Description

dELiA*s, Inc. ($4.48)

dELiA*s, Inc. (NASDAQ: DLIA) is a direct marketing and retailing company comprised of three lifestyle brands (dELiA*s, Alloy, and CCS) primarily targeting customers between the ages of 12 and 19.  DLIA was formed through a spin-off from Alloy, Inc. (NASDAQ: ALOY) in December 2005.  ALOY was a digital marketing and retailing company that was taken public during the height of the dot com boom.  Under changing business conditions and strategy, ALOY decided to focus on its digital marketing business by shedding its retail/catalog assets.

DLIA’s current business structure is easily misunderstood given the corporate name and retail growth strategy.  The biggest part of DLIA’s business is actually a mature catalog business that comprises the about two-thirds of revenue today.  The largest catalog is CCS which sells skateboarding equipment and apparel (it was rated the 7^th best skateboarding brand in a recent survey).  The dELiA*s catalog offers the same merchandise as its retail stores, but also includes other categories and items that are consistent with the brand.  The Alloy catalog features apparel, outerwear, shoes, and accessories that are directed towards a slightly older customer than dELiA*s.  Alloy and CCS do not have any retail locations today.

The direct segment generated $174mm in revenue over the last 12 months while retail contributed $93mm.  In aggregate, the direct segment should continue to grow revenue in the low single digit range.  Through better operations, this segment was able to generate 8.8% operating margins in fiscal 2006 vs. 4.3% for 2005.  With continued improvements, the direct segment should operate at 10% operating margins this fiscal year.  This would imply operating income of about $18mm.  Net income for the direct segment would be $11mm or about 34c per share.  Assuming a modest multiple on the direct business of 15x (more than appropriate given its stability and cash flow characteristics), the implied value of the segment is over $5.  At DLIA’s current price of $4.48, the market is ascribing NEGATIVE value to the $93mm retail business.  Even at more conservative direct segment multiples, the implied valuation for the retail segment is too low given its growth prospects and potential to generate significant cash flow.

This seems like a short-sighted market reaction.  While the dELiA*s retail business is not profitable today, it will be soon.  Importantly, DLIA’s stores are already profitable on a four-wall basis.  DLIA’s retail segment is not profitable on a fully loaded basis simply due to its lack of scale.  With only 80 stores in the current base, the company is unable to effectively leverage its central expenses including executive compensation and marketing.  With continued store growth and the cash contribution from new stores, DLIA’s retail segment should be net income neutral by next year and earnings should accelerate thereafter.  DLIA’s retail segment will be cash flow breakeven this year.

The current executive team was hired under the purview of ALOY’s CEO Matt Diamond, as he planned aggressive growth for the dELiA*s concept.  Unfortunately, the growth plan was already put in motion before this group of seasoned retail veterans joined the company.  Many of the locations were not in ideal sites i.e., not co-located with traffic driving tenants (e.g., Abercrombie, Hollister, etc.) and a successful prototype was not developed before the aggressive rollout.  As a consequence, the majority of the current store base, although cash flow positive, is still not optimal.  DLIA’s will finally end this year with the majority of its stores opened during the current management team’s watch.

Having an experienced retail management team comes at a cost.  DLIA’s c-suite is arguably over-qualified for a retailer of its current size.  Executive compensation alone accounts for close to $2mm of expenses on total operating income of about $6mm.  While the current team is still paid less than management team’s of other specialty retailers, the compensation seems egregious given its current scale.

Rob Bernard/CEO – Before joining ALOY in 2003, Rob served as President and CEO of The Limited Stores from 1996 to 2002.  Between 1994 and 1996, Rob was President and COO of J.Crew.  Rob has great experience in growing specialty retail stores and transitioning from a catalog merchant into a mall-based retailer.  Rob draws an annual salary of $600k.

Walt Killough/COO – Walt joined ALOY in 2002 after spending 14 years at J.Crew where he served as COO before his departure.  He was responsible for all sourcing, catalog circulation and production, warehouse and distribution, retail and direct planning and logistics.  Walt draws an annual salary of $375k.

Steve Feldman/CFO – Steve joined DLIA in early 2007.  Prior to joining, he served as CFO of Urban Brands which operating specialty apparel concepts focused on the urban community.  From 1998 to 2003, Steve served as CFO of Urban Outfitters (NASDAQ: URBN).

Steve Feldman can be held somewhat responsible for the recent action in the stock.  Under the previous CFO’s watch (John Holowko who had absolutely no retail experience and was a vestige of ALOY management), expectations drifted upward unchecked as DLIA’s retail had a great back half last year.  When Steve joined the company, he offered more conservative operating parameters (although not official guidance) that led many sell-side analysts to significantly reduce expectations and ultimately cut ratings on the shares.  In a show of confidence, Steve and a director of the company both purchased shares in the open market in the $7 range.  While the new parameters seemed fairly conservative, Steve again reduced expectations after a precipitous and well documented decline in mall traffic in June and July.  Since dELiA*s does not yet have destination status, it relies more on regular mall traffic to drive its business (this will also improve as it continues to grow its store base).  Importantly, the new expectations assumed no material pick up mall traffic in the second half of the year.  While it may be too early to draw any meaningful conclusions, same-store sales results for most (especially teen) concepts in the mall exceeded expectations.  In any case, business trends in the next 6 months should have little bearing on the intrinsic value of DLIA’s retail segment as it has one of the best square footage growth opportunities in retail.

The growth rate of the dELiA*s concept also seems to be in question after the last earnings release.  Management had set the expectation of 20-25% annual store growth.  During the latest conference call, management slightly reduced the next year’s growth rate to 15-20%.  While at first blush, this may seem like management has lost confidence in the growth opportunity, DLIA will be focusing more on relocations next year.  Recall that half of the current store base is not optimally located in the malls and should be improved.  By focusing on relocations, the company is able to improve the locations of many of its current stores.  Improving current locations in existing malls is not as risky as opening new locations in new malls and comes at much lower cost.  When the retail segment begins to generate cash flow the 20-25% square footage growth trajectory should be resumed.

In terms of price target, DLIA should easily double from here without much more downside risk.  The direct segment more than supports the current valuation at $4.48.  Assuming a price/sales ratio of 1.5x, DLIA’s retail should add another $4.50 of value on a sum-of-the-parts basis, yielding a total value of over $9 per share.  Arguably, DLIA should not be a separate publicly-traded entity today.  This was the unfortunate consequence of a premature separation from its parent.  But this is exactly what provides the buying opportunity.

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