Wet Seal is a classic deep value investment at these levels.  The stock is trading at 3.5x 2011E EBITDA, 3.2x 2012E EBITDA estimates, and has $1.44 in net cash per share (43% of the current stock price).  The company is free cash flow positive and should generate $20-25 mm in cash flow (versus a market cap of $304 mm and an EV of $173 mm).  After going up almost 40% from January to its July 19^th 2011 high of $5.10 on the back of results that were indicative of an early stage turnaround, Wet Seal saw some comp deceleration in September followed by a disastrous October selling month.  The stock was down 21% on October comp day (11/3) and hit a 52-week low of $3.08 on 11/17, heading into the reporting of Q3 earnings that night.  As expected, the company lowered Q4 guidance that night, but rallied 6% the next day anyway, probably because of a few comments that business had stabilized somewhat in November to date.  Given the extremely low valuation of the stock, the almost 40% fall from its July peak, and the rock solid balance sheet, it seems like downside from here is limited.  While the timing of an upside catalyst is uncertain, any sign of turnaround progress (e.g., a return to positive comps) should get the stock above $4, and it wasn’t an expensive stock when it was $5.  The timing of a turn is highly unpredictable because of the fashion leverage in the business, but I think there is probably only about 10-15% downside (using a 2.5x EBITDA multiple on what I think is a reasonable but not Armageddon EBITDA miss for 2012).  The new CEO was very successful in her prior position at AEO, and people were very enthusiastic about this turnaround story until the recent fashion miss.  Because they turn inventory so fast (about 12x/year), fashion misses come swiftly but turnarounds come equally swiftly.  Even if you were in their stores every day, it would be tough to catch the turn.  These quick inflections in the comp lead to pronounced dislocations in the stock, which can make trading it very profitable in a relatively short period of time. 

Background and Business Description:

Wet Seal consists of two fast fashion, mall-based specialty retail concepts.  There are 464 Wet Seal stores which offer low-priced, fashion-oriented clothing targeted at girls 12-20.  The Wet Seal assortment is broad, spanning tops, bottoms, denim, footwear, accessories, dresses, etc.  Some of it is very casual, others items dressier or club-oriented.  There are 86 Arden B stores which offer similarly fashion-trend dependent merchandise at slightly higher prices (but still low in the absolute sense), to a slightly older customer, who is typically 25-35.  They also sell tops, bottoms, denim, dresses, and accessories that range from casual wear to wear-to-work to club wear.  Both brands are mall-based, although Wet Seal is currently testing off-mall (strip center) locations.  While they are not urban brands in any way, I think both brands have substantial Hispanic and African-American shopping contingents.  Wet Seal turns their merchandise every few weeks and is always chasing trend, thus sources domestically from multiple vendors.  Arden B has slightly longer lead times and turns, but they are still very short relative to the rest of retail.  Arden B also primarily sources domestically.  Wet Seal competes head on with Charlotte Russe (formerly CHIC, but taken private a few years ago) and Forever 21 (private, and a big growth retailer).  It also indirectly competes with higher-priced fast fashion retailers H&M and Zara, and even more indirectly with every moderately priced store in the mall catering to teenagers (Aeropostale, American Eagle, JC Penney, Kohl’s, Target, etc.).  Arden B used to compete head-on with Bebe, but after taking their pricing down in 2008, there really is no direct specialty competitor.  They probably compete with a wide range of stores, including Bebe and Guess above them, as well as more moderately priced specialty and department stores (New York & Company, JC Penney, Kohl’s, Target, etc.).  About 90% of operating income before corporate overhead currently comes from the Wet Seal division.

The company was extremely successful in the 90s which led to overexpansion, too much leverage, and eventually a near death experience in 2004, when they narrowly avoided bankruptcy by raising capital at very depressed prices, including the sale of a convert to SAC, which has since been converted and retired.  During this near death experience, the company was forced to close many of their better performing stores because those were the leases they could get out of.  They ended up closing around 100 doors, most or all of which were performing above the company’s average productivity.  With the balance sheet beyond fixed and the operations relatively stable (although often volatile), the company has returned to measured store growth, with a focus on opening Wet Seal stores in A-mall locations they were forced to abandon during their financial distress.  The fact they are returning to malls they were once in somewhat mitigates the risk of opening stores that turn out to be not good investments.

The company had its first attempt at a turnaround in late 2007 and 2008.  For many years, the company had refused to break out the segment results for Wet Seal and Arden B.  New management at the time, who was highly incentivized to get the stock up because of stock option grants, finally released the segment results, and it was revealed that Arden B was losing money and that Wet Seal stores were an OK business with mid to high single digit margins.  With this clarity, the stock ran from $2.33 on 12/31/07 to a high of $5.50 on 7/17/08 (interestingly, it peaked at the same point in the year that it did this time, in 2011). The stock of course got killed with everything else in the fall of 08, but still managed to end the year at $2.97, up 27% in a market that was down 39%.  This little bit of history is interesting because it shows how the company has a history of moving quickly and violently, and also has precedent for extreme market outperformance.  Basically efficient market theory doesn’t hold up too well for this name, probably because of its small market capitalization.  It is just too small for a lot of larger funds to care, which creates an opportunity.

