Monday, January 22, 2007

Turnaround Time - Wet Seal

I've mentioned in the past that I liked Wet Seal (WTSLA), which operates both Wet Seal and Arden B stores, as a turnaround play. At the time I was considering them seriously, their valuation implied that the market was not projecting so strong a recovery in their earnings. Not long after, the company's stock moved from the high $5's to the mid-$7 range. It was then that I felt that I might have missed the boat.

Fast forward about a month, and we see that the shares have retreated. WTSLA is trading at $6.17 at the close of today's market. It is once again entering into what I consider an attractive price range. So, I decided I'd take another good look at it. And, in my digging for more information, I came across a 40 page valuation report on the company issued by Credit Suisse just a couple of weeks ago.

They present a strong case as to why Wet Seal should be worth $9 a share. They break down their DCF-based analysis very carefully. While their valuation model is indeed quite complex, it is welcome, as it takes into account the already complex capital structure of the company.

There are a few key takeaways from the report that I will list here. CSFB believes that a 14% growth rate in square footage can be achieved (stores are far from saturation), which will drive the top line. Couple this top-line growth with operating margins that they believe can improve to roughly 8% by 2008, and you get much stronger earnings growth. They are forecasting a 3-5 year 20% operating income growth rate. Note that the 8% operating margin would put Wet Seal well below its average peer which is sporting a 12% margin.

Analysts at CSFB also mention that the management team is more or less complete at this point. Top positions have been filled with strong industry leaders, and many of them have received good guidance from a strong retail consultant that the company hired to aid in the turnaround. The key risk, as with any teen retailer, is the ability to keep up with fickle teen fashion trends. There's always near-term earnings risk with any turnaround play, as well.

In any case, I will be purchasing some shares of the company on any continued price weakness.

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