Description

Summary: At approximately $2.75, URGI is a significantly undervalued security with the potential to reach a high-teens share price as the current turnaround generates results (already happening). The equity is an extraordinarily inexpensive long-dated option (that is already cash flow neutral to positive) on management’s ability to deliver on its stated goals (as they have done before), with a number of factors working together to provide investors with some level of downside protection (net cash, valuable assets, covenants).

There are multiple ways to win here: (see analysis that follows for thorough detail)

•1: URGI returns profitability to recent peak levels and generates $1.40 EPS – a value of $14 using a very conservative 10x multiple (30% below the bottom of its peer range).

•2: URGI’s Board decides it is finally time to sell (which we have reason to believe is a likely scenario). Even valuing the business off of its recent average (not peak) historical profitability and accounting for modest synergies (2% of Net Sales), yields EPS of ~$1/share, implying a $10 share price. A 25% control premium boosts this figure to $12.50.

•3: URGI chooses to monetize its DC through either a sale or a sale leaseback transaction, generating after-tax proceeds of at least $0.80/share (perhaps much more). In addition to the $0.80/share of net cash currently on the books, at the current share price of $2.75, an investor is only paying net $1.15 per share for a company that generated $1.30 EPS in its recent history – just 0.9x peak EPS.

A combination of the above could lead to a share price as high as $19 before even accounting for NOLs – nearly 7x the current price:

Illustrative Valuation
Assumption Statistic Comments
Net Sales $396.3 2003A Level
Peak Gross Margin 27.1% 107.6 1998A Level
Less: Trough SG&A 20.3% (80.4) 1999A Level
PF Operating Income $27.2
Less: Taxes 35.0% (9.5) Fully Taxed
PF Net Income $17.7
Plus: AT Synergies 5.2 2% of Net Sales
Adj. PF Net Income $22.8 5.8% Margin
Shares Outstanding 12.7
Adj. PF EPS $1.80
Conservative P/E Multiple 10.0x 30% below peer range
Implied Share Price $18.02
Plus: AT DC Proceeds 0.80 $38/sq.ft.; 50% basis
Adj. Implied Share Price $18.83


Company Description

•History: URGI was formed in 1987 through an internal reorganization in which Limited Brands (LTD) combined its Avenue store group (formerly Lerner Woman) with its Sizes Unlimited division. Soon thereafter, as part of LTD’s ongoing effort to shed non-core concepts, URGI was sold in a management led buyout (1/3rd mgmt., 1/3rd LTD and 1/3rd Lazard) and subsequently went public in 1992.

•Concept: URGI operates 530 retail stores (all leased and located primarily in strip shopping centers, as opposed to more expensive mall locations) across 37 US states under the Avenue brand name, selling fashionable large size women’s apparel, accessories and lingerie (solely under their proprietary Avenue brand name) as well as footwear (solely under their proprietary Cloudwalkers brand name). URGI also operates an e-commerce website for at home shopping – currently only 1% of sales, but finally cash flow positive (vs. a peak of 3% of sales in 2001 – prior to the discontinuation of catalog mailings – but historically consistently cash flow negative).

•Target Market: URGI targets fashion-conscious women between 25 and 55 years old who wear sizes 14-30+.

Investment Thesis

•Why have the shares fallen? URGI’s share price has plummeted from ~$10.50 in the summer of 2002 to less than $3.00 today.

-Fashion misses: Management attributes their recent subpar operating performance primarily to product mistakes that began appearing in the 2002 Fall line. The President of Avenue Retail at that time embarked on a strategy of producing a larger quantity of basics (as opposed to higher fashion items) and in a more limited assortment of styles and colors than had previously been available. The customer reacted very negatively and comps went into a tailspin – same store sales growth (which had averaged about +1.4% over the prior 12 months) trailed into sustained negative territory beginning in September 2002 and monthly comps have averaged -5.2% in the 24 months since the decline first began. That individual (who had come from LTD) has since been fired and the CEO has stepped back in to take over her role and lead the company in a turnaround focused on repairing the damage done to the product line.

