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Specialty Retail Margins      

by Louis Corrigan (TMF Seymor)

Atlanta, GA (March 23, 1999) -- Our Rising Margins screen this week offers up Adobe <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ADBE)") else Response.Write("(Nasdaq: ADBE)") end if %>, a leading software firm that may have turned the corner after a rough patch; Apollo Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: APOL)") else Response.Write("(Nasdaq: APOL)") end if %>, the for-profit operator of the University of Phoenix; a number of brand name retailers or manufacturers such as Stride Rite <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SRR)") else Response.Write("(NYSE: SRR)") end if %>, Williams Sonoma <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WSM)") else Response.Write("(NYSE: WSM)") end if %>, and Urban Outfitters <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: URBN)") else Response.Write("(Nasdaq: URBN)") end if %>; and some leisure-oriented firms like Carnival <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CCL)") else Response.Write("(NYSE: CCL)") end if %> and Winnebago <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WGO)") else Response.Write("(NYSE: WGO)") end if %>. But we'll only have time to take a look at two specialty retailers.

Though selling clothes to teenage girls is a challenging business, Wet Seal <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WTSLA)") else Response.Write("(Nasdaq: WTSLA)") end if %> has been meeting the challenge. This specialty retailer operates 458 stores in 42 states, including 421 Wet Seal and Contempo Casuals stores catering to the "juniors" market, 10 unisex Limbo Lounge stores, and 27 Arden B. stores with apparel for fashion-forward young women. While its stock has been slippery over the past year, sinking or swimming along with the market, results remain impressive.

Q4 sales increased 23% to $146 million on 6% better comp-store sales (following a 5.6% comp-store gain for the year ago period). That pushed earnings to $0.95 per share, a penny ahead of estimates but 51% ahead of the year-ago period. Full FY98 results showed sales jumped 18% to $485 million, vaulting EPS to $1.91, up 25% from $1.53 a year ago. Due to weakness early in the year, same-store sales increased just 2.1%.

Although Q4 selling, general and administrative (SG&A) expenses as a percent of sales increased to 21% from 20.6%, gross margins counteracted such higher operating expenses by increasing to 33.9% from 32.7%. Despite the sales growth, inventories are up just 4.2%. Even better, the company bought back some stock late last summer when it was cheap, ending the year with 12.8 million fully diluted shares versus 14 million a year ago. Yet it still has $91.5 million in cash (about $7.15 per share) and no debt. As the Fool Snapshot shows, the company's return on equity (ROE) is an attractive 23%.

During FY98, Wet Seal added 65 net new stores after opening 86, closing 21, and remodeling 29 others. The aggressive expansion continues this year with 105 new stores to be opened, 80 of them in locations acquired from Britches. About 48 of those locations will become Arden B. stores this quarter, quickly turning that concept into a national retail chain with 72 stores.

The consensus earnings estimate stands at $2.40 per share for the year ending next January, giving Wet Seal, at $34, a forward P/E of 14.2. Backing out the cash, we get an enterprise value of just $27 a share, for a forward P/E of just 11.3 despite projected long-term growth of 21%. Due to fashion risks, the market can punish apparel retailers that target teenage girls and young women. Still, for the successful retailer, this is a very sweet spot due to favorable demographics. Wet Seal continues to establish a leading presence in this market. While the stock could get cheaper if the market continues to correct, Wet Seal is definitely worth investigating further.

Noodle Kidoodle <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NKID)") else Response.Write("(Nasdaq: NKID)") end if %>, a specialty retailer of children's "edutainment" products with 42 stores nationwide, reported Q4 sales that leaped 32% to $48.7 million on rollicking 8% same-store sales growth. That was impressive given the 22% comp-store sales increase last year. Reported EPS rose 45% to $0.69. That pushed FY99 results into the profit column for the first time ever after years of losses. FY99 sales jumped 32% to $107.9 million on 16% stronger comp-store sales. That led to EPS of $0.49 versus a year ago loss of $0.25 per share.

Results looked strong across the board, with gross margins improving to 39.5% from 39% and SG&A expenses dipping to 23.4% of sales from 25%. Noodle exited the quarter with $10.2 million in cash and virtually no debt. Inventories were up 25.3% but down 4% on a same-store basis.

Still, those earnings aren't taxed at all, due to $16 million in remaining net operating loss carryforwards (NOLs). On a fully taxed basis, Q4 EPS would have been $0.62 versus $0.43 last year, with FY99 results of $0.30 versus a loss of $0.16. So at $6 3/4, Noodle is valued at 22.5 times fully taxed trailing earnings. Figure the NOLs are worth $5.6 million in tax benefits and add that to the company's cash. Voila, you've accounted for $2 a share in value, effectively reducing the P/E to 15.8. Not bad for a company growing sales at twice that rate and earnings still faster.

Noodle plans to open 12 to 15 new stores this year, increasing its base by 29% to 36%. The two-analyst consensus puts FY 2000 earnings at $0.37 per share. Hambrecht & Quist, one of firms following the company, reiterated its "buy" rating and $12 price target last week.

Noodle is doing a good job working an attractive high-concept niche of the toy market. But that market has become fiercely competitive in recent years. Plus, Noodle's basic economics don't appear especially attractive at the moment. The company's fully taxed return on equity (ROE) was a measly 6.4% last year. Even backing out the balance sheet cash, ROE increases to just 9%.

Moreover, as a small-cap heading into three quarters of projected losses, Noodle's shares could suffer in the near term. Still, growing same-store sales and continued store expansion should allow Noodle to expand its margins still further. So this Noodle isn't quite to my taste, but it's worth watching, especially if the market roughs it up.

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