Does Chico's Deserve a Spot in Your Portfolio?

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In a recent post, I began the search for a solid retail company to add to my portfolio by focusing on stocks with "cheap" valuations.  There was clearly downside to each company identified, and none of them fit the Motley Fool mantra advising investors to "buy great businesses."  Today, this search continues with a look at a number of specialty retailers that focus primarily on women's apparel, including Chico's FAS (NYSE: CHS), Lululemon Athletica (NASDAQ: LULU), Ann (NYSE: ANN) and Limited Brands (NYSE: LTD).  Here's a high-level comparison of each company's current financial profile:

<table> <tbody> <tr> <td> </td> <td><strong>CHS</strong></td> <td><strong>LULU</strong></td> <td><strong>ANN</strong></td> <td><strong>LTD</strong></td> </tr> <tr> <td>CAPS Rating</td> <td>3 stars</td> <td>2 stars</td> <td>1 star</td> <td>3 stars</td> </tr> <tr> <td>Share Price</td> <td>$18.28</td> <td>$72.98</td> <td>$36.36</td> <td>$48.69</td> </tr> <tr> <td>Market Cap (in billions)</td> <td>$3.04</td> <td>$10.60</td> <td>$1.69</td> <td>$14.04</td> </tr> <tr> <td>1 Year Stock Performance</td> <td>52.8%</td> <td>38.0%</td> <td>50.1%</td> <td>17.5%</td> </tr> <tr> <td>5 Year Stock Performance</td> <td>29.1%</td> <td>238.9%</td> <td>4.6%</td> <td>120.7%</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>TTM Revenues (in billions)</td> <td>$2.4</td> <td>$1.2</td> <td>$2.3</td> <td>$10.2</td> </tr> <tr> <td>TTM Price / Sales</td> <td>1.25</td> <td>8.98</td> <td>0.73</td> <td>1.37</td> </tr> <tr> <td>TTM Operating Margin</td> <td>10.9%</td> <td>27.3%</td> <td>7.1%</td> <td>15.4% </td> </tr> <tr> <td>TTM Price / Earnings</td> <td>19.62</td> <td>49.21</td> <td>19.53</td> <td>20.44 </td> </tr> <tr> <td>Forward Price / Earnings</td> <td>14.94</td> <td>32.74</td> <td>14.08</td> <td>14.99 </td> </tr> <tr> <td>PEG Ratio</td> <td>1.18</td> <td>1.44</td> <td>1.45</td> <td>1.38 </td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Dividend Yield</td> <td>1.1%</td> <td>0.0%</td> <td>0.0%</td> <td>4.0%* </td> </tr> <tr> <td>TTM Payout Ratio</td> <td>21%</td> <td>0%</td> <td>0%</td> <td>123%* </td> </tr> <tr> <td>TTM Free Cash Flow Yield</td> <td>6.7%</td> <td>1.8%</td> <td>-6.9%</td> <td>4.7% </td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Price / Book Ratio</td> <td>2.8</td> <td>14.6</td> <td>4.5</td> <td>N/A**</td> </tr> <tr> <td>Debt / Equity Ratio</td> <td>0.0</td> <td>0.0</td> <td>0.0</td> <td>N/A**</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td colspan="5">* Includes the effects of a $1.00 special dividend paid in August 2012</td> </tr> <tr> <td colspan="5">** LTD has approximately $4.5 billion in debt and negative shareholder's equity</td> </tr> <tr> <td colspan="5">Source: Yahoo! Finance 10/11/12    </td> </tr> </tbody> </table>

A Rocket Stock

Of the four companies, Lululemon has received the most attention in recent years as 50%+ annual growth has rocketed the stock past its peers.  However, that growth is expected to begin to slow, with analysts expecting growth of 28% per year over the next five years; that figure is still impressive, but the current valuation seems to expect even more growth than that.  It is certainly possible Lululemon will continue to grow at a rate to justify the current price, but the current valuation (whether it be P/E, FCF yield, P/S, P/B, etc.) creates a healthy amount of risk if there's even the slightest blip on the company's growth trajectory.  This risk may be magnified as competitors, particularly Under Armour and Gap's (NYSE: GPS) Athleta and Gap Fit brands, begin to focus more on Lululemon's target market.

