Activist Investors Eye Chico's as Compelling Take-Out Target

Chico's FAS owns 4 brands - Chico's, Soma Intimates (SI), White House|Black Market (WHBM), and Boston Proper (BP). Having negative same store sales for 1 quarter despite 17 consecutive quarters of positive growth, CHS plummeted 22% to a low of $15.33 in late August 2013. The retailer of women apparel now trades at a multiple that implies almost no growth for its core brands and absolutely no growth for its recently acquired brand, Boston Proper, which is likely to double revenues in 3-4 years.

After a tumultuous history, the company revamped itself in 2009 with the appointment of David Dyer as CEO. The new CEO replaced all but one member of the management team, introduced new products, and overhauled marketing and distribution. Since 2009 the company has seen rising EBITDA per store (40% CAGR), expanding retail space (6% CAGR), strong cash flows (FY12 FCF was 8% of net sales), repurchases of shares for $215m (8% of shares outstanding), and no debt.

A buyout opportunity is possible with the participation of an activist investor who has a proven track record of hitting 40-50% returns in 2-3 years as its third-largest shareholder. My target price per share is $25.35, representing a 57% return from the closing price of $16.16 on 9/13/2013.

WHY THE STOCK IS DEPRESSED
• Missed 2Q14 earnings (reported on August 28 2013) estimates on lower traffic. 2Q14 net income fell 18% YoY.
• Same store sales registered a consistent decline from +8.6% in Q413 to -2.6% in Q214. In Q214, Chico's/SI experienced a 3.1% decline and WHBM a 1.5% decline.
• WHBM, the key growth asset, experienced its first negative same store stores in 17 quarters.
• Comparable-sized retailers such as American Eagle and Abercrombie have registered negative same-store sales for at least 2 quarters. Even retail bellwethers such as Limited Brands have experienced disappointing same store sales in the first half of 2013.

CHICO'S AND WHBM HAVE DISTINCTIVE PRODUCT NICHES, MARKET LEADERSHIP AND OPPORTUNITIES FOR GROWTH OUTSIDE THE US
• Since the overhaul of management in 2009, CHS have had 15 consecutive quarters of positive same-store sales growth and 16 quarters of double-digit per share earnings growth.
• Pop Up Retail Group, a leading expert on retail operations, said that "a large portion of dollar share in women's apparel is spent by women over 45, and having a variety of fit options is always very challenging for a retailer to offer … [but] CHS has made a real point of offering different types of fits - they spend a lot of time figuring out what people want".
• CHS is not the first company to utilize this strategy in offering a wide variety of fits and sizes to distinguish itself. Mark's Work Wearhouse, a retailer in Canada, utilized the same strategy for growth before it was acquired by Canadian Tire Corp.
• CHS dominates the "missy" apparel retail segment that caters to mature women. Both Chico's and WHBM sell to women 30 and older. The average age of a Chico's customer is pegged at mid-50s while that of a WHBM customers at mid-30s. These customers tend to have higher-than-average annual incomes of $50,000 or above, and are more inclined to spend higher-priced, higher-quality apparel tailored for a variety of social contexts than their younger counterparts.
• The dominance in product niches supported Chico's growth from 487 stores in 2005 to 705 in 2013 (5% CAGR) and WHBM's from 160 to 443 (16% CAGR). Revenues more than doubled to $2.5B in the same period.

OVERHAUL OF MANAGEMENT BROUGHT DAVID DYER AS CEO, A RETAIL AND MARKETING VETERAN
• In January 2009, the Board announced that David Dyer, a board member, would replace CEO and Chairman Scott Edmond. David Dyer is most well-known for 2 deals - the sale of Lands' End to Sears and the sale of Tommy Hilfiger to Apax Partners. He was credited for pioneering web-based personalized customer service and building the web and catalog business at Lands' End. His turnaround success at Lands' End made him the CEO of Tommy Hilfiger, where he was credited for redesigning the brand's Web presence, IT infrastructure, logistics and supply chain.
• The company has improved on every profitability measure since David's appointment as CEO. EBITDA per square foot quadrupled to $127 from its lows in 2009. EBITDA per square foot is second only to Limited Brands in the specialty retail space. CHS pursues a small-store strategy that maximizes EBITDA and operating margins. EBITDA reached a record high of $400 million in 2013.
• Same-store sales hit an annual average of 7.5% between 2010-13 since a low of -15% in 2009. Number of stores jumped 26% after being stagnant in 2009-10. The company converts an impressive 8% of revenues to FCF, matching and even beating its peers 10-20x its size.

INVOLVEMENT OF ACTIVIST INVESTOR INTRODUCES MANAGEMENT BUYOUT OPPORTUNITY
• Blue Harbor Group, a private-equity and activist investor, announced a 5.6% stake in CHS in early September 2013. The company is founded by Clifton Robbins, former partner at KKR and notable value investor.
• In an interview with 13D monitor, Clifton called out the sweet spot in market cap as $1-5 billion and a goal of achieving a 30-50% return within 2-3 years at a minimum. He preferred management who "is hungry to win and open to change".
• CHS's CEO David Dyer and Clifton appeared to have cross roads in the past. David prepared the sale of Tommy Hilfiger to Apax Partners in 2006, who sold Tommy to PVH in 2010. Guess who was a large minority shareholder of PVH?
• Retail companies have been the target of PE activism in recent years due to the companies having low debt and high free cash flow. PE firms are able to lever up in buying out the company and use the company's FCF to pay down debt. There was Tommy's sale to Apax in 2006, the acquisition of J Crew by TPG and Leonard Green in 2010, the buyouts of Talbots and Hott Topic by Sycamore Partners, and Blackstone and Bain Capital buying Michael's.

VALUATION
• With 17 consecutive quarters of positive same store sales, CHS trades at a forward ebitda multiple of 6.0. Limited Brands ($17B market cap) trades at a forward multiple of 9.3 despite 9 consecutive quarters of declining same store sales. Urban Outfitters ($5.6B market cap) trades at a forward multiple of 8.8 with only 1 year of positive same store sales in the last 4. On average, CHS's peers trades at a forward multiple of 8.0.
• A 3-year DCF analysis yields a FY17E of $380m operating profit including the effects of share repurchases, representing a CAGR of 6.8% from FY13, lower than the 10-year historical CAGR of 10.5%.
• Conservatively assuming ebitda multiple at 6 and using FY17E ebitda of $520m, I arrive at an implied market cap of $3.9B with a target price per share of $25.35, representing a 57% return from the closing price of $16.16 on 9/13/2013.