Description

Chico’s is trading at a pro forma 10%+ FCF yield, with no net debt, and appears to reflect little value for optionality that reported talks with private equity will lead to an LBO.

Chico’s is a specialty retailer catering to 40+ year-old women with disposable income.  It has four businesses (soon to be three), but does not break out profitability:

1. Chico’s – Founded in the 1980’s, the footprint is essentially mature.  Stores have grown 1-2% per year since 2007.  Now up to 740 stores.  Print and color-oriented fashions.

2. WH | BM – Also founded in the 80’s, CHS ramped up the growth after 2010, now up to 514 stores.  Black and white fashions.

3. Soma Intimates – A buried gem.  Underwear / bras (think more functional vs. Victoria Secret sexy).  25 straight quarters of positive comps.  The chain has grown to 300 stores today and is reaching national scale.  Stores take 5-6 years to mature as customers take time to change their habits in this area.

4. Boston Proper (closing) – Strike out.  Direct to consumer fashion catalog business purchased by current CEO for $200mm in 2011.  Store rollout was a bust.

The write-up uses OCF and FCF (OCF – capex) for valuation and shies away from EBITDA.  Cash rent expense is higher than GAAP expense due to deferred rent and lease credits.

CHS overall comps have been stable but middling the past few years.  Company OCF has dropped from a peak of $360mm in 2012 to $240mm today, with FCF declining similarly from a $220mm peak to $145mm:

CHS has operated in growth mode for the last decade, as it opened net stores even through the recession.  Capex was elevated from 100+ store openings in each of the past four years.  Corporate HQ expanded.  Boston Proper happened and capital allocation was not a strong point.  Until Q1 of this year, CHS had not seen layoffs since cutting 10% of HQ staff in 2009.

Today, CHS has scaled back future store openings (except Soma), cut capex, found SG&A savings, is closing/selling Boston Proper, and is culling about 10% of the store base over the next 3 years for additional profitability.

CHS is trading at an unlevered 10% FCF yield, pro forma for a few “in the bag” adjustments:  

CHS announced $65mm of pre-tax expected savings from closing 150 stores over the next three years.   Based on the footprint, I estimate $10mm of the $65mm is non-cash D&A.  Taxing the remaining $55mm leaves an incremental $34mm for FCF by the end of the third year.

$208mm + $34mm = $242mm = 12.1% FCF

Note the FCF yields are quoted against CHS market cap, and make no adjustment for net cash or net tangible assets, which would push the yields a bit higher.

Deal Optionality

In February 2015, Sycamore was reported to be in advanced talks to purchase CHS:  http://www.wsj.com/articles/private-equity-firm-in-advanced-talks-to-buy-chicos-fas-1423604404

2 weeks later, abandons the effort:  http://www.wsj.com/articles/sycamore-partners-abandons-attempt-to-buy-chicos-fas-1424823457

Reuters said they had an agreement-in-principle and NYT quoted “upward of $3B” (http://dealbook.nytimes.com/2015/02/10/chicos-clothing-stores-near-sale-to-sycamore-partners/?smid=tw-dealbook&seid=auto)

Assuming that refers to market cap, $3B would have been a ~$19.50 deal.  After six months of cash flow and execution of an ASR, a deal today at the same enterprise value would be priced at $20.50.

Last month, Bloomberg reported that Sycamore and others had re-approached CHS about an LBO:  http://www.bloomberg.com/news/articles/2015-09-11/chico-s-said-to-weigh-sale-amid-new-interest-from-private-equity

Last week, Reuters reported that Sycamore’s bid again faced obstacles, and the stock now actually trades a touch below where it was before Bloomberg’s report that talks had rekindled:  (http://www.reuters.com/article/2015/10/02/us-chico-s-fas-m-a-sycamorepartners-idUSKCN0RW1Z720151002).

I think the probability of a sale is 50%, with an expected price of $19 – 20.  Major factors in my thinking:

1. The math works.  Borrow 5.8x EBITDA at an avg coupon of 7.5% and it only takes a $750mm check for the equity.  Adjusted FCF is a 15% yield on that check.  Pro forma for store closures three years out, it’s a 20% levered yield.  Interest is covered well over 2x.  Upside to more aggressive financing, Soma growth, operational improvement, further SG&A saves, cutting capex.  I think all the above FCF adjustments are on the conservative side.

2. CHS CEO is retiring in the spring and owns 1% of the company.  He sold his two previous companies (Lands End to Sears and Hilfiger to Apax).  Should be a proponent (or at least not an obstacle) to shareholders voting on whether the best deal price is an acceptable premium.

3. Sycamore is very savvy.  I am inclined to think they will pull any lever to get a price cut, including negotiating in the press.  This deal would be funded from their 2nd fund ($2.5B) after their 1st fund ($1B) was a home run, so the deal means a lot more to Sycamore than it would to one of the mega funds, which means more incentive to act sharply.  Precedent lies with how they cut price in the Talbots deal (the background in that proxy is a fun read).

4. Talbots, a CHS competitor, proved to be a fantastic deal.  Sycamore should run the same playbook:  cut SG&A costs, run the business well for a season or two and take big money out via dividends https://www.moodys.com/research/Moodys-assigns-B3-Corporate-Family-Rating-to-Talbots--PR_294069.  From another Moody’s report:  “Through the last four quarters ended May 2, 2015 Talbots has grown revenue in the high single digit range, improved its EBITDA margin, and increased Moody's adjusted EBITDA by almost 30%.”  I think CHS’s growth and success has probably left them marbled with opportunity to cut costs and capital spending.     

Some risks and points against:

1. Federal Reserve guidance cautioning banks from leveraged loan commitments > 6.0x EBITDA.  Banks don’t want more trouble with regulators, and there are no bright lines on how strict the 6.0x really is, which if any EBITDA adjustments are acceptable, how leases should be treated, penalties for violation, etc.  Deals are getting done, but financing is not the smooth process it used to be:  SLH sale to Vista used a preferred equity commitment, BEE sale to Blackstone has “fill in the blank” financing with BX being big enough to commit to whatever the equity check ends up being, etc.

2. If the HY market hiccup turns into a major buyers strike.

3. If the negative data-point on CHS’ Q2 call marks the start of a trend.  On the call, the CEO cited a ship collision in China for why comps trended down 4% in early Q3, although CHS thought they weren’t indicative of the current business and kept guidance intact.

Catalyst

Sale to private equity

Further capital investment into repurchasing shares trading at unlevered 10%+ pro forma FCF yield