Description

DLIA - VIC Writeup

dELiA*s, Inc. (DLIA) has a ridiculously capitalized brand name (pun intended).  While capital allocation has been weak, starting with a bloated cost structure following the 2005 spin-off from Alloy which was initially built to support a much larger business, and made worse as proceeds from the sale of a healthy business (CCS to Foot Locker) have largely been wasted on perpetuating this still bloated cost structure, the opportunity embedded in the remaining business seems to be substantially undervalued.  Also, it seems that the shareholder base has evolved to a more demanding constituency, and one capable of materially influencing the course of the company in the nearer term, which should result in improved allocation of resources and a higher probability of realizing fair value for shareholders. 

Seasonally adjusted cash of around $26 million (vs. over $36 million at 1/31/11, and $35-40m projected at 1/31/12) constitutes just over half the current market cap, yet the company is currently burning cash before non-operating items - such as an anticipated $10.7 million tax refund this year, which should result in around zero actual cash burn for 2011.  So, time is of the essence, but they have time.  The company seems to have several years to realize a reasonable value for its brand for shareholders from a position of financial stability.  They just refinanced, securing a 5-year $25m revolver with GE, which replaces a smaller 2-year LC-only facility with Wells Fargo, giving them more flexibility and a longer runway to turn around the business. 

Valuation

With a market cap of $51m, no debt and an average cash balance of around $26m, the $25m enterprise value is just north of 0.1x EV/Sales (using the sole sell-side revenue estimate for 2011 of $222m).  We have usually made money buying struggling, middling retailers around this level, and the potential upside is typically many multiples of the potential downside.  One could argue that both probability of success and upside/downside are favorably skewed (with probability perhaps being the surprise).  Of course it doesn't always work.  This company burns cash, and many people wouldn't miss it, so there is certainly substantial risk. 

Potential Outcomes

(1) Sale

The company is seemingly for sale, despite no public confirmation:

http://dealbook.nytimes.com/2011/02/24/delias-puts-itself-up-for-sale/

If sold before a turn is evident, what would a buyer pay?  Taking the recent, low multiple paid by Advent for Charlotte Russe (CHIC) of 0.37x Sales would imply more than a double.  CHIC at the time was earning a 5% EBITDA margin and slightly negative EBIT.  Same store sales ("comps") were negative (-3.6% in last quarter as public company), although the context was early 2009.  DLIA is expecting flat to modestly negative EBITDA this year, following the most recent round of cost cuts, so they are not quite where CHIC was in terms of stability.  FCF would be -$10m to -$5m, if not for the tax refund (which will not recur in 2012).  Of course if DLIA's comps tick up a few points, then the cash flow situation could be more comparable.  DLIA's comps were positive for the first time in eight quarters, but just barely (+0.9%). 

(2) Turnaround

If DLIA were to turn around successfully, there are many potential outcomes.  0.35x to 1.0x Sales would seem a reasonable, broad range for a healthy teen retailer with catalog and online store attached (115 retail stores drive 55% of sales, the websites drive 40%, and the catalogs account directly for 5%).  This could imply 6-10x EBIT on a long-term average operating margin of 6% to 10%.  This would result in a stock price of $3.30 - $7.90, or roughly a 2x to 5x return. 

(3) Home Run

The most optimistic case is probably 1.0x to 1.5x Sales for a healthy, growing retailer with a long runway of square footage growth from a small, national base of 115 stores... resulting in a 5x to 7x return before any self-funded, high-return store growth, the ultimate reward for investing in a successful growth retailer (which if course this will probably never be...)  It seems a long way off, but so have many small retailers trading around 0.1x Sales and in similar situations (KIRK, URGI). 

(4) Zero

A good place to remind everyone - these don't always work and can be zeroes... all it takes is the banks and/or vendors losing confidence after a protracted stretch of bad comps, and it all ends quickly.  

Activist

9% holder Prentice is an experienced investor and occasional activist in the small-cap consumer/retail sector, and they have recently taken a couple of board seats (2 of 7).  I would guess they are focused on selling the company, and/or resurrecting the website/catalog ("Direct") business, which has fallen behind in the shift from mailing physical catalogs to communicating digitally with the customer.  Already, most of the Direct sales are placed online, but many customers are still reached by physical mail, rather than email, mobile applications, Facebook, etc. 

Another interesting twist is that Michael Gold, who is credited with turning around merchandising successfully at Wet Seal several years ago, recently filed on DLIA with a 5% stake.  Prentice was involved in Wet Seal, so it seems likely that these two investors are on the same page.  Whether or not the recent dismissal of the DLIA's expensive merchandising officer was related to these new shareholders is unclear, but the company is actively looking for a new merchant. 

