to market this year, we do think they will start doing so next year.

4. Street estimates are too low.

Street Estimates 2009 2010

Sales 2294m 2113.5m

EBITDA 64.7m 114m (NOTE: only 1 estimate for both years)

EBIT -60.8 11.1m (2 estimates for 09, -109m and -12.5m; note consensus for 2010 is a 0.5% OM)

EPS -63c 14c (range of -87c to 4c for 09)

Capex 24m 30m (guidance for this year is 24m net of landlord leasehold improvements)

When the company reported its 2q on 8/26, EBITDA estimates by the one analyst who has an estimate for EBITDA for this year was for 75m. Yet, they blew away the 2^nd quarter, reporting EBITDA of 29.5m vs. that analyst's estimate of 18.5m. YTD EBITDA is more than 50m, yet consensus is now lower.

In addition, as discussed earlier at the start of this year, the company announced that they would recognize 125m in cost savings this year. While the majority of these cost saves should flow through ratably over the course of the year; there are some that are more weighted towards the back-end, providing a tailwind to 2H. They also announced some new smaller initiatives this year, which they won't anniversary till next year, helping bridge the gap to next year.

D&A this year will be close to 80m and maybe closer to 70m next year. But even so, this implies that operating margins for 2010 in current street estimates are less than 1% when they were already at 2% for 2q 2009 and 1.5% for 1q 2009. While historically, they make less money in the back half of the year, more of the cost cuts should flow through then, so getting to an EBIT margin for 2% for next year is extremely reasonable.

Finally, we think that the sales trajectory has basically flattened, and next year, given some low hanging fruit on the rev growth side, there could be upside from sales.

5. Turning around the business by: a) cutting expenses significantly; b) getting out of noncore businesses that distract management focus; c) shutting about 200 stores in total, including 100 already done and another 100 to come; d) differentiating the 3 core concepts and driving profitable sales; and e) sourcing more product directly.

a) Cost Cuts - on track for the promised $125m of cost, along w/additional cost cuts next year, thanks to some actions taken this year, such as outsourcing IT to Wipro, etc. Gross margin year to date is up about 40bps, and that is w/rent expense constituting about 40% of COGS, and there being significant sales shrinkage. This is b/c merchandise margins are up more than 200bps. Buying and occupancy expenses are down about 5m a quarter already and should fall further next year as there is still 5% of the store base to be cut.

b & c) Getting out of Noncore Businesses & Shutting Stores - The Fashion Bug business used to get 10% of sales from juniors and girls, and small size adult (size 0 - size 6). This was clearly not their core customer age demographic, and turns and margins were lower. From a store perspective, they already shut the 100 worst performing stores, and they have identified 100 others to close. This should help rent expense drop by another 15-20m next year.

d) Driving Sales - There are several initiatives under way to drive sales some of which just intuitively feel like they will work and make sense. For instance, their research revealed that their customers enjoy shopping online more than most (makes sense, given the plus-sized customers). Yet internet sales are only 4% of sales and sales people did not get compensated if someone came into the store and then bought something online. Fogarty hired a new head of internet sales and in Aug they launched 3 new websites. W/in Lane Bryant, they send out these magalogs (magazine/catalogs) depicting the latest line of clothing. Yet, until a few months ago, you couldn't order out of them. You literally had to bring the catalog into the store. Now, web, phone, and in-store are being tied together better.

Also, both Lane Bryant and Fashion Bug have new heads of design. The LB one has started having new product on the floor and this product is selling better, so Company stated on the 1q call, that by 3q this should benefit SSS (not in analyst numbers). On Fashion bug, new head of the group, new pricing strategy, new store layout, and 3q or 4q will be the first clean quarter.

e) Sourcing More Product Directly - going from 40% direct sourced to 70% in 5-10% increments a year starting next year, but it will take some time. The difference in cost is 350bps. So each 10% increment sourced directly is worth about 4m a year in savings.

Additional notes:

-They have a revolver that they don't plan on utilizing; they burn cash in 3q and generate in 4q (although its not nearly as seasonal some retailers), so a net positive.

-They have a small NOL, worth about 30m or 25c per share on a net basis, but they may have used some of this during the credit card transaction.

Catalyst