Stitches Come Apart at Chico's

The clothing retailer's aggressive growth plan has ripped into sales at its namesake chain.
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A number of apparel retailers have blamed recent sales weakness on a major shift in fashion that's taking place these days, but that excuse doesn't fly at

Chico's

(CHS) - Get Report

.

The once red-hot women's clothing chain operator warned late Wednesday that August is shaping up to be its first month in nine years to have negative same-store sales figures. Moreover, the company cautioned of a continued slowdown and lowered its sales and profit forecast for the rest of this year and 2007.

The outlook prompted investors to flee the stock, which recently was trading down $6.06, or 25%, at $18.02.

With Wall Street fretting about a broad deceleration in consumer spending as the housing market cools, Chico's inevitable slowdown, which caps an extraordinary growth streak that made it the envy of the retail industry, comes at an especially inopportune time.

Growth is slowing at Chico's core namesake brand, which caters to baby boomer women, and the company's heavy investment into its other brands is eating into profit margins. Meanwhile, the retailer is suddenly losing market share to competitors, and recent merchandising missteps didn't help.

"Fashions don't change that much for the Chico's customer, because they're older, they know what they like and they have bodily constraints that younger women don't have," says Pacific Growth Equities analyst Christine Chen.

"The biggest reason for the shortfall at the Chico's brand in August is that they converted to their fall product line too early. As has been the case for a lot of retailers that have had merchandising issues this year, they were trying to get out of the stuff that isn't working and move on to fall. At this point, the strategy looks unsuccessful."

Chico's said it expects same-store sales, a key retail metric gauging sales at stores open for at least a year, to decline 3% in August. At the Chico's stores, the company expects to record a 6% drop in same-store sales for the month.

"August was a disappointment to all of us," said Scott Edmonds, Chico's CEO, on a conference call with investors Thursday morning. He said the Chico's chain disappointed customers by rolling out cooler-weather products, like sweaters, in the sweltering heat of August. He also called the company's recent promotions "too dark and uninspiring at best."

In the back half of the year and in 2007, the company expects its same-store sales to be flat or show a low-single-digit increase -- a marked slowdown from its recent highflying days of double-digit growth. And while the company posted a 10% increase in second-quarter net income Wednesday, matching Wall Street's expectations, its forecast was a big disappointment.

The company now expects to earn 26 to 28 cents a share for the current quarter, below Wall Street's current estimate of 32 cents a share. For the fourth quarter, Chico's projects earnings of 25 to 27 cents a share. Analysts had forecast earnings of 30 cents a share. This lowered expectations come after the retailer had already ratcheted back its outlook when it reported first-quarter results.

"I'm concerned about the core Chico's business," says Chen, and she's not alone. Friedman Billings Ramsey analyst Adrienne Tennant downgraded the retailer's shares Thursday to underperform from market perform, citing concerns that more disappointments are in store.

"We believe that the comp trends at the core business could remain negative for a longer period of time than expected," Tennant said in a report. UBS, D.A. Davidson and Bank of America also downgraded the stock.

The pessimism comes at a time when consumer-spending concerns have taken center stage on Wall Street. Traditionally, Chico's higher-income customer base has been viewed as being insulated from macroeconomic trends to some degree, but as the company has grown, that assumption has been questioned.

"By expanding further into suburban communities around the country, Chico's has tapped into a more middle-income consumer, and that customer could be pulling back her spending habits now," says Chen.

Meanwhile, other companies targeting female boomers appear to be taking advantage of Chico's stumbles. Last week,

Ann Taylor

(ANN)

blew away Wall Street's estimates with its second-quarter earnings and full-year profit outlook. And shares of

Coldwater Creek

(CWTR)

recently were up 7.2% after it reported a doubling of second-quarter earnings and raised its full-year projections.

Retailers like

Talbots

(TLB)

and

Gap's

(GPS) - Get Report

new Forth & Towne chain also have their sights set on Chico's customers.

For its part, Chico's is staking its future on aggressively growing its new concepts, with hopes that they'll pick up the slack as its core brand approaches the saturation point. Its growth plan is stretching inventories and weighing down profit margins, but the company maintains that short-term pain eventually will translate into long-term gain.

"In light of the success our flagship brand has enjoyed over the past several years, our expansion and rapid growth have yielded some issues for us," said Chico's in a press release. "However, the Chico's brand continues to be a powerful franchise and our board of directors is firmly committed to investing for the future. We believe we can continue to be the premier retailer in our category and we are confident in the rationale behind our store opening programs and other initiatives, all of which are easily managed by the strength of our balance sheet."

The retailer is focused on building out its White House|Black Market concept, its fledgling Soma chain and its new Fitigues business. All three show promise. For the second quarter, the Chico's brand posted a same-store sales increase of 3%, while White House|Black Market brand recorded a 19% gain.

The company plans to open 76 to 80 new stores in the third quarter, which is the most stores it has ever opened in a quarter. As a result, its inventories are growing faster than sales, which increases the level of risk for the company, especially with consumers getting defensive.

"The concern is that the margin compression resulting from the new store growth is weighing down investment returns for the overall model," says Tennant. "The growth plans may pay off in the future, but that remains to be seen. In the near-term, it's a recipe for pain."