RgStudio
Introduction
Chico’s FAS (NYSE:CHS) shares dropped 14% during the two trading days since issuing its Q3:F2022 earnings report, its third consecutive beat-and-raise. In our view, this sell-off is unwarranted based on the company’s absolute and relative performance and comparative valuation. In this article, we explain why shares offer a compelling value.
For reference, here are links to our three previous articles about Chico’s FAS:
Chico’s FAS: A Chic Turnaround Underway, Potential Substantial Upside
Chico’s FAS: Building Greater Confidence
Chico’s FAS: Sell-Off After Beat-And-Raise Presents Buying Opportunity
Q3:F2022 Key Highlights
In our view, these are the key highlights from the Q3:2022 earnings report that strengthen our confidence in CHS.
Exceptional, Sustainable Same-Store Sales Growth
Total same-store sales increased 16.5% year over year and 27.9% compared to Q3:F2020. The Chico’s brand jumped 28.8% year over year and 23.3% compared to Q3:F2020, while White House Black Market grew by 17.0% year over year and 33.4% compared to Q3:F2020. However, comps at Soma slid by 6.1% year over year, while expanding 30.2% compared to Q3:F2020.
We’re not concerned by Soma’s relative weakness, given (1) the tough comparison to Q3:2021 and the 35% increase compared to 3Q:F2019; (2) the effective normalization of the loungewear category post-pandemic; (3) Soma is the smallest brand of the three for CHS; (4) Soma continues to gain market share; and (5) new leadership with recent hiring of Christine Munnelly as Senior Vice President – Merchandising & Design at Soma.
In our view, investors need to fully recognize the reasons underpinning the extraordinary same-store sales performance. These factors would help determine whether same-store sales growth is transitory or sustainable. Of course, the magnitude of comp growth is likely to decelerate, however some investors may be questioning whether comps can even stay positive next year given what appears to be challenging comparisons.
We think the business has substantial momentum to continue realizing same-store sales growth, given several structural tailwinds. During the recent earnings conference call, Molly Langenstein, CEO, indicated that “consistent newness, innovation, and product enhancements drove strong digital, store traffic, and sales growth.” Strategic marketing continues to drive more customers to the brands with total year-over-year customer count and spend per customer up high-single digits, and the average age of customers continuing to trend younger.
In addition, Langenstein stated that “digital tools are driving higher average order value in both [digital and brick-and-mortar] channels.” Further, PJ Guido, CFO, implied that Q4 guidance is conservative. He said that the company is experiencing “very healthy consumer behavior in both channels as measured by traffic, conversion, and average dollar sale” and therefore management did not adjust its plan for Q4 despite being “cautious” on the macroeconomic environment. We interpret this to mean that there is upside to Q4 guidance.
Moreover, Langenstein disclosed an exciting new structural growth driver for next year that should significantly augment Soma’s sales. CHS plans to roll out a re-platform for its digital channels whereby a universal shopping cart will enable customers to one-stop shop all three brands in the same online basket. We think the cross-selling opportunities within the apparel brands (Chico’s and White House Black Market) and Soma will be very accretive.
Tight Expense Management Mitigates Economic Risk
In Q3:F2022, CHS realized 190 basis points of SG&A expense leveraging, resulting in SG&A as a percentage of sales of only 33.9% compared to 35.8% in the year-ago period. Guido indicated during the conference call that the retailer’s ability to “flex” its cost structure would enable it to mitigate potential soft sales trends from worsening economic conditions.
Robust EBITDA Growth
CHS generated approximately $42 million in EBITDA during Q3:F2022, resulting in almost $170 million year-to-date. This year-to-date amount exceeded F2021 and was more than double that of F2019, pre-pandemic. In our view, this is clear evidence of significant fundamental improvement during the past three years.
Clean Inventory
CHS ended Q3:F2022 with inventory up only 9% year over year, reflecting strategic inventory management to align assortments with seasonal consumer demand to support planned sales growth. In our view, this is prudent, considering management expects Q4 sales to grow 10% (mid-point of guidance), and vindicates its supply chain strategy of in-transit inventory and early receipts during Q2 when inventory ended up 68% (although on-hand inventory was only up 25%). As a result, concerns following the Q2 earnings report about bloated inventories and skepticism about the supply chain strategy were meritless.
