The Children's Place May Be Too Big for Its Britches

Two short-sellers say numbers in the clothing retailer's otherwise glowing earnings report foretell of hard times to come.
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The Children's Place

(PLCE) - Get Report

, a clothing retailer for kids, has shown it can multiply profits.

But now two short-sellers say the numbers don't add up. They point to red flags in the company's financial data that they say raise questions about the quality of those earnings. They also question the abrupt cancellation of an advertising campaign that was set to launch this fall and was much ballyhooed by Children's Place executives.

Children's Place says the questions have no merit. And for now, the company looks like it's doing

plenty right. It sells miniature-adult styles for tykes, a departure from the path competitors like

Gymboree

(GYMB)

have chosen. And Children's Place's strategy is the one kids and parents like.

But questions have dogged the Secaucus, N.J.-based company since its early days, thanks in part to its chief executive's past.

CEO Ezra Dabah's father founded

Gitano

, a clothing manufacturer that filed for bankruptcy and was liquidated in 1994 amid allegations that the company misstated aspects of its financial condition. Ezra Dabah was in charge of design and merchandising during his 20-year stint with the firm. His brothers, Haim and Issac, pled guilty to violating U.S. customs laws when they falsely reported the country of origin of $2.7 million worth of Gitano blouses.

In 1989, Ezra Dabah and some members of his family bought Children's Place. Dabah became CEO in 1991.

Shortly after its 1997 IPO, Children's Place missed analysts' earnings estimates, and investors crushed the stock. A shareholder lawsuit followed.

But since then, the fortunes of the 261-unit retailer have improved. In the second quarter ended July 31, the company earned $1.4 million, or 5 cents a share, compared with a loss of $500,000, or 2 cents a share, a year earlier. Total sales climbed 54% to $73.9 million, while the all-important sales at stores open at least one year jumped 19%.

The stock has followed, climbing 109% for 1999 through July 15, when it hit 52 9/16, though it recently has been hit like all retailers by interest-rate concerns. Monday it jumped 5 1/16 to 39 1/16.

Nevertheless, the short-sellers say the recent financial data point to some curious trends. They wonder why investments in property, plant and equipment climbed to $70.9 million in the fiscal second quarter, from $55.4 million in the fiscal first quarter ended May 1. But during the same period, depreciation declined to $2.9 million from $3.3 million. Since depreciation is a noncash charge that records the aging of assets, it typically grows when assets increase.

The short-sellers also point to decreasing inventory turns, the cost of goods sold divided by inventory, that can signal a company is having trouble selling all of its goods. "It tells you there's something rotten in the woodshed that will eventually have to

be sold at lower gross margins than the company's average," says one of the short-sellers, who specializes in retail firms and asked to remain anonymous.

Another measure, inventory yield (gross profit divided by inventory), also has been flashing red on short-sellers' radar screens. In many cases, a declining inventory yield can foretell declining profits, because it means that the company's return on its inventory is decreasing. Put another way, it requires larger quantities of merchandise to generate the same profits.

Seth Udasin, Children's Place's chief financial officer, chalks up the disconnect between property, plant and equipment and depreciation to the timing of its opening of a distribution center and office building, which became operational at the quarter's end. Investments in the facility were recorded in the period, but depreciation won't show up until the fiscal third quarter, he says. Also, the company has been refurbishing stores, which requires removing old fixtures and replacing them with new ones. So, depreciation on the old fixtures was increased in past quarters so they could be written down to zero when they were replaced, Udasin says. This inflated depreciation in the fiscal first quarter.

He says declining inventory turns are the result of a strategy begun last July to push merchandise into stores more smoothly. The plan requires the company to hold the pint-sized shirts, pants and sweaters at its distribution center for a longer period before shipping to stores to ensure that color-coordinated ensembles arrive in sync. As the company passes the anniversaries of these changes, inventory turns should stabilize, he adds.

As for inventory yield, Udasin says he doesn't track the measure.

Also striking the shorts as odd was the cancellation of an advertising campaign that Children's Place executives had talked up recently, including during a conference last spring. "Our vision is to have a place in everyone's mind," Dabah said in interview earlier this year. "To do that, we'll begin marketing extensively this fall."

The

Della Femina/Jeary & Partners

agency had developed a test campaign last spring and was given the go-ahead to create TV commercials for fall, says Michael Jeary, a partner. Then, abruptly, after paying Della Femina roughly $2 million (of the planned $6 million) to cover creative costs, Children's Place ended the relationship, citing creative differences.

Short-sellers figure Children's Place canceled the campaign to save money. Says Udasin, "We didn't cancel this for the sake of saving money. That is a big lie."

The short-seller says the proof will ultimately be in the numbers. "I've done 500 models, mostly in the retail sector," he says. "The correlation between numerical issues and stock under-performance is very high."