Description

Pier I (PIR) has been underperforming for years, and as a result, the stock price has come down considerably. Because company performance has continued to deteriorate, and because we disagree with the bull case, we believe that PIR still presents a good short opportunity.

Sales/Sq. Ft. growth has been negative for the past 3 years and each of the past 4 quarters. This is understandable given that PIR has increased its footage by between 7% and 11% over each of the past 4 years, and it is reasonable to expect that new stores won’t sell at the same rate as established locations. However, Same Store Sales (SSS) should get a lift from this expansion as newer stores tend to comp. higher off of lower base sales. This has not been the case as SSS have been negative for the past 3 years and for each of the past 8 quarters. In each case, the downward trend has accelerated with Sales/Sq. Ft. going from -3.6% in FY ’04 to -5.6% in FY ’05, and hovering around -10% for the first 3 quarters of FY ’06. The SSS for the same timeframe are -2.2%, -5.8%, and -8.7%. In fact, PIR has actually managed to show negative sales growth overall during each of the past 4 quarters at the same time they have increased their footage by 6%. Looking at the 2 year comp., they could be negative again in January.

We believe that the trend in inventory and gross margins are also telling. PIR inventory was up in FY ’04, ’05, and for the first 3 quarters of FY ’06. Many retailers will claim that inventory is increasing in excess of sales due to store expansion. This is why we look at Inventory/Sq. Ft. for PIR which has been up 2.3%, 11.6%, and 8.1% for the past 3 quarters after falling by 5.3% in FY ’05. Gross margins have fallen from 41.8% in FY ’04 to 38.3% in FY ’05. In addition, over the past 3 quarters, gross margins have been down 514bp, 592bp, and 277bp year over year.

This means that PIR has been adding stores, increasing inventory, and selling less at lower prices. The trends are getting worse as are the fundamental reasons behind PIR’s poor performance. PIR used to have a unique look. Over the past few years, competitors such as TGT, WSM, LIN, and CPWM have added merchandise that competes more directly with PIR’s offerings. TGT in particular has been a problem for PIR as customers already in a TGT have bought items there rather than make a separate trip to PIR. This trend is also accelerating as TGT has added a Global Bazaar section to their stores that is designed to compete more directly with PIR. We have heard mostly positive comments on Global Bazaar.

PIR has decided to respond by remerchandising their stores again. They have tried this multiple times recently and ended up with weak sales leading to markdowns. This time, PIR is targeting a more modern look that has been described as similar to West Elm. We believe that if PIR changes their appearance too much, they run the risk of losing their core customer, and taking some pain before a new customer finds them. The company claims that they are not changing the appearance of their stores too much, and that they will still look like Pier I stores. They also say that they are changing between 70% - 75% of their SKUs. Technically, it may be possible to change three quarters of your merchandise, and still look like the same store that your customers will recognize, but that seems like a tough act for a merchandising-challenged management team.

More importantly, this remerchandising could lead to an earnings miss. Analysts are expecting gross margins of 35.5% for the quarter ended 2/28/06 which is only a 162bp drop from 4Q ’05. PIR is rolling out their new modern look over the next month to all 1,200 of their stores. This means they need to dump existing inventory to make room for the new product. To do this, PIR is converting an additional 18 of their full price stores to clearance stores. This takes the number of their clearance stores from 17 to 35. As mentioned above, gross margins have been running approximately 300 – 600bp below last year’s levels. If they double their clearance stores, and dump inventory, we suspect that gross margin and earnings estimates for the quarter are too high. Conversations with the sell-side analysts reveal they have little confidence in their numbers.

The stock has traded up recently on a bull case which we find questionable. Those points are as follows:
- M&A activity. There is speculation that with LBO firms flush with cash, and recent M&A activity in the retail space, that PIR is a potential acquisition target. First, we believe that a financial buyer would look at the trends in PIR’s business, and if they were still interested, would at least wait until performance stops deteriorating in order to buy the business at the lowest possible price. Second, if PIR were to be bought at the same multiple of revenue that LIN was, it implies a price of $10. An EBITDA multiple implies a price of $6.50 for PIR, and depends on PIR improving operations to get to that level. Some have suggested that a financial buyer could buy PIR for a multiple of EBITDA based on historical profitability. We think that is possible, but unlikely. Third, PIR leases substantially all of their stores, so there is no opportunity for a K-Mart or Toys R Us style real estate play.

- There is talk that PIR could replace their management or merchandising team. We agree that this could happen, and that a better team could provide a lift to the stock. However, PIR is currently in the process of remerchandising all 1,200 of their stores. We think the board is unlikely to change management teams while implementing a strategy meaning that things would have to get worse before they would take this positive step.

- Several analyst reports suggest that PIR could improve their financial performance by shutting a large chunk of their stores. The company has no plans to do this, and in fact, is increasing their net stores this year. PIR does close some stores each year, but they don’t have that many stores with four wall performance that is bad enough for it to be economic for them to take the hit from early lease termination.

- There was a recent mention in Barrons that the stock was getting close to its asset value and mentioned that the corporate headquarters was worth $100MM. The fact is that PIR should end the fiscal year with no net debt so isn’t a candidate for bankruptcy in the near future. However, if PIR has to realize the value of its corporate headquarters, we think that works out well for a short position.

- PIR is facing very weak comps. in Feb. (-15.3%) and March (-18.2%). It is possible that PIR could print a positive SSS number. While we concede that this is a risk, given likely continued declines in gross margin, we are prepared to take the risk that PIR’s sales for those two months exceeds last year’s dismal results. In addition, given the liquidation of existing merchandise, these potentially higher sales may not add value.

- High dividend yield. PIR’s 4% dividend yield is attractive to some investors, and as of now, the company has no plans to reduce it. We would point out that free cash flow for each of the past 5 years has been $187MM, $78MM, $56MM, $43MM, ($49)MM (Negative $49MM is estimate for FYE 2/06). If PIR has another year like last year, they will have to cut the dividend.

- There is always the risk that the new merchandising effort will work.

Catalyst

- Analyst expectations for gross margin for the quarter ending 2/06 are too high. PIR may sell more merchandise, but with planned inventory liquidation, we believe these sales will not be profitable.

- Analysts expect improving sales and operating profits in FY ’07. It appears that results are actually getting worse.

- Shift from positive to negative FCF has put a stop to stock buyback, and may cause a dividend cut.