-Competition: A second influence (although significantly less impactful, according to management) has been the increase in competition across all channels of the large size apparel market as concepts as varied as Walmart (WMT) and Old Navy (GPS) expand their offerings into larger sizes. There have traditionally been a multitude of choices for large size girls in the junior category, but as these women aged, their only real alternatives were dedicated plus size retailers such as URGI. And for women who were once thinner, but have since moved into the 14+ category over time (“swing sizes”), there is a substantial psychological barrier in moving from mainstream retail into the dedicated plus size stores. However, now as Kohl’s (KSS), JC Penney (JCP), Sears (S), Target (TGT) and others have begun offering them an alternative in their familiar mainstream shopping environment, these swing sizes are no longer forced to migrate to concepts such as URGI – a move that they may see as “admitting defeat”. This has likely impacted URGI growth.

•The turnaround: In just the last few months, management’s new merchandising strategy (launched towards the very end of 2003) has begun to bear fruit and URGI’s situation is getting progressively better:

-New management strategy: An added benefit of the new strategy is that it requires primarily intellectual capital and very little financial capital:
1. Improve merchandise design to increase product differentiation – this includes a greater focus on lingerie.
2. Market more items together as coordinated outfits to meet a defined customer need and to increase the dollar value of each sale – accessories are an important (high margin) part of this strategy.
3. Put more emphasis on fashion, rather than basics – this increases differentiation, improves the shopping experience, increases customer loyalty and mitigates price deflation/commoditization.
4. Improve merchandise presentation to enhance customer experience and encourage outfit buying.

-Recent results: Although still generally negative, comp store sales have recently begun to improve and are down an average of only 1.8% in the last 4 months (May – August). July’s comp of +1% came on top of July 2003’s impressive figure of +4% (one of only 2 positive months in 2003). Finally, the most recent August 2004 comp of -2% is an unfair comparison with last year as the August 2003 figure included Labor Day sales, which will be reported in the September figure this year.

-History: This is not the first time that this same management team has led a turnaround of the business as a result of a fashion miss. In 1996-1997, URGI’s sales declined 2% as product design failed to satisfy consumer tastes, putting pressure on the gross margin, which fell as low as 20.3% in 1996 (vs. recent 2003 low of 20.8% and 10 year historical average of ~23%). By 1998, management had reversed the sales decline and had revived the gross margin to a healthy 27%.

•Prudent financial discipline:

-Positive FCF: From 2000-2002 (when URGI was opening an average of 47 new stores each year), the company was generating negative free cash flow of roughly $10M per year. However, even in the face of 2003 comp store sales of -7.0%, URGI was able to generate positive FCF of $2.5M through a diligent focus on a reduction of working capital as the company closes unprofitable stores (50 over the past 2 years, with another 20 scheduled for 2004) and restrained capital spending as only 5 new stores were opened in 2003, with just 2 more planned for 2004. This focus on FCF rather than undisciplined growth strengthens URGI’s value as a long-dated option as it reduces the likelihood that the company will face liquidity issues anytime soon.

-Strong balance sheet: Cash of $18M offsetting total debt (including capital leases) of only $8M, for a net cash position of $10M (nearly $0.80 / share), offering further downside protection. Additionally, half of the total debt is mortgage style financing related to URGI’s Ohio-based distribution complex. Mgmt. also notes approximately $18M of current liquidity.

-External discipline: Covenants in the working capital financing agreements with CIT prevent URGI from spending more than $5M on capital expenditures, further ensuring fiscal prudence.

•Relatively stable business:
-Attractive demographics: Target market of US women aged 25-55 that wear size 14 or larger has increased substantially in recent years and this trend shows no signs of slowing. Some estimates show that as many as 50-60% of US women now wear size 12 or larger.

-Low fashion risk: Significantly less than other specialty retailers, such as Wet Seal (WTSLA) and Urban Outfitters (URBN).

-High customer loyalty: Existing customers are very emotionally attached to stores as they embrace an environment which allows them to shop free from embarrassment or fear that other retailers will not carry desired items in their sizes – other retailers selections of large size clothing tend to be much more limited.

•Attractive real estate footprint: 85% of stores are in strip shopping centers, where rent is typically ~50% of that in nearby malls, where concepts are often said to have to generate $250-$300 / sq. ft. to operate profitably (vs. URGI’s LTM sales / sq. ft. of only $165). The fleet of 530 stores is also well balanced geographically, covering 37 states on both coasts.

