You Can't Short Stage Stores Anymore... Right?

| About: Stage Stores, (SSI)
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SSI trades just above $2 after yet another ugly earnings report.

Somewhat incredibly, the stock now offers a 28.3% yield - and SSI can keep that dividend going for some time.

In other words, SSI could be a buy - on its way to zero.

I've been arguing for a short of Stage Stores (NYSE:SSI) loudly and often for a year now - but even I never thought SSI would get to $2 this fast. Yet SSI actually broke through $2 on Thursday, after yet another ugly earnings report with an apparently fraudulent SEC filing from an activist interested in acquiring the company thrown in for good measure.

SSI closed at $2.10 - and I think the stock is headed to zero, an outcome that appears increasingly likely with each passing quarter. But Stage Stores' dividend policy and revolver availability are such that SSI could provide positive returns even if that scenario plays out. I'm hardly ready to turn long, but that pondering alone seems to negate the short case - and create a rather interesting and unique story for the stock.

Will SSI Stock Go To Zero?

At this point, I think the answer almost certainly is yes. Stage Stores highlighted the fact that it drove positive cash flow in FY16 (ending January 2017), and said it would do the same next year based on its guidance.

That's all well and good. But FY16 free cash flow was $10 million. FY17 seems likely to be lower. And trusting Stage Stores guidance at this point is simply impossible. The company guided for EPS of $0.65-$0.90 in Q4; the actual figure was $0.20, on an adjusted basis. Over the two-year collapse in SSI - it's easy to forget this stock traded at $22 in 2015 - Stage Stores has been nowhere in the ballpark with its guidance, with a continuing pattern of missing, pulling down projections, and then missing again.

Assume, however, that Stage Stores finally has its guidance right. The company has $150 million of net debt on a revolver due in 2021. Adjusted EBITDA for FY17 was $56 million, using non-GAAP figures from the Q4 release. That figure probably goes lower next year, given guidance for lower net income.

On a forward basis, then, SSI's leverage ratio likely is around 3x or higher. There is no way a struggling retailer is going to refinance that debt on the back of a few million in cash flow and a 3x+ leverage ratio. Bear in mind, too, that SSI's dividends - $16 million a year - are likely going to outpace free cash flow next year and add to that debt.

Basically, to survive past 2021, Stage Stores needs to stem the bleeding. And I see no evidence of that coming, for multiple reasons.

1. Management is completely lost.

To hear management tell it, the key problems at Stage Stores have been the oil and gas bust and the weakening peso. Roughly one-third of stores are in four key oil & gas states (OK, TX, LA, and NM), and another ~7% of sales comes (or perhaps came - that figure likely came down in FY16) from stores near the Mexican border.

The problem, particularly relative to O&G, is that the current environment isn't abnormal - it was 2011-2014 that were abnormal. In retrospect, it sure looks like U.S. shale exploration was somewhere close to a bubble in the beginning of the decade. If you make that assumption, and similarly assume that SSI's one-third of O&G-heavy markets benefited from that bubble, the post-crisis trend in the business becomes alarmingly clear:

source: author from SSI filings; FY17 figures at midpoint of guidance

Management still is using the O&G bust as an excuse, highlighting that problem in both the Q4 release and on the Q4 conference call. But that's all it is: an excuse. For one, from a long-term standpoint, O&G employment figures are not that bad:

source: Bureau of Labor Statistics

Secondly, SSI has lapped the worst of the bust. But most importantly, the performance at the rest of the chain is awful. On the Q4 FY15 conference call, here's how CEO Michael Glazer framed FY16 guidance:

As we move into 2016, we feel very good about all of our initiatives. However, it does appear that we will continue to face a lot of external headwinds. It is extremely difficult to predict any real improvement in the combined oil patch and border stores in 2016. Therefore, we are taking a cautious approach to the current environment and providing a comp sales outlook of minus 1% to minus 3%.

The initial guidance for FY16 - which also included an expected profit of $0.40-$0.60, against what turned out to be an $0.89 loss, even on an adjusted basis - was ridiculously, terribly, horribly wrong. Yet that projection was based on no "real improvement" in the impacted stores.

That leaves one conclusion: the other ~60% of Stage Stores' base underperformed terribly. 6%+ negative comps, per the Q4 call, support that assertion. That means the "initiatives" about which Glazer felt so good were essentially failures. And that means management is at fault - no matter how hard it tries to blame a "weak retail environment" and $50 oil.

2. The model doesn't work anymore.

Stage Stores' entire model was predicated on being the "only game in town". That's gone in an e-commerce era - and so is the company's moat.

Stage is trying to catch up with the 'omnichannel' experience, and cited double-digit growth in e-commerce for FY17. But the company also has spent at least $25 million in doing so, and now has a market capitalization just over $60 million. Management cited potential closures by JC Penney (NYSE:JCP) as a tailwind going forward - but that's a short-term help. There's little differentiation for Stage at this point - and undifferentiated retailers are getting eaten alive in the new retail environment.

3. There's no levers left to pull.

Stage has remodeled a decent amount of its footprint - over 40% of its sales come from remodeled stores, per the Q4 call. But it's also pulling back on capex investments to keep cash flow positive in 2017.

