Bebe Stores: Unloved, Undervalued, And Set To Rally

| About: bebe stores, (BEBE)
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The past year has been one of steady gains for the retail sector, which is up nearly 20% in the past 12 months, driven by a rebound in consumer spending as well as improving financial conditions. However, bebe stores (NASDAQ:BEBE) has not been a part of this rally. Over the past year, shares of the women's retailer have lost over half their value, as the company began to post losses on the back of a weakening product line and unfocused execution. But with shares trading at $4.16 as of this writing, bebe's stock does not reflect the company's potential to turn things around. In our view, a new management team, a strong, cash-rich balance sheet, and a return to profitability are likely to lead to a rally in shares of bebe, and we break down our thesis below.

Overview: What Went Wrong

Manny Mashouf founded bebe in 1976, and the company's first store was located in San Francisco. The retailer went public in July 1998, and in a thriving economy, bebe's stock price marched higher, reaching a peak of almost $29 in July 2005. As late as October 2006, shares of bebe were trading at almost $26 per share. But, with the recession and global financial crisis, shares of bebe were battered alongside the rest of the retail sector. However, unlike its peers, bebe never recovered.

The recession bifurcated the retail sector into 2 distinct groups: those that can execute, and those that cannot. Bebe found itself squarely in the latter group: its performance over the past 5 fiscal years (the retailer's fiscal year ends June 30) has been sporadic at best, While the retail sector as a whole has recovered from its 2009 lows, the gains have been driven by retailers with consistent execution. In an environment that many investors and analysts see as uncertain, retailers that are unable to execute have seen their share prices punished.

Bebe Historical Results (in Thousands of $)

2012

2011

2010

2009

2008

Revenue

$530,831

$493,274

$479,911

$551,592

$628,737

Gross Profit

$211,073

$191,810

$193,897

$225,710

$279,864

Gross Margin

39.76%

38.89%

40.40%

40.92%

44.51%

Operating Income

$19,407

$5,889

$10,680

$19,485

$81,606

Operating Margin

3.66%

1.19%

2.23%

3.53%

12.98%

EPS from Continuing Operations

$0.14

$0.05

$0.09

$0.21

$0.71

EPS

$0.14

-$0.02

-$0.06

$0.14

$0.69

As the chart above shows, bebe's performance over the past 5 fiscal years has been erratic. Operating margins have recovered in fiscal 2012, but are still nowhere near fiscal 2008 levels. Gross margins have failed to recover, and while bebe's underlying (continuing) operations have remained consistently profitable, continuous restructuring and turmoil have taken a toll on the company's GAAP EPS. Over the past several years, bebe has lost sight of its core demographic, and has failed to keep pace with changing fashion trends, as well as a shift to e-commerce. The retailer's online and physical channels were not integrated (something that Nordstrom (NYSE:JWN) has shown can lead to sustained sales growth), and the effects of these operational missteps can be seen in the company's fiscal 2013 estimates: the retailer is forecast to post a loss of 5 cents per share on revenues of $495 million, a 6.75% decline from fiscal 2012 levels.

Bebe's most recent quarterly results and its sales reports for the current quarter highlight the company's need to restructure. In Q1 2013 (fiscal), bebe posted revenues of $117.091 million, a 7.27% drop from Q1 2012. Gross and operating margins slipped as well, falling to 36.1% and -3.3% respectively, down from 40% and 2.7% a year ago. Bebe posted a loss of 3 cents per share, versus a profit of 3 cents per share in Q1 2012. And earlier this month, bebe announced that Q2 sales came in at $124.6 million, an 11.7% decline from the $141.1 million in Q2 2012 sales. The company stated that 2% of the decline could be attributed to the effects of Hurricane Sandy, as well as the shifting of New Year's Eve into the company's fiscal third quarter, whereas it was in the fiscal second quarter in the prior year period. As a result, the company stated that its earnings for Q2 2013 would be "at or below the lower end of our previously provided guidance of $0.01 per share." How can we recommend shares of a retailer that is posting sales declines and is slipping into unprofitability? The answer lies in 2 key factors: bebe's ongoing restructuring efforts, as well as its solid balance sheet.

