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Wet Seal (WTSLA) is not my kind of stock

January 16, 2011 | About:
I was looking through this spreadsheet where I track the valuations of several retailers. Since I use a Google spreadsheet to track the data, the stock prices, EPS and P/E are automatically updated.

Two of my current holdings, GameStop (GME) and Aeropostale (ARO) showed up on the list and they continue to remain very cheap with TTM P/E of 8.5 and 10 respectively. I also noted that BestBuy (BBY) seemed quite attractive at 10.7x P/E ( after a sharp fall in price after recent earnings).

I found a new name Wet Seal Inc (WTSLA) trading at 4.4x TTM P/E. I was quite intrigued and decided to take a look to see if it was worth doing detailed research. After about 5 minutes I had made up my mind to give it as pass.

Wet Seal operates two nationwide, primarily mall-based, chains of retail stores under the names “Wet Seal” and “Arden B”. Wet Seal is a junior apparel brand for teenage girls who seek trend-focused and value-competitive clothing, with a target customer age of 13 to 19 years old. Wet Seal seeks to provide its customer base with a balance of affordably priced, fashionable and basic apparel and accessories. Arden B is a fashion brand at value price points for the feminine contemporary woman with sex appeal. Arden B targets customers aged 25 to 35 years old and seeks to deliver contemporary collections of fashion and basic separates and accessories for various aspects of the customers’ lifestyles.

The recent stock price was $3.76 with a market cap of 376 million. TTM Sales were $566 million and net income of $88 million.

Here are some of the reasons I passed on Wet Seal.

1) No sales increase over a decade: Sales in 2001 were $580 million. Sales in 2010 were $561 million. In the years from 2001 to 2010, sales see-sawed and are actually lower than the sales in 2001.

2) Inconsistent history of profitability: 4 years of losses from 2004 – 2007.

3) Heavy dilution of shareholders: Shares outstanding went from 25 million in 2006 to 70 million in 2007 to 100 million in 2008.

4) Low Op margins in the low single digits.

5) FCF much lower than net income: Earnings increased by 200% in 2010 from $30 million to $90 million but FCF went in the opposite direction and decreased by 31% from $35 million to $19 million.

That said, Wet Seal has about $140 million in excess cash out of a market cap of $376 million. Every single metric says the stock is cheap when looked at TTM numbers. (EV/EBIT = 7, EV / FCF = 7.7, P/E = 4.4, P/B = 1.4, EV / Sales = 0.4). Some investors undoubtedly would consider it as a candidate for a turnaround. With such a cheaply valued stock, if there is improvement in terms of sales and operating margins, the stock could see significant upside.

However, given a choice I always prefer investing in a company that has consistently been able to increase sales, profitability and cashflows and YET trades at a cheap multiple. Aeropostale and Gamestop are two such companies. You can check the analysis I posted on Aeropostale here. Part 1 | Part 2

No thanks Wet Seal.

Disclosure: I have a long position in Aeropostale and Gamestop at the time of writing this post.

Update:

After I posted the original article, I was intrigued to know how come the EPS went from 30 cents to 90 cents from fiscal 2008 to fiscal 2009. I found that the EPS number was a misleading number.

If you looked at Q4 earnings release ( http://ir.wetsealinc.com/releasedetail.cfm?ReleaseID=454791) , you will find the following relevant line.

“Net income, including a non-cash tax benefit to reverse a deferred tax valuation allowance of $71.3 million, was $80.8 million, or $0.79 per diluted share, as compared to $4.3 million, or $0.04 per diluted share, in the prior year quarter. Excluding the tax benefit and $0.5 million in asset impairment charges, net income was $10.0 million, or $0.10 per diluted share, in the fourth quarter of fiscal 2009″.

“Net income was $93.4 million, or $0.92 per diluted share, as compared to $30.2 million, or $0.30 per diluted share, in fiscal 2008. Fiscal 2009 net income, excluding the $71.3 million tax benefit mentioned above, the $1.2 million of additional net sales from change in estimated breakage and the $2.3 million of non-cash asset impairment charges, was $23.2 million, or $0.23 per diluted share. ”

So, really the company earned 23 cents in Fiscal 2009 and not 92 cents. If you then replace the earnings of the three quarters of Fiscal 2010 for 2009, the EPS is 19 cents on a trailing 12 month basis. Using current stock price of $3.76, we get a P/E = 3.76 / 0.19 = 20!!

I understand the company has a lot of cash and if you subtract the cash, the P/E would be 12.5. ( Not sure if you can take out all the cash as a lot of it is needed for working capital).

This is one reason it makes sense to look at the Operating Income or EBIT number. This number excludes the effect (positive or negative) of taxes and interest. Some times, special charges can throw off the EPS and net Income. Investors then relying on the P/E ratio without further research can make mistakes. I always look at multiple valuation criteria such as EV / EBIT, EV / FCF, P/E , EV / Sales and P/B.

About the author:

Adib Motiwala
Adib Motiwala is a Portfolio Manager at Motiwala Capital LLC, an investment management firm that manages separate accounts for its clients.

Visit Adib Motiwala's Website


Rating: 3.4/5 (10 votes)

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