Investing in Le Chateau - Earnings Power or Book Value

A few years ago, I invested in Le Chateau, a well-known Canadian apparel retailer, for about $9.75/share.  Seven or eight months later, after pocketing three dividend payments totaling about $0.50, I sold the shares for better than $14.00, and gave himself a hearty, self-satisfied pat on the back.  After all, 50% or so gain in eight months is an annualized gain of about 75%.  Not bad.  Not bad at all. 

But the investment was a mistake, since it was made on the assumption that the business would grow slowly, but steadily, for at least several years in the future.  At worst, I believed, the company would be able to maintain the level of profitability that it had established, then north of $1.00 EPS.  Return on equity was over 20% and a large portion of earnings were consistently being paid out as a dividend, so the downside seemed limited.

Founded in 1959, Le Chateau has grown carefully and at a manageable pace.  While the barriers to entry in apparel retailing are low, the company operates over 200 stores and has a reliable presence in all of Canada's significant cities, usually in malls.  With sales in excess of $300 million, Le Chateau enjoys the scale to advertize in a major way, keeping the company's brand in customers' minds.  Unlike most of its clothes-peddling competitors, the company designs, develops and manufactures (some of) its merchandise, giving it flexibility and shorter lead times, a valuable asset in the fast-changing world of fashion. 

Profits peaked, however, in fiscal 2009.  EPS was $1.55, which slipped to $1.22 in 2010 and $0.79 in 2011.  Unfortunately, in 2012, the company lost $0.10 per share.  Most companies stumble at some point, though, and one bad year should not be fatal.  However, the balance sheet is more concerning than the income statement: indeed, liquidity has become a major threat to the company.  A year ago, the company had $48 million in cash and investments, compared to $36 million in debt.  At present, cash and investments have fallen to just over $7 million, while debt has grown to $46 million.  The kamikaze-like stock has plummeted, recently trading at 1.53.  In market parlance, the stock is "discounting" bankruptcy. 

In fiscal 2011, the company increased access to liquidity in moderate amounts.  Fortunately, the company was recently thrown a lifeline.  In late April, it signed a credit agreement with GE Capital Canada on a 3-year, $70 million revolving credit facility.  This gives Le Chateau time and capital to attempt a turnaround.  As the stock flirts with penny territory, is it time to buy? 

Warren Buffett would likely say no.  In the past, he's remained faithful to companies and their managers through periods of sub-par performance, but he would likely conclude that Le Chateau doesn't enjoy the unbridgeable "moat" that he requires.  With few barriers to entry, apparel retailing is intensely competitive.  While clothiers have the ability to create a unique product and brand to differentiate their threads from all the rest, it's difficult to do so.  One indicator of future performance is past performance.  The company has grown steadily over decades, but the trend over the past few years has been downward.  For an investor that prefers the unchanging businesses of Coke, railroads and wallboard, the dynamic world of fashion is too unpredictable.

Ben Graham, on the other hand, might have been intrigued.  Graham looked for companies trading at a discount to tangible book value, and was particularly fond of the "net-net," or a company trading for less than working capital minus debt.  Le Chateau doesn't quite meet the second, more elevated, criteria, but it trades for a mere fraction of book value.  Indeed, tangible shareholders equity currently stands at $138 million, or $5.59/share, nearly four times the share price.  The $234 million of assets are almost entirely inventory ($119 million) and property and equipment ($96 million). 

Some balance-sheet oriented investors consider book value as more of a theoretical yardstick for measuring a company's worth, while others take it more literally.  This latter group of fundamentalists appraise what a company is worth "dead, not alive," knowing that it may indeed be liquidated at some point.  For investors worried about the company's future as a going concern, what's a reasonable estimate of the present breakup value?

The liabilities, alas, are rock-solid.  What of the assets?  While inventory is accounted for at the lower of cost or net realizable value, the second benchmark is only an estimate: the company was forced to write down the value of inventory in each of the past two years, and may yet have to write down more to sell it.  Only time will tell what it's actually worth.

The property and equipment consists mostly of leasehold improvements, furniture and fixtures.  It's impossible to tell what they would fetch in a fire sale, but it would be wise to assume a number far smaller than what they're being carried for.  This is not to suggest in any way that assets are being accounted for aggressively, but it's difficult to tear fixtures out of a store built specifically for a particular company and receive full value for them.

Some investors are attracted to a discount-to-book-value style of investing because they view it as easy.  After all, one only has to compare book value to market value, which allows for hassle-free, computer-based screening.  Certainly, there are cases where a company is sitting on valuable real estate that's not needed for its operations, or has set up shop in a ritzy building that could be monetized in a sale-leaseback.

But this method of investing is not always so straightforward in practice.  With few exceptions - Peter Cundill and the late Walter Schloss, to name two - today's value investors use Buffett's more expansive, earnings-based definition of "intrinsic value," rather than Graham's asset-based conception of value.  The "margin of safety," buying at a discount from value, is timeless, but in most cases "value" lies in the earnings power of a business, not the assets.

Conclusion

The future of Le Chateau is unclear.  If it returns to even half its former level of profitability, the stock will appreciate handsomely.  Indeed, at EPS of 0.60-0.75, the company currently trades at a mere 2x future earnings.  If it fully reclaimed its former glory, just the dividend would pay out that amount every year. 

2012 will be about reducing inventory, cutting costs and correcting fashion mistakes.  Year end inventory was 39% of sales in 2012, compared to 29% in 2011 and 18% in 2010.  The company intends to bring this proportion down to more normal historical levels, which will require margin-squeezing markdowns.  On the plus side, the rise in inventory explains most of the company's rising debt, but as inventory falls, debt is expected to decrease, too.  Le Chateau's capital expenditures will fall to $6.5-8.0 in 2012, far less than the $20-25 million of recent years, and depreciation and amortization will likely be around $20 million in 2012.  If the company posts modest losses on a net income basis in 2012, it should at least be cash flow positive.

Le Chateau's long-term performance has been impressive, the short-term has not.  It's unsettling how quickly the company's recent short stumble left them desperate for liquidity.  Would-be investors in Le Chateau must invest in the company with the expectation that it can turn things around, and cannot depend on liquidation value as a backup.  First, it's not easy to arrive at.  Second, whatever it's worth today, it would surely diminish if the company continues to struggle.  The best approach for investors is to find businesses with durable competitive advantages whose future earnings can be roughly predicted.

Disclosure: The author did not have any position in Le Chateau at the time the article was published.

Sources: The company's most recent MD&A, Financial Statements and Annual Information Form, which can be found at sedar.com

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