Chico’s FAS (NYSE: CHS) said its growth story remains intact, even though consumer spending is expected to remain soft. Additionally, despite falling margins at its flagship stores and rising inventories, the women’s clothing retailer is taking few steps to preserve cash.

Founded in 1983 as a small boutique selling Mexican folk art and cotton sweaters on Sanibel Island in Florida, Chico’s now operates more than 1,200 outlets and boutiques throughout the U.S., selling casual-to-dressy apparel and related accessories under the Chico’s brand, White House/Black Market and Soma Intimates names, catering mostly to women over the age of 35.

Although net sales for the third quarter ended October 29 increased 11.5% year-over-year to $539 million, the Fort Myers, Fla.-based retailer posted quarterly earnings of 16 cents per share, lower than the consensus analyst estimate of 20 cents. Absent traffic, the company was forced to increase promotional activities and offer aggressive discounts to move merchandise, especially at its namesake stores. Gross margin fell 100 basis points to 56% and inventory increased 38% to $247 million.

Though gross margin is forecast to fall 100 to 200 basis points in the fourth quarter (reflecting a need to push-out end-of-year merchandise through discounting), management insists the decline is not related to execution problems. Chief executive officer David Dyer pointed out on the third-quarter 2011 conference call with analysts that the White House and Soma brands “delivered record sales and margins in the third quarter, thanks to a more fashionable mix of lingerie, dresses and beauty.”

“It’s the economy, stupid!” ~ Democratic strategist James Carville

All four brands — from dinner party fashions at Boston Proper to pajamas and “Vanishing Back” bras available at Soma Intimates — are resonating with shoppers, said chief financial officer Pamela Knous on the earnings call. “And I am proud to say,” declared Knous, that the 11.5% increase in sales “represents the tenth consecutive quarter of positive comparables.”

What Knous did not say was that consolidated sales comparables grew only 3.7%. Her double-digit growth comment reflected increases from new store openings — not actual organic growth at locations open more than one year!

Even more troubling, although new traffic was up for the combined Chicos and Soma Intimates brands, which accounted for 66% of quarterly revenue, comparables grew only 0.6%, compared to sales growth of 3.6% last year. Knous said the slowdown reflected the Chico’s customer’s “cautious purchasing behavior in light of continuing uncertain economic conditions.”

“When I see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck.” ~ American poet James Whitcomb Riley (1849 – 1916)

Notwithstanding, the Chico’s namesake brand, average dollar sales and transaction counts are supposed to be up across all other brands, according to management. Why, then, will the company not break out segment profit and loss (P&L) statements?

Looking to extend its customer’s experience to intimate apparel, a $13.5 billion market (led by Victoria’s Secret’s commanding 25% share), Chico’s has grown the Soma label from 10 stores in 2005 to more than 200. Given the company’s ambitions are no longer “a secret,” why should the brand’s contribution to P&L still be considered such — unless discount pricing is driving sales growth — and eating into profits?

Management contends that there is space for another specialty lingerie brand. Though sales and profits are sizzling these days at industry bellwether Victoria’s Secret, owned by Limited Brands (NYSE: LTD), the playing field is not level for an upstart like Chico’s: Soma Intimates does not have the real estate. With just one-fifth as many stores, the company cannot similarly leverage product campaigns (do not expect an NBC runway show in primetime anytime soon). Additionally, deep-discounters like Wal-Mart Stores (NYSE: WMT) and Kohls (NYSE: KSS), with respective market shares of 17% and 8%, are battling for the budget-constrained pocketbooks of shoppers (looking for bargains) too. Ergo, Chico’s promulgations of full pricing and fashion parading hand-in-hand at Soma Intimates, in my opinion, is just fantasy talk.

On the earnings call, Nomura retail analyst Paul Lejuez was ignored when he specifically asked Dyer or Knous to detail the P&L impact of Soma Intimates on quarterly income. The company did not return my call seeking comment, too.

Troubling Trends Ahead

There are stormy headwinds blowing toward Chico’s, which management — whether deliberately or blithely — refuses to address:

• “Excluding $3.5 million of non-recurring, after-tax Boston Proper acquisition and integration cost, earnings per diluted share were $0.18 compared to $0.16 last year, a 13% increase,” said Knous. “Our best third quarter earnings per share results since 2006.” If this is Chicos’ best — I’d hate to see “average” performance. The quality of the company’s earnings is suspect. Actual net income year-on-year fell 8.2% to $26.46 million, according to regulatory filings. Share-net income received an artificial boost because actual (weighted) share count outstanding fell by 10 million in the last year due to open-market stock repurchases.
• In total, the company should exit the year at 1,250 stores, an increase of about 8% in square footage. However, in-store inventory is up some 17% per square foot, which suggests a continued reliance on aggressive promotions to push out seasonal merchandise — and a delay in margin turnarounds.
• Further evidence of a disconnect with female shoppers is found in days inventory outstanding (DIO), a performance metric that measures how long it takes inventory to be replaced on store shelves. In the third quarter, DIO rose year-over-year from 73.5 days to 81 days. Part of the cash conversion cycle, an increase in DIO whispers a liquidity crisis could be in the wind, as Chico’s inventory accounts for almost 46% of current assets (of $543.5 million).

“The best offense is having the right product for the customers.” ~ Chicos CEO David Dyer

Management believes that Chico’s has sufficient capital — cash flow from operations and existing cash and marketable securities balances — needed for the 100 (plus) new store openings in 2012 ($100 – 120 million), plus continued investment associated with the Soma brand, store remodel/expansions and cash required for inventory levels associated with this growth. Additionally, the company has no long-term debt and, if necessary, an untapped bank credit-line totaling $70 million.

Cash and equivalents totaling $195 million plus year-to-date operations that threw off $181 million suggest that liquidity should be sufficient to weather more of the same soft retail environment predicted for 2012 (including continued pressure on margins from promotional activities). That said, the company is spending money like a drunken sailor: $212 million acquisition of Boston Proper last fall, $70 million in dividend payouts, $176 million stock repurchases of 13.7 million shares (since August 2010) and the just-announced $200 million new stock buyback program.

Strong quarterly results at Limited Brands and Ann Inc (NYSE: ANN), parent company of Ann Taylor and LOFT brands, demonstrate that even in a weak economy customers will pay “full-price” for the right products. However, in my opinion, the company has overestimated its own pricing power. Consequently, if trouble follows the company into 2013, build-outs planned for Boston Proper and Soma could grind to a halt. As the share price of Chico’s FAS is down some 36% from its 52-week high of $16.60, consensus among investors would be to agree — and flee.

David J Phillips

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