After good stock performance in 2008, the company hit some operational challenges.  The last CEO, Ed Thomas, was successful in stabilizing sales trends at Arden B in 2009 by dramatically changing the business model, moving it from higher priced, longer lead time merchandise competing head-on with the also troubled Bebe, to more of a fast fashion, lower priced concept.  Arden B went from going for a more affluent customer to going for the lower income woman who had outgrown Wet Seal, but still couldn’t afford to shop at places like ANN, LULU, or URBN.  Arden B returned to profitability in 2009 as sales stabilized, but unfortunately Wet Seal stores did not execute well from a fashion perspective in 2009 (comps were down 8.5% on top of a 4.5% decline in 2008).  When Wet Seal comped flat in 2010 and failed to show any momentum, the board decided to replace the Ed Thomas.  Susan McGalla was announced as the new CEO of Wet Seal in January of 2011.  McGalla had been the Chief Merchant at AEO and left at the end of 2008 when she was passed over for CEO.  McGalla was a highly respected merchant, both by industry and Wall Street, and after she left AEO, the women’s side of that business went off the rails pretty quickly and has never fully recovered.  After two years off the grid, McGalla’s reappearance at WTSLA was greeted with excitement by Wall Street (the stock rallied 12% on the day it was announced she had joined – 1/12/11).  Since joining, McGalla has implemented a number of strategic initiatives which include:

1. Doing market research around who their customer is and what they want in order to better serve them
2. Efficiency/process improvement initiatives and store level training to improve sales productivity
3. A re-positioning of the internet business from being a clearance channel to more of an emphasis on full price selling and brand building
4. Sharpening of price points around fewer key levels
5. Management of merchandise margin through more targeted promotions

It’s still early days to make an assessment of the current or potential impact of these efforts.

Comp trends improved in 2011 for the Wet Seal division, and by August, the company had 8 consecutive months of same store sales increases under its belt.  Then things slowed somewhat in September, when Wet Seal posted a flat comp, citing a slowdown after back-to-school ended.  Then things completely went off a cliff in October, when Wet Seal stores reported comps of -9.9%.  About half the decline can be attributed to not selling low margin Halloween costumes this past October (unlike the prior October).  The rest was attributed to a fashion miss in 70s-inspired looks that proved to be too literal.  It was a crappy month, but the company lost 26% of its stock price and a whopping 40% of its EV over one bad month.  Seems like an overreaction.  Sales results in the months since have been erratic.  November and December showed some stabilization/improvement, but then January was a big disappointment.

One big misstep the company made in 2011 was buying back stock over the summer, when things were going well, just before operations took a dive in the fall.  After years of denying shareholder requests for a buyback, the company went and bought back 13 mm shares over the summer in one fell swoop, spending $57 million at an average price of $4.36.  This is evidence that they were clearly blindsided by the post-BTS slowdown as well as October’s fashion miss.  While the buybacks represent horrible execution, it is water under the bridge at this point, the stock is still cheap, and they have the capacity to do more if the stock doesn’t recover.

Sales comps will remain difficult in 2012 until Q3, at which point they get much easier.  It’s hard to say when things will get better, but at this level, you probably don’t have much to lose by buying it and waiting, especially if you believe the new CEO and the merchants she has recently hired to support her are talented.

Earnings Outlook and Valuation:

It is clear from the chart below that the company is extremely cheap, even in the scenario in which results continue to deteriorate. 

5x consensus EBITDA for 2012 yields a $4.63 stock price, which would be equal to a 13.5 PE ex cash, assuming $20 mm in free cash flow creation in FY12.  This represents 39% upside from current levels, and improving results leading to a beat would support an even higher valuation.

Liquidity and Short interest:

WTSLA trades an average of just under 2 mm shares per day.  Short interest has crept up over the last year, but is well off its highs, and stands at a not-insignificant 13% of the float with 7 days to cover.

Upcoming Events:

• Q4 2012 Earnings Report – late March 2012…will get guidance on sales and earnings, as well as square footage growth for 2012
• The company is planning to do its first investor day since 2007 sometime mid-year, once the results are back from all the market research projects underway

Potential Catalysts:

• A return to positive same store sales at the WTSLA division would get this stock up
• Several months in a row of positive same store sales at WTSLA would probably get this stock up 40-50%
• Decent 2012 earnings guidance/square footage on the Q4 call
• Revelation of more details around the strategic initiatives that are still pretty much under wraps
• Acceleration of store openings/re-entry in A-malls once business has stabilized
• An additional buyback authorization (not holding my breath given how much they screwed this up over the summer)
• All retailers should be experiencing a commodity-cost tailwind by the second half of this year, as cotton prices spiked in 2H 2011 and have since retreated

Potential Risks:

• Given the extremely low valuation and net cash position, the primary risk in the short-term is macro, especially since their lower income customer is under pressure and teen unemployment is so high
• Quality control remains a problem.  There were issues with denim for BTS, and issues with sweaters in October.
• Consistency remains a problem.  It looked like the company was starting to stabilize in Nov/Dec, then Jan sales missed expectations.
• Longer-term, an inability to compete with Forever 21 would be the biggest threat

• A return to positive same store sales at the WTSLA division would get this stock up
• Several months in a row of positive same store sales at WTSLA would probably get this stock up 40-50%
• Decent 2012 earnings guidance/square footage on the Q4 call
• Revelation of more details around the strategic initiatives that are still pretty much under wraps
• Acceleration of store openings/re-entry in A-malls once business has stabilized
• An additional buyback authorization (not holding my breath given how much they screwed this up over the summer)
• All retailers should be experiencing a commodity-cost tailwind by the second half of this year, as cotton prices spiked in 2H 2011 and have since retreated