Talbots (TLB) is currently undergoing the first two quarters of a three year turnaround that could result in EPS of $1.40 and FCF of $1.80 (less maintenance capex) by 2013. Initial results have caused sales to falter, resulting in excess inventory and rendering the stock untouchable for the next few months as the company sells through this product at a loss.  While Q1 is definitely at risk, this uncertainty offers longer-term investors an attractive risk/reward. The inventory issue will eventually work itself off and with shares now trading at 10x 2011 earnings, the market is putting a very low probability on a turnaround ever occuring.  Any signs of life would result in a very quick revaluation of the business, and if management is ultimatly able to achieve their three-year goals, the stock would likely double over the same time period.

You've got to have a little patience here, we had to start with the product being fixed first, and that's what we did. We had to fix our financial health, and we did it. We're actually going to wind up having a very solid year, even though we would like to see the customer acquisition and reactivations ramp up faster, we are now able to spend against making that happen as well as refreshing the stores. We're 20 weeks into these strategic missions and we think that as we invite her back in, she does like the product, so it resonates with her, but this will take time. These initiatives will produce the desired results over time and we feel that we are totally on the right strategies. And the fact that our product innovation and product refresh has been so widely received and accepted, we're very encouraged by that. - CEO Trudy Sullivan, Q3 Earnings (12/07/10)

BACKGROUND

TLB sells clothing to relatively affluent women ages 55-65. The company has been around since launching its first store in 1947 and its first catalog in 1948. It was bought by General Mills (GIS) in 1973 which later sold out to Jusco, a Japanese retailer (later renamed AEON). Under AEON's ownership, TLB was taken public in 1993 at $9.75 a share and a market capitalization of $650MM. Shares spiked up to $50 at the top of the bubble in 2000 and settled in a trading range of around $30 for about six years until 2006. At this point the business first started to show signs of slowing down.  

In an effort to rejuvenate sales, the board decided it needed to modernize its brand to appeal to a younger demographic and in late 2007, CEO Trudy Sullivan was brought in from Liz Claiborne (LIZ) to transition the brand. Unfortunately, Trudy did not get much time because the recession started shortly thereafter. In 2008, the deteriorating economy caused sales per store to drop 14%, effectively forcing the company into crisis mode. Trudy quickly closed the struggling Men's, Kids, and UK businesses and hired Michael Scarpa from LIZ where he had served as the COO. In 2009, comparable store sales fell another 19% and management responded by cutting $150MM in costs and selling the money-losing J. Jill chain of 280 stores to Golden Gate Capital for $75MM. This sale marked the removal of a huge albatross, as TLB had actually acquired J. Jill at its peak after outbidding LIZ in 2006 by offering $517MM for the company. In 2010, TLB merged with BPW Acquisition Corp (BPW), which was a SPAC whose sole assets consisted of $350MM in cash. The deal was fairly innovative, as it enabled TLB to payoff nearly half a billion in debt while simultaneously buying out AEON's majority shareholder stake which had been an overhang for the last twenty years.

Today, TLB has a clean balance sheet and a much more focused business model. The retail business consists of stores averaging around 7,200 square feet and generating $1.7MM in annual sales. Sales have obviously been impacted by the economic environment, as prior to the recession individual stores were generating more than $2MM a year. In aggregate, TLB's retail business business consisting of 580 stores currently generates about $1B of sales a year. The company also operates its direct business which generates around $230MM in annual sales, split between $160MM Internet and $65MM Catalogue.

FINANCIALS

*Q4 estimates have recently fallen from $330MM in sales and $30MM in EBITDA

TURNAROUND

Over the last year, management has undertaken a number of initiatives intended to achive mid-teens sales growth and double of EBIT margins by 2013. Specific guidance from management is below.

In total, a successful turnaround would about ~$100MM of EBITDA. The strategies being deployed were fairly basic but reasonable, and many of which had shown or were beginning to show traction in the last few months. The major ones are listed below along with general approximations of their impact.

1. Transition Brand (?): TLB currently generates 35% of its sales from customers ages 35-54, 55% from customers ages 55-75, and 10% from customers over the age of 75+. In order to increase sales, management is trying to skew away from the older 75+ demographic and pick up sales from the 35-45 demographic. To do this, the company redesigned its logo and is planning on spending an incremental $60-75MM over the next three years in a national marketing campaign to reintroduce the brand and $120MM to refresh half its stores with new fixtures and signage. The company updated a handful of stores this year and these refreshed stores are currently growing sales by 5%.

2. Close Stores ($10-30MM): Around 300 stores have lease expiration or renewal events over the next three years. The company is planning on closing 75-100 stores of which about half are losing a material amount of money. Earnings should benefit not only from shedding the bad stores but also from some decannibilization as a portion of lost sales are captured in either nearby stores or in the direct channel.

