Overview:

Charlotte Russe is a mall-based retailer focused on fast fashion for the junior market.  Their target customer is in her late teens to early 20s and searches for low-priced clothing items that reflect current trends.  It’s sort of disposable clothing – buy it, wear it 2-3 times, and move on.  This customer doesn’t want to wear the same outfit on a Saturday night twice.  Average unit retail is around $12 and the average transaction at the register is around $32.  Unlike other retailers, fast fashion stores turn their inventory every 35-45 days, or about 8-10 times per year.  The frequent restocking of the stores to reflect current trends causes CHIC and its peers to do the bulk of its buying domestically, unlike almost all other retailers who directly source from Asia and thus must plan for and live with a 3-6 month lead time for inventory.  CHIC’s primary competitors in the mall are Forever 21 (private) and the core Wet Seal division of WTSLA.  To a much lesser extent, CHIC competes with other junior-focused specialty retailers such as Urban Outfitters and Hot Topic, as well as the junior departments at midtier department stores like JC Penney’s or Kohl’s.

Investment Points:

·         Valuation, valuation, valuation – It’s hard to not eventually make money long-term in a stock that is 3-4x EBITDA which is cash flow positive and has a good balance sheet.

·         Room to grow – CHIC currently has 410 stores (7/25/07) and will end the year with 432, but they think they have room for 600 in the US.  They added 50 new stores this year and plan to add 60 next year.  With 14% square footage growth, topline growth is in the bag for the next couple of years.

·         Strong cash on cash returns from new stores – They claim to have 80% cash on cash returns for new stores and that new stores mature quickly, doing about 85-90% of the sales level of a mature store in their first year. 

·         Limited inventory risk in the fast fashion model – While they can be “on” or “off” at any given time with their assortment, the fact that inventories are typically held at less than 40 days of sales mitigates the financial impact of any one fashion miss, because they just don’t hold that much of anything.

·         Opportunity to improve margins through an expansion of their limited sourcing program – There are a few categories for which direct importing is a feasible strategy.  They say they want to take directly imported items up to 15% of the store from the current 7.5%.  At an 800 bp initial margin differential, this seems to be a 60 bp margin opportunity on a company-level, which could be closer to a 75 bp opportunity if they can find overseas suppliers that support a 1000 bp sourcing differential (1000 bp is the savings bantered around in a lot of categories by companies in the consumer space).

·         Recently authorized share buyback program - $25 million authorization in place, equivalent to 7% of market cap and 9% of EV.

Investment Risks:

·         Current negative business momentum yields earnings risk as well as earnings revision risk – Short term momentum in the junior fast fashion space is terrible, as indicated by WTSLA’s disappointing September comp.  CHIC even acknowledged on their Q3 call on 7/26/07 that things started getting much worse in terms of traffic and transactions towards the end of June and that the July comp was negative (CHIC, unlike many of its peers which report monthly, only publishes quarterly comps).

·         Will miss Q4 (September quarter) earnings estimates – They predicated their Q4 guidance on improving results in August and September relative to July, which seems unlikely to happen since things got so much worse for WTSLA from August to September.  They also guided to the promotional activity level being higher, but the environment is possibly worse than even they expected on the promotional front, which will put margins, as well as sales, at risk.

·         Operating margin risk – They are currently at an operating margin of 8.7% and they are targeting a 10% run rate as a goal by the end of FY2008.  It should be noted, however, that while the company has done an operating margin over 10% four times in the last ten years, the last time they did it was 2001.  Over the last five years, the operating margin has averaged 6.9%, so there is a risk that margins, especially in a weak environment, revert to recent historical averages.

·         Geographic risk – 13% of store base in California and 10% of store base in Florida, both among the worst housing markets.  This risk may be mitigated by the fact their customer is too young for a mortgage, although she may get her allowance from someone who has one.

·         Surging capex hurts free cash flow – Capex for the 5 years prior to this one averaged $44 million, yet initial guidance for 2007 capex was $65-75 million but it is likely to come in at an even higher $80 million.  It’s not 100% clear where all this money is going.  D&A is around $37 million, so assuming that is a maintenance capex spending level and adding $350K per store for 50 new stores would account for $55 million in capex.  They are doing a bunch of things with IT, but $25 million sounds a bit steep for what they are doing, and while they haven’t yet given 2008 capex guidance, it didn’t sound like they were planning a dramatically lower number.  The company has never been great at converting net income to free cash flow but with this increase in spending, free cash flow will get knocked almost all the way to zero.  This doesn’t make sense given their claim the cash on cash return on new stores is 80%.

·         Inherently a lower return business model within retail – A fast fashion focus leads to structurally lower gross margins because of an inability to source much product from Asia.  This lower gross margin filters through to operating margin, profits, and return on capital.  For this reason, CHIC always has and should trade at a multiple discount to the rest of specialty retail.  Also, there is very limited ability to bring up price.  There is frequent price elasticity testing in their stores and the tests reinforce the price sensitivity of their customer.

·         Economic risk – It remains to be proved, but it seems we are in the middle of a mild consumer recession.  And their customer is near the bottom of the economic food chain.

Upcoming Catalysts:

·         Q4 and FY07 earnings release – expected around 11/9/07 give or take a week

·         WTSLA October comp report – 11/8/07

Valuation:

The potential for 15%+ earnings growth for several years (through a combination of square footage growth of 10%+, small comp gains, slight margin improvements through leverage, and stock repurchase) needs to be weighed against the less attractive structural economics in fast fashion versus other specialty retail categories.  Putting this together, an appropriate multiple might be a 12-13 ex-cash p/e on earnings power of around $1.50.  This math yields a $22.20 target (+49% from the current quote).  If people got excited about this company again (comps were positive and operating margin crept towards 10%), the stock could easily trade in the mid to high $20s.  On the downside, if they comp negative mid single digits next year and have margins revert back to 6.9%, they would probably make only around $1.35.  At a 10 p/e on that, there’s maybe downside to $13.50, which is less than 10% down. 

Looking at it from an EBITDA perspective, they should do around $100 mm this year.  5x EBITDA yields $23.  6x EBITDA yields $27.50.  If EBITDA margins contracted to the 5 year historical average of 11.9% and they comped down mid single digits, EBITDA would be around $95 mm in 2008, and the stock at its current quote is just over 3x that EBITDA.

Summary/Recommendation:

I would recommend buying this company as a deep value investment.  The only reason to not buy a retailer trading at 3x EBITDA that is profitable and has a good balance sheet would be if you thought their business was permanently impaired and could be displaced from the market.  I don’t think that’s the case here.  It’s not that their consumer is shopping elsewhere; they just aren’t shopping much right now.  With a long-term view, you will make money, and likely very quickly make money, when there is evidence that their consumer has gotten better.  That said, that day is not on the visible horizon.  This is a stock without any near-term positive catalysts and with a plethora of potentially negative ones (likely negative comps and earnings revisions downward).  Hopefully, at this price, a lot of that bad news is priced in, which is why I would say buy it despite the horrible short-term outlook.  It’s just too cheap.