Third Consecutive Beat-And-Raise
With its Q3:F2022 earnings report, CHS beat-and-raised for the third consecutive time. Net sales were $518 million (compared to consensus of $508 million) and EPS were $0.20 (compared to consensus of $0.13). In addition, management raised its full-year guidance including for net sales to $2,153 million to $2,173 million (from $2,140 million to $2,170 million) and EPS to $0.89 to $0.92 (from $0.79 to $0.87).
Some market speculators with a glass half-empty perspective interpreted these stellar results with negativity claiming that the Q4 guidance was short of “consensus” expectations for $0.10 in EPS, as guidance is merely $0.07 to $0.10 and therefore the mid-point is less than Wall Street expectations. First, guidance is a range for a reason, and consensus is within the range. Second, CHS is an under-followed stock with only one analyst. Therefore, consensus with merely one analyst estimate should not be considered “consensus” and rather taken with a grain of salt as one opinion. Third, even if we were to view CHS as having “missed” Q4 EPS expectations, we would then have to essentially marginalize the overall beat-and-raise and essentially disregard the fact that full-year guidance was raised and that the mid-point is above that one analyst’s full-year EPS estimate of $0.90. Fourth, even if we were to penalize CHS for “missing” Q4 EPS expectations by $0.015 which equates to $13 million of market capitalization value (based on 125 million diluted share outstanding and a 7x multiple) the market overreacted by dropping the stock by $125 million in market capitalization ($1 per share).
Apparel Retail Comparative Valuation
Now that we’ve established that CHS has achieved solid results, despite a challenging overall economic environment owing to its resilient, affluent customer base and excellent strategic and operational execution, we now turn to examining the apparel retail landscape. For purposes of this analysis, we will focus on Capri Holdings (CPRI), Vera Bradley (VRA), Lululemon Athletica (LULU), Ralph Lauren (RL), Guess (GES), and J.Jill (JILL). These are apparel / accessory retailers that cater to affluent women. CPRI recently reduced its holiday season forecast and now trades at 8x full-year guidance (April fiscal year-end). Based on full-year consensus estimates, VRA trades at 20x, LULU at 36x, RL at 14x, GES at 8.5x, and JILL at 9x.
In addition, while not the best comparable companies, given different demographics, it may be helpful to compare American Eagle Outfitters (AEO) and Abercrombie & Fitch (ANF) given that they are also “mall-based” retailers. While both of these retailers have their own challenges and recently posted encouraging yet cautious holiday season outlooks, AEO trades at 20x and ANF at 26x. Both of these stocks are up nearly 20% since reporting Q3:F2022 results the same day as CHS. We note that ANF merely increased its full-year operating margin guidance to 2% to 3% (from 1% to 2%) on the heels of narrowing the outlook for its net sales drop to 2% to 3% (from mid-single digits). Somehow this performance by ANF merits a 26x P/E multiple, while CHS, which guided for net sales increase of 20% and operating margin of 7%, is currently assigned a 7x multiple.
Conclusion
In our view, CHS has clearly demonstrated the sustainability of its turnaround with exceptional same-store sales trends, impressive customer statistics (i.e. growing customer count, spend per customer, etc), tight and flexible expense management, and opportunistic inventory management. Moreover, our confidence is bolstered by clear operational tailwinds next year, including the launch of its universal digital shopping cart, continued scaling of its new loyalty program, and customer-focused fashion innovation.
In addition, after paying down debt by $30 million in the most recent quarter, net cash is $72 million (gross debt is only $69 million). Given strong free cash flow generation (mid-teens FCF yield), we expect the CHS balance sheet to be debt-free by mid-F2023.
We strongly believe that the recent 14% drawdown in CHS shares during the past two trading days is totally unwarranted. The retailer is executing is strategy near flawlessly, yet the stock is on the “clearance rack” of the NASDAQ, trading with a 7x forward P/E multiple despite double-digit sales and earnings growth.
Perhaps CHS is simply an orphaned (i.e. underfollowed / undiscovered) stock with only one sell-side analyst. Alternatively, maybe short sellers are controlling the stock, given the 15 million shares short as of October 30, 2022, representing approximately 15% of the float. If so, then CHS should be near the top of short squeeze candidates.
Upcoming catalysts include monthly CPI reports that show decelerating inflation, as well as the company’s holiday season business update prior to the ICR Conference in January.
We think CHS now deserves to trade at a 10x P/E multiple, which would equate to a $10 12-month price target, based on our F2023 estimate of at least $1 of EPS. In addition, as investors gain more confidence in the sustainability of this retail turnaround, we expect CHS shares to ultimately re-rate higher with a 15x P/E multiple in-line with its anticipated long-term EPS growth rate.
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