It doesn't really seem to matter what customer or socioeconomic group a retailer targets, it's hard to bring customers in through the doors (and/or get them to leave with full bags). Between weak teen retailers like American Eagle (NYSE:AEO) and Abercrombie & Fitch (NYSE:ANF), stagnant-to-down discount retailers like Kohl's (NYSE:KSS) and Target (NYSE:TGT), and the flat results at upper-end retailer Nordstrom (NYSE:JWN), Chico's (NYSE:CHS) is in familiar company. While I do have my concerns about mall-based retailers in the face of competition from companies like H&M (OTC:HNNMY), I do believe the Street is underestimating the long-term value of the Chico's business.
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Another Retailer Reports, Another Retailer Disappoints
You may as well joke this quarter that “How do you know a retailer disappointed the Street? It reported earnings...” To that end, Chico's performance relative to expectations wasn't all that bad for the industry.
Revenue rose 3% as reported, with flat comps. Although the core Chico's/Soma franchise saw a nearly 3% decline in same-store sales, the White House|Black Market concept saw comp growth in excess of 6%. While growing the online/direct sales channel is a stated priority of management, Chico's is fairly typical in that these sales cannot compensate for sluggish in-store traffic trends in the face of adverse weather.
With weak traffic and sales Chico's turned more to promotion and markdowns to move merchandise. That led to a half-point decline in gross margin. It also didn't help matters that SG&A spending outpaced revenue growth, leading to a 6% decline in operating income and a 120bp decline in operating margin.
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Weather, Economics, And/Or Fashion?
I tend to be dismissive of companies that blame the weather for their failings, but I think it's pretty apparent that weather did smack around this sector in the fiscal first quarter. While it's admittedly a different business, Brown Shoe (NYSE:BWS) reported just 1.1% same-store growth this quarter, but with April comps up about 14% - highlighting just how much weather sat on sales growth earlier in the year.
That said, I'm not 100% certain that weather is the only challenge for Chico's. I also believe that weak economic conditions (poor job growth, weak wage growth, and the impact of the payroll tax hike) are hitting results. Chico's targets an older, more work-focused clientele and it stands to reason that weaker data there could be impacting sales.
Longer term, I also have some concerns about the company's ability to withstand competition. Companies like H&M and Inditex are expanding in the U.S. and bringing relatively high-quality fashionable assortments at much lower prices. While I don't want to rule out Chico's ability to fight fire with fire (through strong merchandising and better supply/logistics cost efficiency), it's not going to be easy.
A Good Brand And A Good Plan
My concerns about a significant shift in the apparel retail market notwithstanding, I do think there is a lot to like about Chico's. The company has a very strong record of generating good returns on invested capital, and though the company saw a major decline in margins from 2006 to 2009 as poor merchandising decisions and brand fatigue hit the company, I am confident that management is back on track with its so-called “omni-channel” focus, as well as its international expansion plans.
The Bottom Line
Although I don't expect Chico's to go back to years of 20%-plus revenue growth and operating margins in the 20%s, I do believe the company can still look forward to years of growth. Amidst the teen-focused (and generally work-inappropriate), high-end, and discount retailers, I do see an ongoing market for affordable and stylish clothing aimed at working-age women. Of course companies like Kohl's, Ann Inc (NYSE:ANN), and H&M will target these same shoppers, so it's not as though success is assured.
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Right now, I'm looking for long-term revenue growth of about 6%, or about 50% more than the underlying market growth. I do expect margins (and cash flow generation) to improve, such that free cash flow grows closer to 8% a year for the long term. If that proves accurate, fair value today is about $23. Should Chico's prove less able to boost margins, I would see about 2% downside risk to the free cash flow growth and fair value closer to $20. Accordingly, while I think Chico's could still be in for a tough calendar 2013 (particularly if economic/job market factors are hurting sales), there seems to be worthwhile value here.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
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