Slippery Times at Wet Seal

Hedge fund financiers are eating into the retailer's bottom line, while inventory issues have hurt sales.
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Wet Seal's

(WTSLA)

bottom-line gains are being gobbled up by its hedge fund financiers. With the retailer's first drop in monthly same-store sales since December 2004 coming this month, minority shareholders might be wondering if there will be anything left for them when the feast is over.

The hedge funds that financed Wet Seal's dramatic turnaround, Prentice Capital Management and SAC Capital, exercised a slew of convertible preferred stock holdings in the retailer during the first quarter. That, combined with the expensing of options for the company's management, its board and its high-priced merchandise consultant, mired an otherwise good quarter in red ink.

When the maze of charges on Wet Seal's books finally goes away, the mall-based teen-apparel chain could be an engine of profit growth if it can keep up its impressive sales. But the company warned analysts on its Monday conference call that it will post a same-store sales decline for May. If that's a sign that its impressive string of double-digit increases in monthly comps is over, this stock could lose its sizzle and leave minority shareholders burned.

Wet Seal said late Monday that its first-quarter loss widened to $13.7 million, or 22 cents a share, from $8.6 million, or 23 cents a share, a year earlier. Minus the interest and debt-related charges, the retailer earned $8 million, or 9 cents a share. The company's sales rose 20.5% for the quarter to $125.1 million, while its comps, or sales at stores open at least a year, jumped 20%.

Although Wet Seal said it expects comps to increase in the midsingle digits for the rest of 2006, it's forecasting a May decline in the high-single digits due to a lack of inventory in fashion tops and dresses at its namesake chain.

"What has been fueling this story is these endlessly positive double-digit sales comps," says Weeden & Co. analyst Kevin Starke, referring to Wet Seal's 44.7% gain in same-store sales for fiscal 2005. "Suddenly, they have an obvious execution issue that calls that whole framework into question."

Last year, shares of Wet Seal more than doubled as traders latched onto its huge monthly sales gains. The retailer's comps were bound to slow at some point, but the May inventory snafu raised concerns about whether the sales turnaround orchestrated by merchandiser Michael Gold will be sustained.

Gold, the owner of Toronto-based discount retailer YM Inc., is a part-time consultant to Wet Seal. He will be paid $2.8 million for that role this year, and $1.2 million next year. He's also getting two tranches of performance shares of 1.75 million each on top of 2 million shares of restricted stock that vested in January.

In the first quarter, Wet Seal recorded a $4.1 million non-cash charge related to Gold's stock compensation. Also, the company recorded $1.3 million in expenses for stock options and restricted stock grants to its board and employees.

For the full year, Wet Seal estimated charges related to "performance shares" will total $11 million, and charges for stock options and restricted stock will be $5.3 million. The charges may vary depending on fluctuations in the company's stock price.

Eric Beder, an analyst with Brean Murray, Carret & Co., estimates that the majority of Wet Seal's expenses for stock options this year will be the result to Gold's compensation package.

Meanwhile, the biggest charge weighing on Wet Seal's results came from the exercising of the company's convertible preferred stock grants that are a holdover from the financing arrangements made by SAC Capital in 2004. At the time, the hedge fund put up the money to keep Wet Seal afloat as it was reeling from massive sales and earnings declines.

Michael Zimmerman, who was involved in those financings, moved last year from SAC, where he managed the fund's retail portfolio, to form Prentice Capital Management. Along with its stake in Wet Seal, Prentice owns shares in

KB Toys

and

Movie Gallery

(MOVI)

.

During the first quarter, Wet Seal investors converted $22.5 million in convertible notes to 14.99 million shares of common stock. Wet Seal recorded a net interest expense of $18.2 million for the current-year period, mostly consisting of a writeoff on the notes, compared with $1.8 million for the year-ago period.

For all of 2005, Wet Seal recorded only $8.8 million in non-cash interest charges associated with conversions of its convertible notes. It ended the year with $12 million in liabilities on its balance sheet for secured convertible notes and $10 million for convertible preferred stock. At the end of the first quarter, it recorded $6 million in liabilities for secured convertible notes and $9 million for convertible preferred stock.

"If additional conversions of the convertible notes occur, the company would incur similar noncash charges in future periods," Wet Seal said in its press release. It declined to comment on the charges for this story.

Beder says Wet Seal issued $46 million in convertibles at face value that were almost immediately in the money as Wet Seal's stock began to rebound. Most of the issues, he says, are probably held by the hedge funds that participated in the financing.

"They're valued on the balance sheet at a small value of their face value," Beder says (he doesn't own shares of Wet Seal, and his firm doesn't have a banking relationship with the company). "So, when they get exercised, you have to eliminate the entire face amount. The difference between the value on the books and the face amount becomes interest expense on the income statement. That's what we're seeing this year."

Beder says the rest the expenses related to the convertibles likely will come this year, and the charges shouldn't be viewed as the result of any kind of accounting chicanery.

"In some respects, it's a legacy of when this company was nearing bankruptcy and they had to finance it to keep it going," Beder says. "They had some pieces of paper that are somewhat strange to most retailers, but you had to do at the time what you needed to do to survive."

Starke says that Wet Seal's charges make it a difficult company to value based on EPS measures and year-over-year comparisons. He views the retailer on a cash flow basis, where its performance looks strong. Its gross profit increased to $46.8 million for the quarter, up from $32.6 million in the prior year, and as a percentage of sales, it rose 600 basis points to 37.4%.

"Minority shareholders are getting milked by the majority shareholders and the management they put in place right now, and deservedly so," says Starke. "Without the people who financed the turnaround, and without Michael Gold around to lead it, there wouldn't have been a turnaround. From the get-go, there has been a sense that minority shareholders will benefit, regardless of the dilution, from the actions taken by SAC and Prentice and the people they put in place."

Starke does not own shares in Wet Seal, and his firm has no banking relationship with the retailer.

But when the charges finally go away, will Wet Seal still be a thriving retailer?

"It sure looks like it, and I have a lot of confidence in the management team," says Starke. "This company will be a lot easier to analyze when the converts are all converted, when all the warrants are exercised and when Michael Gold gets all of his shares."