Description

Gottschalks, the regional department store chain, trades at 5.7x 2004E free cash flow, 0.7x tangible book, 0.3x revenue and 12.5x very conservative 2004E EPS. We have been increasing our position in the stock because (i) its valuation has become more attractive, (ii) we believe the chances for a going private have increased significantly and (iii) management has finally started an investor relations program designed to educate investors on this unfollowed stock.

With a $65mm market cap, GOT is a leading regional department store operating in secondary markets in the Western U.S., primarily California and Washington. GOT operates and leases 63 department stores and 10 specialty stores. The company offers moderate to better merchandise brands and attempts to individualize each store’s offerings to differentiate them from competitors. 25% of the company’s stores are located in markets which face no direct competition from other department stores as the markets are too small for larger retailers. The Company has gone through a tremendous operational and financial turnaround including closing unprofitable stores, selling its proprietary credit card accounts business, improving gross profit (more private label), reducing sg&a, refinancing its expensive debt, reallocating capex and hiring a new CFO.

After releasing 2004 Q1 results (SSS +4.8%), the company increased the midpoint of its full yr EPS guidance from $0.32 to $0.39. We believe the company can greatly exceed this estimate, which is conservatively based on 1.5% SSS growth, only slightly improved margins, a 50pbs increase in interest rates and a higher tax rate. Given the company’s past difficulties, we believe management is being overly conservative (both on a top line and margin basis) in an effort to re-establish its credibility with investors. For example, after the close of the last month of FY 2003, the company estimated FY 2003 EPS would be $0.10-0.12….however, they eventually reported total EPS of $0.14 and $0.21 from continuing ops). Based on conversations with management and other industry sources, we believe a more realistic 2004 EPS estimate is in the mid to high 40s. Management guided to 2004 free cash flow of approximately $11mm after $8-9mm capex (no new stores, but several remodels) and while we believe that free cash flow estimate is conservative as well, we realize management could easily reinvest any “excess” free cash flow into the business. We believe that 2005 can be an even stronger year for the company as it plans to close 2 stores which lost a combined $0.7mm last year ($0.03 eps), use 2004 free cash flow to paydown debt and perhaps open 1 or 2 new stores in its existing markets…however, we doubt GOT will remain public long enough to report FY 2005 results. GOT should benefit in 2004 and beyond from, among other things, renewed management focus on store operations as the turnaround (closing stores, refinancings, etc) is largely complete, additional private label launches, more capital available for store remodels, new efforts to attract Hispanic shoppers (critical in California) and a new bridal registry program.

Given its small market cap, no analyst coverage, relatively expensive sec fees, no plans to issue equity and its attraction to various strategic and financial players, GOT should not remain public. We believe that previous efforts to sell the company have been hampered by “personal” issues as opposed to financial considerations. However, we believe many of these issues have now been resolved. Furthermore, the ongoing consolidation in retailing, the largely completed turnaround of GOT and the improving economy provide further impetus for a sale. GOT’s 2 major shareholders are Joe Levy, 11% and Harris Company, 16%. Mr. Levy is part of the Gottschalks family, is 72 years old and no longer has any children working at the company. We understand that for estate planning and other personal reasons, Mr. Levy is interested in monetizing his stake. Harris Co. is part of a large Spanish retailer, which acquired its shares in an asset sale to GOT. The GOT investment is tiny for them and since they have shown no interest in buying the company, I imagine they would be interested in monetizing their investment as well. The synergies available to a strategic buyer are obviously significant (sga, increased purchasing power…no SEC fees increases GOT’s EBIT by 10%+ alone). There are no “go dark” issues which would make buying the company prohibitive (store leases, pensions, parachutes). Given GOT’s valuation and investor base, a financial buyer could also acquire it if strategic buyers are too busy digesting/assessing other acquisitions.

We never invest in a stock simply in the hopes of a takeout and we realize there are obviously risks to owning a retailer (consumer spending) and one with a big California presence (workers comp, gas prices). However, given GOT’s cheap valuation and our belief that a takeout occurs sooner rather than later, we believe the risk/reward is very attractive here.

Catalyst

Eventual sale of company now that turnaround is largely complete and other "sale" issues apparently have been resolved.

Increased investor awareness as management has finally started investor relations program to tell their story.