Can Chico's Be Chic Again?

By Stephen D. Simpson, CFA | February 22, 2011 AAA

Women's retailer Chico's (NYSE:CHS) was a great growth stock for almost a decade, profiting off its relatively fashionable offerings for working women and ability to differentiate itself from the likes of Gap (NYSE:GPS), Limited Brands (NYSE:LTD) as well as mall anchors like JCPenny (NYSE:JCP) and Dillards (NYSE:DDS). But then Chico's experienced what almost all retailers experience - merchandising missteps, overexpansion, questionable acquisitions and a customer base that just wants to shop somewhere else for a change.

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The good news for retail investors is that there are certainly second acts in retailing (as well as third, and fourth). The question, though, is whether Chico's has whipped itself into shape in time to take advantage of an improving market. (For related reading see 5 Retail Stocks For 2011.)

An Iffy End to the Year
Chico's did not report especially exciting numbers for the fourth quarter, but the market was expecting worse so it all netted out to a "positive quarter", especially as the company gave encouraging sales growth guidance for fiscal 2011.

Revenue in the fourth quarter rose 9%, with the company reported 1.1% comp-store growth. That was not especially strong, but again there were whispers and rumors that results were not going to be so good. Looking at the details, the core Chico's and Soma stores saw 1.2% comp growth, while White House | Black Market delivered a 0.9% comp despite some active markdowns. (For related reading, check out Whisper Numbers: Should You Listen?)

Profitability was a mixed bag. The aforementioned WH|BM markdowns and some direct-to-consumer promotions clipped gross margin by more than a full point, while the company held SG&A expense growth to less than 5%. All in, then, operating income grew 17% and Chico's only missed its bottom line estimate by a penny.

The Road Ahead
Chico's management has been pretty serious about looking at ways to remove costs from its operations. Whether its shifting transportation from air to ocean freight or keeping a lid on sales floor headcount, Chico's has pulled several levers and the company has a relatively decent operating margin for its market.

By the same token, events outside Chico's control could become problematic. Much has been made of the volatility in cotton (as investors can see in the iPath Cotton ETF (NYSE:BAL)) and while prices have tumbled off a very high new high, prices are still very high on a historical level. Moreover, oil prices are once again approaching triple digits and that has implications for the price of synthetic fibers, transportation, and consumer spending.

If that weren't all enough, Chico's gets about two-thirds of its goods from China and labor is about 20% of the cost of garments - a problem given the ongoing rise in Chinese wages. Now Chico's is not helpless here, and production can be moved to locations like Indonesia or Vietnam, but any solutions would take time and passing on higher input costs to the shopper is tricky, though Hanesbrands (NYSE:HBI) and Polo Ralph Lauren (NYSE:RL) are going to give it a shot.

Oh, and don't forget competition. Lululemon (Nasdaq:LULU), AnnTaylor (NYSE:ANN), Kohl's (NYSE:KSS) and Talbot's (NYSE:TLB) would all like to grow and there are only so many dollars to go around.

The Bottom Line
Chico's earnings do not pop out, and the company's plan to resume store growth will suck cash out of free cash flow. That said, the stock does not look expensive. An EV/EBITA below six is pretty appealing for a growing retailer and the company's forward cash flow picture is still attractive even with a higher level of store openings. The post-earnings bump has taken the stock below the 30% undervalued threshold that I would like for a company like this, but any sort of pullback would make these shares an interesting ongoing turnaround play for 2011.

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