Turning bebe Around: New Management, and New Strategies

With shares of bebe down over 50% in the past year, there is clear skepticism in the markets that the company will be able to salvage its business. However, consensus estimates for fiscal 2014, as well as ongoing changes at bebe belie the notion that the retailer will continue to post losses. Bebe is forecast to post a profit of 8 cents per share in fiscal 2014 on revenues of $526.9 million, near the company's fiscal 2012 levels. And bebe is not standing still. Earlier this month, the bebe's board of directors announced that it hired Steve Birkhold as bebe's new CEO, replacing founder Manny Mashouf, who will stay on as non-executive chairman. Steve Birkhold comes to bebe from Lacoste, where he served as President and CEO of its North American division. Prior to his position at Lacoste, Birkhold served as head of Diesel's North American division, and has also served in various executive roles at VF Corporation (NYSE:VFC). Bebe is also revamping its digital and e-commerce operations, and in November 2012, the company appointed Ben Braum as its first Chief Digital Officer, who will be reporting directly to the company's CEO. Prior to his appointment at bebe, Braum served as head of business development for Google's (NASDAQ:GOOG) shopping division, as well as Senior Group Manager of Merchandising for Target (NYSE:TGT). Braum brings much needed experience to bebe as the company begins to rectify many years of neglect at its digital and e-commerce divisions. Bebe has brought back its e-commerce business in-house (previously, e-commerce was handled by third parties), and is in the process of rolling out in-store pickup, as well as international shipping. Bebe is also expanding its international sales efforts. The company sells its products through licensees, and as of the end of Q1 2013, bebe sells merchandise in 21 different countries through 121 different points of sale, up from 77 in Q1 2012. On the company's Q1 conference call, bebe's management team was frank in its assessments of what ails the company, and pledged to invest across all aspects of the company, including marketing, inventory control, localization initiatives, as well as its core product portfolio. In our view, bebe's management team has planted the seeds of a turnaround. Chairman Manny Mashouf has recognized that the company needs new leadership, and has ceded the CEO post to Steve Birkhold. And the company hired as its Chief Digital Officer an executive from what is perhaps the world's best incubator of digital business experience, Google. Critics will scoff at these efforts, arguing that even if bebe were able to meet fiscal 2014 estimates of 8 cents per share in profit, the results would be a shadow of the company's historical performance. And while it is true that in the years to come, bebe is likely to see structurally lower levels of profitability, the company does not need to return to historical levels of profitability for the stock to do well. Over the past 5 years, shares of bebe have fallen almost 64%. At the beginning of 2008, shares of bebe neared $13; for new investors in the company to see decent returns, shares need not reclaim those levels. And with Manny Mashouf owning over half of the company, there is a clear incentive for bebe's management team to engineer a turnaround as quickly as possible. And we believe that bebe's management team has what amounts to an ace up its sleeve: a clean balance sheet filled with cash.

Cash Reserves & Insider Ownership

If one were to simply look at bebe's stock price, it would be easy to assume that the retailer is running dangerously low on cash. After all, it is logical to assume that companies in dire financial straits have all but exhausted their cash reserves. Bebe, however, is not one of those companies.

The company ended its latest quarter with $222.403 million in cash & investments, and just $500,000 in trade letters of credit as debt. Bebe has a clean balance sheet, and based on its 84,397,250 outstanding shares, bebe holds $2.62 per share in cash. Based on bebe's share price of $4.16, as of this writing, 62.98% of the company's market capitalization is in cash. Few retailers have such high levels of net cash relative to their market capitalizations, and we believe that bebe's cash provides a floor to the company's share price. And while bebe is using cash in its operations, the company has ample cash reserves to invest in its business until it once again reaches sustainable profitability In Q1 2013, bebe used $10.716 million in operating cash, and this was driven by working capital changes. Bebe saw an $8.087 million drag from prepaid expenses and accrued liabilities, a $2.313 million benefit from accounts payable, and an $8.112 million drag from inventory, which is due to bebe's investments in repositioning its stores to carry a broader and more relevant assortment of merchandise, as well as its strategy to localize its product offerings. We detail the company's performance below.

