Bad Year for Chico's, but Worth Holding On to the Stock

2006 is by far the worst year Chico's FAS, Inc. (CHS) has ever had as a public company. Several readers wrote to me after their drastically reduced earnings outlook was announced yesterday afternoon and asked what I thought.

Well, I'm not sure.

The facts are pretty grim for the near future. This company, one of the finest growers and highest margin retailers of the last ten years, is, not unlike the Fed, pausing. And just as with Bernanke, it's very hard to tell whether that pause is the precursor to a resumed climb or a surprising fall.

The company revealed in its earnings release that they enjoyed 18% sales growth and 10% earnings growth in the last quarter. Which is the flip side of what we have grown accustomed to seeing with Chico's, where their excellent margins generally have led to earnings growing faster than sales. That's no great surprise given their tepid same store sales growth in the mid-single-digits over the past several months. So, they essentially hit the current earnings estimates even as they were slightly light on the sales numbers.

What was truly surprising was the outlook. Chico's now looks like it will have its first negative same store sales growth number in many years, as August SSS are now down about 6%, and management indicated that they're going to have to work hard to recover steady sales growth by sacrificing margins and reducing their earnings expectations for the next year. The low end of their earnings estimates for 2007, which after this bad news has sunk in should, I expect, be very conservative, is $1.28 a share.

It's encouraging in a way, because management is clearly aware that there is a problem and is investing in solutions by way of reducing costs (they're shipping more by sea than by air now), acknowledging the failure of recent marketing campaigns, and bringing in more merchandising expertise to help increase sales and store traffic.

I have given Chico's the benefit of the doubt as they had merchandising troubles this Spring, but have we now gotten to the point that these problems go beyond merchandising?

That's the real question -- has Chico's reached a saturation point or have their core customers lost interest in the brand?

I'm still inclined to give them the benefit of the doubt to some degree, and to chalk their same store sales stagnation and poor forecast up to some serious merchandising hiccups in a company that has been growing very quickly for ten years without any serious problems.

But I'm not yet jumping in to buy more. Certainly, the shares got repriced almost instantly today for a much lower growth rate and they look much more appealing today than they were at twice this price a year ago -- but I need to watch this a little more before I decide to add to my Chico's position.

The problems at Chico's are solely with the core brand -- the Chico's stores themselves. Soma is growing well and Fitigues performing well, albeit from extremely tiny starting points, and, more importantly, White House/Black Market (WHBM) is continuing to shoot out the lights, racking up the kind of growth that the core Chico's stores had five years ago (this past month, Chico's same store sales growth was a near-record-low 3%, but WHBM was at 19%).

There are some good signs -- I'm tentatively optimistic about the fact that they hired another industry veteran with a good track record to focus on rebuilding growth at Chico's. They still have an excellent relationship with their consumers, but they've clearly had trouble this year in stocking the right designs at the right time.

Michelle Delahunty, who was hired a few days ago as head merchandiser for the Chico's brand, might help -- she was at Ann Taylor in 2003 and 2004 when that company really began the recovery that they're enjoying today, and I think more talent has every chance of being a benefit for a company that may have outgrown the capabilities of the core management team that has led their growth for more than ten years (assuming it doesn't lead to the kind of internal strife that tore New York & Company's management apart).

But with continued growth, albeit slow growth, I think Chico's has every opportunity to return to its winning ways. The company remains small in the grand scheme of retailing chains, with (and this is an argument I've made before) room for at least a couple hundred more Chico's stores and 500 more White House/Black Market shops before they reach full saturation across the American mallscape, and the fact that they are continuing to see great success with WHBM makes me quite optimistic that this management team will be able to solve whatever problems the Chico's brand may have.

The company is having sales growth trouble, but is not itself a troubled company. Chico's has buckets of cash and no debt, and while one concept may be slowing or maturing somewhat, their other three have yet to hit the first turn on the track. I can be patient with these shares, so while I'm going to wait and see how their initiative to restore growth in the Chico's brand performs before I add to my position, I am confident enough to hold on to the shares I already own. In my opinion, this is still a quality company that has every chance of regaining its lost lustre.

If we assume that they hit that conservative earnings estimate next year, we're dealing with a company that, after the selloff of the last six months, has a PE of about 14 on 2007 numbers, and an earnings growth rate from 2006 to 2007 of about 14%. If you think management will be able to restore growth to the Chico's brand as WHBM continues to shoot out the lights, that's a bargain .Even if you think that the Chico's brand will merely continue to muddle along with mediocre growth, it still seems to me that it's a fair price.

CHS 1-yr chart:

Comments

[J Howard:]

Look at CHS as if it were not growing the store base...