Cost Cuts

All in, DLIA is cutting $10m in costs during 2011, but will be "re-investing" $2.5m in digital delivery and marketing.  Some examples of cost cuts include: renegotiated leases on 7 stores, which will save around $1.3m; circulation cuts at the catalog, which could save around $2m; and various other reductions in overhead. 

The Catalog as a Source of Additional Cost Reduction

Catalog circulation cuts save a lot of money.  46m units were circulated in 2010, and cutting circulation by at least -10% this year implies savings of over $2m on postage and paper, which total 54c per catalog mailed.  I have wondered whether they might be well advised to cut the catalogs much deeper.  They generated a measly $12m in sales placed through the catalog last year, while it cost the company $23m to produce and mail.  Of course, there are many catalog readers who buy online (and also some who go to the stores).  But by shifting to digital delivery, as long as the shift is effective, I would guess they can save over 80% on cost of delivery (54c per catalog mailed, over 30c of which is postage, down to my guess of 10c fully-loaded for digital delivery).  Cutting the catalogs completely could mean $18m in costs saved, which allows for a fair amount of sales leakage before becoming a bad decision.  The combined Direct segment does <$100m in sales, so even at a nice 55% merchandise margin, they could afford to lose up to a third of their Direct sales and still have the elimination of physical catalogs be a reasonable gamble.  The company thinks up to 2/3 of its website sales are in some way influenced by the catalog, but the CEO has always been protective of the catalog (with a frustratingly minimal amount of data to back up his stance).  His background includes running the catalog at J. Crew.  While cutting the cord completely is probably not going to happen, new board members and outside consultants should lead to an acceleration in catalog circulation cuts as the year progresses, increasing cost savings. 

Other Pros and Cons

Positives:

Replacing their head merchant... never know, but could help. 

Company is fashion follower, somewhat reducing fashion risk. 

Recent outsourcing of the design process further de-risks the product, and merchandise margins responded very positively in Q1 as a result. 

The company doesn't need much in terms of margin improvement to reach FCF breakeven.  They may do a -1% EBITDA margin this year, whereas a 3% EBITDA margin gets them to breakeven ($6m in EBITDA, less $6m in CapEx... no interest expense or taxes).  They have a pass this year from the tax refund.  So, we are hoping they can find 400 bps of margin, equivalent to $8m of cost cuts and/or merchandise margin improvement, and/or positive comps, by 2012.  Typically, if an apparel retailer's fortunes turn, 400 bps is small potatoes. 

Comps are very easy, going back two years (but they were "easy" last year). 

Shareholder base is heavily weighted toward those who would take a deal if one emerged, I suspect, and management is now under a microscope after several years of foolish spending. 

This has been a huge value trap since the spin-off from Alloy in late 2005, and I think many of the likely shareholders have been burned, creating a fatigue dynamic which helps keep expectations low.  The market cap has dropped to untouchable for many.  Only one analyst (Raymond James) covers, and she is neutral.  She writes that she may upgrade when she sees retail become profitable.  At that point the stock could be trading at 0.5-1.0x Sales, or $4.50-8.00 before any cash generation.  If this concept is ever deemed to work, it is again a big growth story with only 115 stores. 

Negatives:

On an absolute basis, $35-40m in year-end cash ($26m seasonal average by my estimate) is not that much and can disappear quickly if it gets really ugly. 

They seem to have been somewhat for sale (NYT article earlier this year) and don't seem to have garnered a ton of interest, but I don't have any real insight here.  I suppose buyers want to see positive EBITDA first, but the stock will likely be a good deal higher by then. 

Management has been weak, and the board has been passive, but I suspect this dynamic should improve as both have experienced significant turnover. 

Inventory is a little heavy in the Retail segment after Q1 (maybe $1-2m heavy vs. $18.7m total), although higher payables as % of inventory corroborate their story that it is fresh and mostly timing related (and mostly in transit to stores).  They say that Retail inventory at store level is only +1% per average store, equal to the Q1 comp.  This implies the excess is in transit (so new, for now).  Still, this puts some additional pressure on spring/summer comps in stores.  On the other hand, direct channel inventory is down a lot and seems in very good shape. 

Catalysts

Continued positive comps

Continued merchandise margin improvement

Additional cost cuts

Announcement of new chief merchandising officer (if noteworthy)

Restructuring of Direct business

Sale of the company

Catalyst

Continued positive comps

Continued merchandise margin improvement

Additional cost cuts

Announcement of new chief merchandising officer (if noteworthy)

Restructuring of Direct business

Sale of the company