•Substantial insider ownership: CEO Raphael Benaroya is URGI’s largest shareholder with ~2.5M shares (nearly 20% are options) or 18.5% of the company. CFO George Remeta owns another 4.3% (40% of this amount represents options). Both have been with the company since before it was separated from LTD in 1987. The weighted average exercise price of URGI’s stock options is approximately $7, further aligning management’s incentives with those of shareholders.

•Under-followed: No analyst coverage – very little coverage at all since the late 1990’s rise in US market capitalizations put it below the radar of most research firms and no coverage whatsoever since Regulation FD was instituted. Any change in this status should increase investors’ awareness of URGI’s recently improving fortunes.

•Recent new shareholders: Until recently, management owned 20%+ and LTD owned 12%+. Most people (investors as well as strategic acquirors) assumed that the CEO effectively "controlled" the passive LTD block, making the inside piece nearly one-third of the company. According to the CFO, on August 27, 2004, LTD’s 1.6M shares were purchased by 3 funds (one of which filed a 13G indicating current ownership of 9.5%). Presumably these funds care more about maximizing value than LTD did. Moreover, if LTD's ownership was an impediment to potential strategic acquirors, that obstacle is now gone.

•Significantly undervalued:

-Historical averages and peer multiples: Substantial upside potential from current discounts to URGI’s historical and normalized margins or to valuations of peers:
-Currently trading at just 0.06x Enterprise Value / 2003A Net Sales vs. its 12-year historical average of ~0.24x LTM Sales, its historical peak of 0.92x and its 5-year average of 0.17x (all based on quarterly data). For additional reference, URGI’s peers (CHRS, DBRN, CTR and others) are currently trading at an average of about 0.62x LTM Sales.
-Currently trading at only 2.0x previous peak EPS of $1.31 (1998) and 4.2x 5-year average of $0.64, prior to the difficulties of 2002-2003. URGI’s peers are currently trading at about 13-18x forward earnings.

-Turnaround valuation potential:
-What could URGI look like? If the gross margin returns to its 5-year average (prior to the difficulties of the 2 most recent years) of 24.6% (applied to the recent 2003A depressed sales base) and SG&A returns to the historical average over the same period of 21.8% on the same conservative sales base, URGI would earn approximately $0.58 per share on a fully-taxed basis (a 1.9% net income margin before the consideration of any benefits of the NOLs). A very conservative earnings multiple of only 10x (30% below the bottom of its peer range) would imply a share price of ~$5.80, or approximately 110% upside from current levels.
-Additional upside? Furthermore, if the gross margin returns to its recent historical peak (1998) of 27.1% (applied to the 2003A sales base) and SG&A returns to the recent historical trough (1999) of 20.3% on the same conservative sales base, URGI would earn approximately $1.39 per share on a fully-taxed basis (a 4.5% net income margin before the consideration of any benefits of the NOLs). A very conservative earnings multiple of only 10x would imply a share price of approximately $14, or approximately 400% upside from current levels.
-Potential acquisition candidate: An additional circumstance which might trigger such a valuation arises from the fact that URGI is an attractive acquisition candidate for a strategic buyer (further described in the Catalysts section below):
-Duplicative overhead elimination: An analysis of recent specialty retail transactions yields a synergy range (expressed as a percent of the target’s LTM Net Sales) of 1.6%-9.0%, with an average of approximately 4.0%. If URGI were acquired or actively sought by a strategic player that could reduce or eliminate duplicative overhead (using a very conservative 2% of Net Sales or ~$8M in additional savings in this case) beyond the regression to historical average (not peak) margins described above, the pro forma (or store level) net income margin could be approximately 3.2%. A very conservative 10x multiple on the resulting $0.99 EPS would imply a share price of nearly $10 – a move of 260% from current levels.
-Is this achievable? The only question that remains is whether URGI’s historic peak margins are still achievable. Management believes that they are and again points to the company’s prior turnaround in 1996-1997. Additionally, management sites sales productivity as the most important factor in securing such a return to prior profit levels. For instance, sales were approximately $190/sq. ft. in 1999 and only approximately $170/sq. ft. in 2003. Restoring this productivity decline is paramount to the company’s current strategy and management believes that it is quite possible.

