About Wet Seal & recent results
Wet Seal (WTSL, Financial) is a specialty retailer selling primarily through brick and mortar locations in the US. It targets female customers in the 13- to 34-year-old range, but its Wet Seal brand is more targeted at 13- to 23-year-olds. It had 478 Wet Seal stores located in 47 states and Puerto Rico at the end of the last quarter.
In 2Q14, sales were $121 million and same store comps were down 12.4%. Wet Seal stores had sales decline by 11.1% and Arden by 22.8%. Management’s guidance was for a decline of 8%-11% in sales on a same store comp basis. Positively, e-commerce increased by 11.4% for the whole company and 25% at Wet Seal. Pro forma EPS was a loss of $0.15 versus guidance of $.09 - $0.12. Margins were down by 560 bps in the quarter.
For 3Q14, management issued guidance for a pro forma EPS loss of $0.22 - $0.28 and same store comps are expected to decline in the mid-to-high teens.
Teen retailers are in a difficult environment
Source: WSJ
Abercrombie & Fitch (ANF, Financial), a teen apparel retailer, reported earnings on August 29, 2014. Comments indicated that sales trends were favoring cheaper brands that are less centered on logos. Wet Seal could benefit from this trend and the movement away from premium brands like Abercrombie and Hollister.
E-commerce growth, store closures
Currently, e-commerce represents just 7% of total company sales. This part of the business will become increasingly important, and management expects it to account for 10% in the near-term. Wet Seal is a bit late developing this portion of the business given the market has been shifting towards online for some time. However, it plans for 20%-30% of sales to come from e-commerce in the next 3-5 years.
Source: eMarketer, Forester Research
In November 2013, the company introduced the Demandware e-commerce platform, and it has seen improved mobile traffic and conversion rates compared to earlier periods. This likely is driving some of the increase and should continue to benefit Wet Seal through the rest of 2014.
In order to cut costs and shape the business around where consumers are shopping, it will also close some of its mall locations in favor of e-commerce but also off-mall stores. It believes off mall sales could account for 40% of its locations. Malls used to account for 92% of stores and currently 80%. Declines in mall traffic have negatively weighed on sales. Management’s move away from this part of the market is also positive.
Source: Bloomberg, Market Realist
Wet Seal Plus another vehicle for growth
In the second half of 2013, Wet Seal tested its Wet Seal Plus concept. It is a plus size store and brand extension. Initial results were positive in the 35 locations in which it was tested. The PSFs were $225, and the company has a goal of $270 PSF. It will have 31 locations in old Arden B stores starting out.
Closure and conversion of Arden B stores is positive
The Arden B brand was targeted at 21- to 35-year-old women and enjoyed limited success. It contributed 11% of total sales in the most recently reported quarter. The brand never hit critical mass with only 54 mall-based stores. Management decided to exit this business and close the stores by late July 2014. Instead of taking the loss, the company will temporarily convert these locations to Wet Seal Plus, 31 of the stores, or Wet Seal, 23 of the stores. However, long-term plans are to shut most of these locations down as leases expire. It will close 17 by the end of this fiscal year and another 9 in 2015. In addition, it will look into exiting the remaining 23 leases early that expire after 2015. Management estimates pre-tax savings of $1.3 million starting in 2Q14 associated with staff reductions and other cost savings related to exiting Arden B.
The savings associated with Arden B are meaningful for Wet Seal and exiting Arden allows the company to better focus on higher growth, higher margin options. Arden B had a sales decline of 19.4% in 1Q14 compared to a 16.9% company-wide decline. However, its loss was $4.6 million versus a loss of $8.4 million by the Wet Seal brand, which accounts for the other 89% of sales. Sales per square foot were down y/y to $68 per square foot versus $81. It was essentially a break-even business in better times. It either needed to be shut or substantial investment. Other areas are more attractive for investment, mainly e-commerce and its Wet Seal Plus concept.
Healthy balance sheet at Wet Seal positions it to manage challenges
Wet Seal’s strong balance sheet provides it an opportunity to position itself for the future while weathering the current storm. With sales shift away from malls, high competitive pressures and a muted growth outlook in the teen category. Wet Seal can look for growth elsewhere to drive future earnings. In addition, if new management can turn around the Wet Seal brand, it will have a good platform with healthy financials for growth through bolt-on acquisition and other ventures.
Wet Seal has $40.3 million in cash and short-term investments. In 2Q14, inventory per square foot, ex Arden B was down 7.9% from the same period in 2013.
Source: Company filings
Management change is big positive
Ed Thomas Returns as CEO
Previous management was not able to stop the bleeding at Wet Seal and changes were needed. Ed Thomas was announced as the new CEO of Wet Seal. Previously, he served in the same role from 2008 to 2010. While Thomas was CEO, the company had a mid-single digit operating margin, up around 200bp from the prior management team. He also successfully turned around the Arden B brand during his prior tenure from a loss to a positive contribution. Mr. Thomas pushed the off-mall strategy by Wet Seal although this slowed during prior management. His expertise in store placement/real estate strategies should help Wet Seal get its footprint right.
New CMO Should Impact 2015 Sales
On July 31, 2014, Wet Seal announced it hired apparel veteran Christine Lee as its Executive Vice President/Chief Merchandising Officer. Since 2010, she was a head of women’s apparel & accessories at Pacific Sun (PSUN, Financial) and turned that group around. Prior to that, she held various roles over 18 years at Urban Outfitters (URBN, Financial). In our view, the ability to attract quality management can help the companies merchandising initiatives further and help drive future growth.
Source: YCharts.com
Room for margin improvement
Margins at Wet Seal are down by 500+ bps from peak levels at the company (see below table). Management has adopted a strategy to recapture at least some of the lost margins. Right-sizing the expense structure and better merchandising can lead to improved margins. We estimate that a 300-500 bps improvement in gross margins would contribute $0.10-$0.20 in EPS in FY15. The closing of Arden B was a start, but it will also make changes within Wet Seal. First, it will try to increase with average dollar value of each transaction by some price increases and mixed improvement. For example, it now has a greater percent of its denim under the premium denim category. It also slightly increased prices early this year. Wet Seal has done this while it will still utilize promotions to drive traffic. Last, the mix shift will favor higher margin items. It will increase dress sales, which carry higher margins, in its stores to help facilitate this.
Source: Company Filings
Technical trading indicators are positive
A quick review of the primary technical indicators is negative for Wet Seal. The relative strength index (RSI) is at the upper end of its range and indicates momentum is positive. In addition, the MACD also shows that there is additional downside risk, although it that could be turning around.
Source: StockCharts.com
Conclusion
Wet Seal presents an interesting opportunity for investors. The downside risk is somewhat limited, and it is essentially an option on the new management team’s ability to turnaround the company and target an older customer base. If Wet Seal can return to profitability, we see upside to ~$1.50 per share based on 6-7x EBITDA. The track record of Mr. Thomas’s new growth initiatives with Wet Seal Plus and e-commerce, expectations of a margin recovery, and improvements in its end markets all resulting in a rebound in earnings. It’s a Hold.