3. Optimize Sourcing ($20-30MM): The company entered into a relationship with Li & Fung in September of last year. While a lot of the easy blocking and tackling has been completed, there is considerable upside as TLB continues to refine the process. The company still sources from 69 different vendors with the top 10 representing 50% of costs. While it will take longer, smaller changes such as taking the concentration of the top 10 vendors up to 60% or shifting costs away from Asia and into emerging countries with materially lower duty costs should continue to drive margin. Management believes that further supply chain optimization will expand margins 50-75 bps a year

4. Add Outlets ($10MM): The company has opened 27 outlets so far and intends to add 60 over the next three years. The outlets are smaller at around 4,000 square feet, but they are comping up in the double-digits and generating more than twice the sales per square foot as current stores.

5. Segment Stores (?): Management segmented its stores into three different categories in order to better match product with local preferences. Specifically they identified 150 Always stores (value), 300 Classic stores (mix), and 86 Premium stores (premium). This occurred in August and product flowing in 1H 2011 should have meaningful allocation differences.

6. Overhaul IT (?): Management is planning on spending a $60MM a year to upgrade its technology systems. Most of these changes, such as upgrading the eCommerce platform and better planning allocation of product to stores, should impact revenue in small but positive ways. A number of these overhauls should be in place by Q2 2011.

TURNAROUND STUMBLES

Shares are down for the year and have underperformed the SPDR S&P Retail ETF (XRT) by 50% over the last six months. The lackluster performance is the result of two events. The first event occurred on October 5^th, when the company provided details on its turnaround plan. Management put out a detailed 152-page presentation explaining the transition but the market only took one thing from the entire commentary. Q3 sales were trending down slightly versus prior estimates of a slight gain. Shares fell 15% on the day.

The second negative event occurred on December 7^th, on the Q3 earnings call. EPS of $0.27 actually beat estimates of $0.25, but comps of (7%) were lower than the already reduced street estimates. To make matters worse, management indicated Q4 would likely be down flat to negative LSD, which given the 11% increase in inventory, implied that the excess would have to be heavily promoted. As a result, gross margins were guided to be 31.5% or down 3.8% from last year's levels of 35.5%. The net affect was a reduction in full-year guidance of $0.84-0.92 to $0.70-0.78 causing the street to lower expectations for Q4 from $0.15 to ($0.02). Topping this all off, management also indicted a potential for the mid-teen rise in inventory to continue through year-end, which would put margins in Q1 at risk as well. Shares fell 23% on the day.

Also, we've guided to flat to down, low single digits in sales and based on our momentum coming out of the first half of the year, we bought inventory for a comp that would have been up low single digits. As you look at what's happening in third quarter and coming into fourth quarter, we have a little bit of an overhang on inventory that we'll be promoting and moving through the stores and moving to our surplus outlets at the appropriate time... I look at the inventory increase for the quarter of $19MM and basically two-thirds of it is related to receipt flow from holiday and one-third is really from the sales miss in the third quarter in terms of our initial expectations around sales. Roughly $6MM of inventory was being carried over into 4Q from 3Q that we hadn't originally anticipated...And obviously we want to end the year in a good inventory position. So we'll take the appropriate markdowns to get our inventory in line at the end of the year. - CFO/CEO Michael Scarpa, Q3 Earnings (12/07/10)

There are multiple explanations for what went wrong. Trudy said that they biggest problem was weak sales in August which caused some excess inventory that continued to roll through the other months. Sales picked up but not enough to catch up. They also noted that pants performed poorly, delivery timing was suboptimal, stores ran out of light-weight sweaters, weather was too hot and then too cold, jackets did not offer enough variety, not enough fashion products in the mix, etc. External research suggest that the company had good styles but poor fitting and bad allocation of sizes, resulting in pockets of product that did not sell though. Bottom line is that they ordered about $20-30MM more inventory that they needed and will now be stuck working through it until the end of Q1. The only silver lining was that business improved sequentially as August was the worst month, followed by September, then October, and then November.

VERY LOW VALUATION

About six months ago, sell-side analysts were raising price targets into the low $20s. After sales lost momentum, they are now suggesting that investors wait on the sidelines until inventory levels normalize after Q1 2011. With absolutely no reason to be owned through year-end, shares of TLB now trade at a reasonable discount to most of its peers and record-low EPS and EBITDA multiples. The single most bearish sell-side analyst can barely justify their $8 downside target.

* Not expected to generate earnings in 2011

TLB also has some overlooked assets that should be taken into consideration in its valuation. First, the company had an NOL of $130MM at the start of this year which is likely only down to about $120MM now. The company expects to reverse a substantial valuation allowance in 2012 as it becomes more likely that these tax assets will be utilized. Second, and perhaps more importantly, TLB still operates its own private label credit card. As of last quarter, they have $171MM in receivables owed by customers which generates more than $30MM a year in income net of charge offs. The company's valuation should be given some benefit for this asset or they should sell it off.

RISKS

Brand Dies. Brand transitions can take multiple years, jeopardize sales and margins, as well as alienate core customers in the process. TLB's new product was well received in the press and customer tests but the younger look may be turning off older customer before new younger customers even know that a transition has occurred. However, with good FCF and reasonably healthy margins, it is unlikely this 63-year-old brand is dying tomorrow.

IT Issues. TLB is consolidating multiple data warehouses into a single Oracle system. There could be issues as both Merchandise and Assortment planning systems are scheduled to convert in 1H 2011.