•Net Operating Losses: Given URGI’s recent operating performance, the company has accrued approximately $19M of deferred tax assets that may have value to shareholders as soon as the company generates positive net income and resumes paying taxes.

Risks

•Unproven strategic shift: New higher fashion merchandise strategy could alienate core customer base, increase inventory obsolescence risk and manufacturing lead times and still fail to generate new sales.

•Increasing competition: Increasing entry of mass merchandisers (KMRT, WMT, TGT) as well as brands such as Old Navy (GPS) into market may further erode existing customer base while preventing “swing sizes” from coming to the concept.

•Negative operating leverage: Continuing negative comps could put pressure on cost structure as fixed expenses are leveraged over a shrinking revenue base.

•Deflationary environment: The CPI for women’s and girl’s apparel reveals that URGI’s industry has been in a sustained deflationary environment and there is no reason to believe that this trend will not continue – the CPI declined 5.0% in 2001, 1.9% in 2002 and 1.8% in 2003. However, this trend is mitigated by a focus on fashion (as opposed to basics) and an increasing mix of accessories and lingerie. URGI’s proprietary brands and strong customer loyalty also help to counter this trend.

•Insufficient inventory: Although inventory levels have increased somewhat recently, after falling by 21% in 2003, they may still be too low to take advantage of any unanticipated pick-up in demand. Management does not believe this to be an issue.

•Insufficient capital investment: Current capex levels may be insufficient to properly maintain the store base. Management does not believe this to be an issue.

•Insider selling: Jon Grossman (VP, Finance) has recently (since Sept. 1, 2004) sold ~18K shares or more than 50% of his holdings – only represents about $50K.

•Illiquidity: Small, illiquid market capitalization of only $34M, with only about 45K shares (or roughly $125K) traded per day (excluding the recent LTD block trade).

Potential Catalysts

•Product strategy & current turnaround: Same store sales trends should continue to improve – Fall 2004 line will be key to determining how well product strategy is working. However, given the strong balance sheet and positive cash flow trends, URGI should have more than one or two seasons to get things right (downside protection).

-Although Q2 2004 comps were down 2%, management indicated that it saw substantial improvement in a number of product categories which was masked and offset by a significant decline in bottoms (skirts and pants) due to URGI’s limited offering. This is a much more positive sign than if products had declined across the board and indicates that aspects of management’s strategy may soon show additional outward signs of progress.

-September 2004 sales will include Labor Day (last year did not), increasing the likelihood of positive comps for the month.

•Potential acquisition candidate (and/or monetization of DC):

-Attractive asset: URGI operates in an attractive segment (very strong demographics) with a very strong brand name, a fiercely loyal customer base and a 530 store base across 37 states.

-Impatient board members: It is our belief that certain board members are becoming increasingly frustrated with management’s slow progress.

-CEO is highly incentivized to maximize value: As the largest shareholder, we believe the CEO may be inclined to put the company up for sale if he is unable to achieve success with the current Fall line.

-Significant potential cost savings:
-Corporate overhead: As with any retail business, store level economics are more profitable when considered before any duplicative overhead (expenses relating to distribution, administration, legal, etc.) that would likely be eliminated by any strategic buyer.
-Distribution complex: Located in Troy, OH, the 325,000 sq. ft. DC has significant excess capacity (in a key geographic location) which could be used by another company or sold. The current DC is equipped to service 900 stores (the company only has 530 currently – a utilization rate of only 60%) and the 128-acre site is adequate for a total of 4 similar facilities, creating a current theoretical utilization rate of only 12%. As a point of reference, distressed Footstar (FTSTQ) recently sold its CA and SC distribution facilities for a total of $43M or an average of approximately $38 / sq. ft. This benchmark would imply a value of ~$12M for URGI’s DC or an additional $0.97 / share (before any tax effects). It is unclear if the FTSTQ valuation is perfectly comparable, however it does seem conservative given FTSTQ’s distressed nature (currently in Chapter 11), the excellent strategic location of URGI’s DC and the significant excess land available at the Ohio site (far more than FTSTQ’s DCs).

•Analyst coverage

Disclosure
We own URGI shares at current market levels.

Catalyst

•Product strategy & current turnaround
•Potential acquisition candidate (and/or monetization of DC)
•Analyst coverage