You would have $560m in CASH FLOW, defined as NET INCOME AFTER TAXES + DEPRECIATION. SUBTRACT $80m in MAINTENANCE CAPITAL EXPENDITURE, which I estimate at 100k per store. The result is $460m in FREE CASH FLOW. This is probably conservative since the business is STILL GROWING ORGANICALLY, even if it's not growing as fast as some would like. The number is also conservative because my hypothetical analysis of new new store openings does not add back the new store opening expenses that are not capitalized (i.e. they are directly expensed as incurred).

Since the highest savings rate you can get today is around 6%, I will apply a 7.5% yield to the $460m in FREE CASH FLOW that CHS generates under my scenario. This yields $6.1b. If I add the $250m in cash and securities, I get $6.35b. This number, divided by 180m FULLY DILUTED SHARES yields $35.27 per share, nearly DOUBLE the current stock price.

Basically, the growth guys are PUNISHING the stock for guiding lower and value guys should be jumping in.

My analysis stems from an OWNERS perspective, i.e. if I were to own ALL OF CHICOS and I were to say hey, "lets hold up on opening stores for now", these FREE CASH FLOWS are what I can expect to pull out of the business.

These FREE CASH FLOWS are UNLEVERED, and debt would only ENHANCE the equity value.

Some may dispute this post and say, "but wait...they ARE opening stores, so the FREE CASH FLOW you discuss is not realistic." TRUE. However, one can make the argument that the FREE CASH FLOW YIELD on a new store once it is open for one year, is even greater than the FREE CASH FLOW YIELD on the business as a whole given the operating leverge (i.e. infrastructure and corp overhead costs do not go up meaningfully as new store count increases). The point is you get a great FREE CASH FLOW YIELD on a company that can REINVEST that FREE CASH FLOW YIELD into even HIGHER FREE CASH FLOW YIELDING projects. This is the effect of compounding.

Value investors should be adding, while the growth group looks for the next "hot" concept.

2006 Aug 26 11:25 AM

[brombonz:]

I read your several CHS postings only recently, and I must correct a false statement that introduces this Aug. 26th letter. Throught the third fiscal quarter, 2006 is NOT the worst year CHS has experienced as a public company.

It went public in 1993. In the fiscal year ended Jan. 1, 1995, net income declined from $4.9 million in the prior year to $3.3 million, and continued to decline in the year ended Dec.31,1995 to $1.7 million (also the same result in the pro forma fiscal year ended Jan. 28, 1996 following conversion to the "retail" calendar year from the standard calendar year.

EPS declined on shares then outstanding from $.62 to $.42 to $.22 ($.21 in the pro forma year).

Net sales per store declined from $647 to $613 to $527 ($537 pro forma).

Net sales per selling square foot declined from $496 to $478 to $413 ($405 pro forma),

Same stores sales went from +12.1% to -7.3% to -10.4% (10.1% pro forma).

In the fiscal year ended Jan. 1, 1995 working capital decreased from $4.8 million to $1.5 million (rebounding the next year to $4.5 million or $5.4 million pro forma).

Operating margin dropped from 18.9% to 10.3% to 6.0% (5.9% pro forma).

To my way of thinking these results in what the company would now call Fiscal 1994 and 1995 do not allow 2006 to be characterized as the worst year for CHS in its history as a public company.

I make this comment in hopes that you will amend any future "worst year" statement to fit the facts (that is, by tightening the time frame),

I have no quarrel with any of the substantive statements made about CHS in any of the comments listed here. I've followed the stock since 1998 and owned it since Feb. 2000. I also own a large number of other apparel/footwear retailers and suppliers.

2006 Dec 15 03:25 PM

[Travis Johnson:]

Stephen, sorry I wasn't more precise in my characterization of Chico's year -- it's true, they did have a nice blip up in the year following their IPO, followed by a significant decline that may have outpaced this year's 50% decline (it's hard to tell from the historical charts, since the price has gone up so much that the early years are a flat line that doesn't emphasize the dip from a split-adjusted 60 cents or so to 20+ cents.

In some ways, I think this year is worse than those early years for Chico's, but largely because the company has grown so much larger and expectations are much higher, so that a mathematically smaller decline and "less bad" performance makes for a worse year, but that's all in your perspective -- when it comes to earnings and stock price, it's true that this was Chico's worst year in ten, and their worst year as a mature company, but not quite their worst year ever.

Thanks for catching that.

Cheers,
Travis

2006 Dec 21 01:14 PM

[brombonz:]

Your latest comment seems to imply that the Aug.26 posting of "worst year ever" was based on the [approximately] 50% price drop in 2006. However, your message of that date was entirely about fundamental oerformance, and on that basis fiscal 1994 and 1995 were far worse than is likely for 2006. None of this is material to what happens now, so forgive me if you consider this nitpicking. I just don't like to see a misstatement that can be carried farther and so possibly in itself do damage to the stock price, especially since the postings (including your own) that I've read so far on seekingalpha are both more thoughtful and more lucid than most posted elsewhere.

2006 Dec 22 08:16 PM