Slow and Steady Wins the Race

A clear contender for my portfolio jumps out in the table above based on its balanced combination of growth, stability and reasonable valuation.  It may not be obvious at first glance, but Chico's has a lot of what I look for in stocks.  First, the free cash flow yield of almost 7% is an attractive figure, since it indicates that the company can afford to pay a sizable dividend based on its stream of positive cash flows.  Chico's began paying a dividend in 2010 and has increased the payout in each of the past two years, but with a payout ratio of just 21% there is plenty of room to grow the dividend going forward.  Second, the company has no debt and has managed to finance its growth using cash on hand (more on this later).  Third, Chico's still has room to grow based on analysts' 15% annual growth forecast for the next five years; 15% is well short of Lululemon's 28% target, but it creates a compelling risk/reward proposition with a PEG ratio of less than 1.2.

Beyond the Numbers

Chico's may look good by the numbers, but there is always more to the story of a business than you'll find on a balance sheet or income statement.  Chico's runs over 1,200 retail locations under its namesake Chico's brand, White House Black Market and Soma franchises.  Additionally, Chico's acquired catalog and online retailer Boston Proper in 2011.  This acquisition was financed completely by cash on hand (rather than issuance of debt or dilution of shareholders); Chico's has $358 million in cash and short term investments and no debt as of the most recent quarterly report, indicating that the company can continue to finance growth (both organic and through acquisitions) in this manner.

In addition to acquisitions, Chico's has grown same store sales by 8% in each of the past three years.  As noted in an analyst day presentation in March by Pam Knous, Chico's CFO,  this growth combined with a reduction in SG&A expenses as a percentage of revenues has driven substantial free cash flow growth.  In addition to funding the dividend and acquisition of Boston Proper, this free cash flow has also allowed Chico's to re-purchase $200 million in shares from 2009-2011; in the most recent four quarters, Chico's has re-purchased 9 million shares at a total cost of $110.6 million, which clearly took advantage of Chico's depressed stock price earlier in the year and is an excellent method of returning value to shareholders.

More importantly, management has a plan to continue to grow each of its brands whether it be through store expansion, expanded online presence, marketing or other initiatives in the future.  Based on the recent track record, there's no reason to believe that management will fail to execute its growth plan.

Is Chico's a Buy Today?

Admittedly, this question would have been far more useful to address last November when the share price dropped into the single digits.  At the time, there were very real concerns about competitive pressures (from companies like Gap and Ann) and the impact on margins.  Additionally, the general market sentiment was bearish as exemplified in this article.  Has the competition gone away? Certainly not.  However, analysts currently expect a strong holiday season to result in Q4 EPS of $0.20 per share, which is up 33% from last year's $0.15.  Sales volumes and margins will continue to dictate whether Chico's meets these targets or not.  

This gets us back to the ultimate question.  Are Chico's shares a buy TODAY?  The company has been successful in the challenging environment over the past few years, has a pristine balance sheet and solid financial discipline.  As this relates to the current valuation, the company's share price appears reasonable even near its 52-week high based on most traditional valuation metrics.  Based on the reasonable valuation, there appears to be no reason to believe the company will fail to compete successfully and will therefore be able to generate returns for shareholders on par with the broader market.  However, even with 15% expected growth in upcoming years, there doesn't appear to be a known catalyst that will cause Chico's to generate significant market-beating returns in the near future.  As a result, those looking for a rule breaking stock that will crush the market will likely find that Chico's falls short with its "slow and steady" march forward.

BrewCrewFool has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Lululemon Athletica. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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