Bebe Historical Operating & Free Cash Flow (in Thousands of $)

Q1 2013

Q4 2012

Q3 2012

Q2 2012

Q1 2012

Operating Cash Flow

-$10,716

$10,050

-$9,954

$28,453

$4,151

Purchase of Property & Equipment

-$8,945

-$27,422*

-$6,521

-$6,644

-$4,313

Free Cash Flow

-$19,661

-$17,372

-$16,475

$21,809

-$162

*Includes cost of purchasing the company's distribution center for $18.8 million

Bebe is set to see an influx of cash in the current quarter, as Q2 is a seasonally strong quarter in terms of operating cash flow, giving the company more funds to invest in its business. It should be noted that bebe pays a quarterly dividend of 2.5 cents per share (for a yield of 2.4% at current levels), which costs the company just over $2.1 million per quarter. Should bebe run into financial constraints, this dividend can be suspended, and a yield of 2.4%, while respectable, is unlikely to be a primary reason for bebe's non-insider investors to hold the stock.

We should note that bebe's management team has a great deal of incentive to turn the company's operations around. Founder and Chairman Manny Mashouf holds over half the company, and other officers own thousands of shares as well. We break down bebe's insider ownership below (note: only stakes involving bebe stock are listed; options and restricted stock units are excluded).

Bebe Insider Ownership

Name

Position

Shares Held

Corrado Federico

Director

21,070

Caden Wang

Director

19,661

Cynthia Cohen

Director

19,661

Barbara Bass

Director

19,661

Liyuan Woo

Controller & Principal Accounting Officer

4,188

Emilia Fabricant

President

58,276

Manny Mashouf

Founder & Chairman

47,172,857

Founder & chairman Manny Mashouf owns 55.89% of bebe, and other officers and directors hold tens of thousands of shares (officers and directors not listed above hold a mix of restricted stock units and stock options). This gives Mashouf every incentive to turn bebe around; and we believe that his stake in the company will act as a catalyst for a turnaround, for Mashouf has lost millions alongside bebe's existing investors as the stock has fallen over the past year. Interestingly, bebe has a buyback program in place; in November, the company launched a $30 million buyback (equivalent to around 8.5% of the company's market capitalization at current prices). Should bebe indeed turn around its operations, the company will likely accelerate and increase the scope of its buybacks, as the company's ample cash reserves, and expected increases in operating cash flow will allow bebe to continue funding its turnaround.

Upcoming Earnings & Options Protection

With bebe set to report Q2 2013 earnings on Thursday, January 31, the company will give investors another chance to evaluate the state of business. The consensus forecast calls for bebe to post a loss of a penny per share on sales of $139.3 million (the latest forecasts likely take into account bebe's holiday performance in the United States). Although we believe that bebe is a longer-term restructuring play, and as such think this quarter should be viewed in that context, the market may not see it that way should bebe miss estimates. Therefore, risk-averse investors who wish to buy into bebe ahead of its earnings report should consider utilizing options for downside protection. Specifically, the February 16 $4 put should be considered, which is currently trading at $0.15 per contract. With shares of bebe trading at $4.16 as of this writing, losses are capped at 7.75%. And should bebe beat estimates, the stock does have the potential to rally, given that the market's sentiment regarding bebe is quite negative. Alternatively, investors can consider purchasing longer-term puts (bebe's listed options currently stretch out to September). The September 21, 2013 $5 put can be bought for $1.15 per contract, therefore setting a net cost per share of $6.33 as of this writing, which represents a maximum loss of 6.2% by expiration. In our view, that is an acceptable level given the potential upside, and the September puts give investors a chance to hold bebe through 3 earnings reports (including Q2 2013).

Conclusions

Over the past several years, bebe has seen a deterioration in its business. And while the stock has, unsurprisingly fallen as a result, at under $4.50, shares of bebe do not reflect the company's potential to turn itself around. Bebe has hired a new CEO, with experience in both luxury and mass-market retail, as well as a new Chief Digital Officer. Founder Manny Mashouf has ceded his post as CEO, and with a stake of over 55%, he has every incentive to oversee bebe's restructuring and boost its stock price. And with a clean balance sheet and ample cash reserves, bebe has the resources it needs to continue to invest in its turnaround. We believe that in the long run, bebe will be able to turn itself around, and for risk-tolerant investors, there are solid profits to be realized. While the turnaround of bebe is unlikely to be complete this fiscal year, bebe is set to return to profitability in fiscal 2014, which will place the company on an even firmer financial footing from which to continue its restructuring. For new investors in bebe, shares need not return to historical highs from 2008 or years prior for investors to see profits.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BEBE over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We are long shares of JWN & GOOG