The rest of the initiatives for FY17, as listed on the call, don't sound like enough:

  • Building the online business, including "ship to store". There's probably some modest help here - but given that the same core brands (such as Nike (NYSE:NKE), Calvin Klein, Nautica, etc.) are available everywhere online, I'm not sure what Stage's edge is here.
  • "Invigorating our merchandise mix" and pulling back on underperforming categories. This seems like standard operating procedure for retailers - if there's enough room for improvement on this alone, then management should be replaced.
  • Adding 30 smaller-format cosmetic counters. That's less than 4% of the store base.
  • Boosting margins by reducing discounts. That seems unlikely to help traffic or sales - or to allow Stage to compete with online peers like (NASDAQ:AMZN).
  • Better marketing and higher private label credit card penetration. The former, again, should be SOP. As for credit, it appears bad debt rates already are up creeping up, given that penetration increases are outpacing income contribution.
  • Fixing a "service culture" that has "eroded". Again, that doesn't reflect well on current management, and if online competition is the problem, better service is unlikely to be the answer.

I'll admit it's not impossible for Stage Stores to post some sort of turnaround. The company probably has some significant room to negotiate rent reductions; in many of its markets, there simply isn't a viable replacement for a Stage or a Goody's. Maybe there's enough in an omnichannel model to replicate some of the company's former "only game in town" moat.

I'm highly skeptical, and even more skeptical under current management. The insistence on blaming O&G - and then casually citing a series of apparent execution errors as opportunities for improvement - doesn't reflect well on Stage management. The inability to forecast the business calls all of Stage's commentary into question. Very few brick-and-mortar retailers are driving even flat revenue in this day and age. Doing so with poor management seems highly unlikely. Yet flat - at least - is what Stage needs to stay viable into the next decade.

How Much Cash Can Shareholders Pull Out?

Where it gets interesting for SSI as a stock, however, is in the timeline. Stage extended and expanded its revolving credit facility in December; it now matures in 2021 and has a peak capacity of $450 million. (As an aside, how the company was able to do that is absolutely beyond me. The facility is secured by inventory and credit card receivables - not real estate. It's bizarre that the lending group - which includes several major banks - was willing to extend that level of credit.)

Per the credit agreement, the borrowing base is based on 90%-92.5% of inventory (depending on seasonality) plus 90% of credit card receivables. Stage needs to keep 10% of the base in availability to avoid a 1:1 fixed covenant charge of (essentially) normalized FCF plus interest to interest expense. Year-end inventory was $400 million - which means the maximum availability should be over $300 million at the moment.

Stage has borrowings of just $163 million at the moment, and even in a disappointing FY17 should keep that level under $200 million. Meanwhile, the credit agreement allows for the company to pay up to $30 million in dividends a year - over $1 per share.

Theoretically, SSI could increase the dividend and essentially guarantee current shareholders a profit: it could pay $2.85 by the end of CY19. It would be an odd decision, to be sure, but even keeping the current $0.60 payout doesn't seem like that strange a decision at the moment. $16.5 million a year doesn't necessarily change the case for Stage Stores' viability post-2021. Either the company turns around - in which case it can refinance the credit facility - or it doesn't. Cutting or eliminating the dividend to save $50-$60 million seems like a reasonably unwise decision at this point: it's not enough to guarantee solvency come 2021, and Stage is going to have to refinance regardless barring some unprecedented turnaround.

If SSI's board just stays the course, total dividend payments through the maturity date of the revolver would be $2.70 per share - discounted back, slightly more than Thursday's close. Glazer demurred on answering a question about the dividend on the Q4 call, saying it was up to the board. But it's worth considering that the board isn't really incentivized to cut the dividend.

I don't think there's a strong enough case to buy the stock for the dividend, keeping upside optionality from even an unlikely turnaround. That case still rests on the board acting aggressively - and if the board acted aggressively, both Glazer and CFO Oded Shein would have been let go long ago. But it's certainly a key consideration for anyone betting that SSI will go to zero - it could very well do so, only to provide a short sale minimal returns. Even accelerated weakness doesn't bring revolver covenants into play until 2019 at the earliest (probably), and a maintained dividend will require $1+ per share in coverage over that period. And if that dividend is coming from the credit facility, on which Stage could default, not corporate cash, which theoretically should come out of equity value, then SSI shares shouldn't necessarily re-rate to account for those distributions.

To be sure, I thought the dividend was enough to keep the stock somewhat afloat at $4 back in November, one reason I covered my short and missed out on further gains. But in the low $2's, the board can basically guarantee some sort of residual equity value for shareholders, if it so chooses. And it has to at least be aware that a dividend cut or elimination would send the stock tumbling even further.

I wouldn't put my money on SSI's board doing the right thing at this point. Still, it's getting harder to see any real upside for a short, given the time it would take to get to zero even in a bearish outcome, and the possibility of having to cover some level of dividend payments in the near future. How SSI chooses to proceed will be interesting - but I don't see any edge in trying to predict its direction. All told, I think it's time to move on from SSI for now, from both sides - but it will be interesting to see how this all plays out.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

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