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Wednesday, May 12, 1999

FOOL ON THE HILL
An Investment Opinion
by Louis Corrigan

Claire's a Clear Gen Y Winner

Did you know when The Spice Girls' popularity began to wane and merchandise covered with butterflies started flying off the shelves? I didn't, but the folks at teen retailer Claire's Stores (NYSE: CLE) did. They were prepared for it. Such merchandising smarts, and the sourcing relationships and distribution system needed to respond quickly to such changing tastes, have helped Claire's deftly negotiate a notoriously faddish part of the fashion industry where Jennifer Aniston necklaces become must-haves one month and obsolete trinkets the next.

What's ironic is that the catalog firm Delia's (Nasdaq: DLIA), with its newly public iTurf (Nasdaq: TURF) online subsidiary, has seduced investors into believing that it's the leading marketer to Gen Y, the baby boomer's baby boom. Yet, the understated Claire's has five times the sales of Delia's, making it one of the companies actually delivering the goods to this bulging market niche, and in highly profitable fashion. Indeed, Claire's has a long history of turning costume jewelry, hair bands, and other accessories only a pubescent girl could love into a high return on equity business. (That's why it was my top pick in the teen retailing sector in the Fool's 1999 Industry Focus.) And after a surprisingly strong fourth quarter that helped the stock recover from a brief funk, Claire's should report terrific Q1 results tomorrow.

The company operates 2,082 stores, mainly in the U.S. It did, however, acquire the 53-store Zurich-based Bijoux One chain of fashion accessory stores last November as a base to expand its European operations beyond the U.K., where it runs the Bow Bangles chain. The company crams 7,000 items priced at $2 to $20 into compact mall-based stores called Claire's Boutiques or Claire's Accessories (average size 960 square feet), or its slightly larger stores operating as The Icing or Claire's Etc. (average size 1,375 square feet). Two years ago, the company furthered its controlled expansion into apparel by acquiring Mr. Rags, a U.S. chain selling "skater/urban fashion" apparel and accessories, mainly to male teens.

Part of what I like about Claire's is that management, led by octogenarian Chair/CEO Rowland Schaefer and his daughters Marla and Bonnie (both Vice Chair), takes a cautious approach with new initiatives, experimenting but insisting on economic returns. The stock dipped last fall following news that spending on its newly launched Just Nikki:) catalog wasn't translating into expected sales, forcing Q3 earnings to come in below expectations. By January, the company had decided to shut down the operations, recording a pre-tax loss of $4.8 million, or six cents per share, to write-down the investment. The catalog just didn't produce the required return on investment.

Such discipline has produced exceedingly cool numbers. For FY99, ended this past January, sales rose 23.3% to $662 million (excluding $14.7 million in sales generated by the shuttered catalog). Income from continuing operations increased 20.2% to $72 million (or, excluding the one-time loss, around $75 million, up 25.3%). EPS excluding the one-time charge increased 28.1% to $1.46 per share. Sales over the last four years have grown at a compound annual rate of 20.1% while earnings per share have increased at a 30.7% annual pace. Return on equity has increased steadily over this period to 26.1% last year as net margins rose to nearly 11.3% last year (excluding the one-time loss). That's despite the fact that lower-margin apparel and non-jewelry accessories have risen in the sales mix, as this table shows.


FY99 FY98 FY97
Jewelry 43.5% 45.1% 50.1%
Accessories 47.5% 47.8% 43.9%
Apparel 9.0% 7.1% 6.0%

Indeed, gross margins have remained virtually unchanged at 51.8% over the last three years, despite this unfavorable mix shift. Claire's has simply managed to squeeze out cost-savings from suppliers and from tight inventory management while spreading its occupancy costs over increasing sales per store. Comp-store sales increased 10% in FY97, 3% in FY98, and 7% in FY99. Meanwhile, selling, general and administrative expenses have declined as a percent of soaring sales from 33.1% in FY97 to 32.1% in FY98 to 31.5% last year.

Same-store sales have been particularly strong of late, after some weakness a year ago. Although analysts were expecting the retailer to earn just $0.63 per share in the fourth quarter, EPS excluding the charge came in at $0.72. Sales shot up 29% on the strength of dynamic 12% comp-store growth. The number of transactions per store increased 5.5% in Q4 even as the average dollar amount per transaction rose 5.4%.

And the good news keeps coming. Last week, the company announced that April sales strutted ahead 20% on 5% same-store sales growth. Due to the earlier Easter this year, investors should probably look at March and April together. Sales for this two-month period soared 30% on a 15% increase in same-store sales. Full Q1 revenues jumped 30% to $170.5 million on a 13% increase in same-store sales. On the year-end conference call held February 18, CFO Ira Kaplan had said inventories per square foot would rise by 3% to 4% to meet expectations of a 5% increase in same-store sales for the spring and 3% for the fall.

Noting that Q1 results were running ahead of plan, analysts have boosted their earnings estimates to $0.24 per share, up from $0.20 a year ago. The consensus is that earnings for FY2000 (ending in January) will rise 14% to $1.67 per share ($1.70 high-side estimate). With apparel an increasing part of the sales mix, the company has said gross margins could decline by 100 basis points this year, eating into some of the benefit of the rising comps.

Still, Claire's continues to expand. After adding 302 stores last year, it plans to open at least 240 more stores this year for a 12% increase in retail square footage. The 99-store Mr. Rags chain alone could add 50 to 75 new stores this year on the way to 400. Yet, this is controlled expansion. No additions to the newly acquired Bijoux One are planned during FY2000 because the company wants to train Bijoux employees in Claire's best practices, improve the stores' product mix, and link these stores to the Claire's U.K. inventory system.

Claire's also has $153 million, or $3 a share, in cash and no debt. It's looking to do accretive acquisitions. Last summer, the company acquired a million shares (11.8%) of Gadzooks (Nasdaq: GADZ), a more fashion-forward, 316-store teen retailer that ran into inventory troubles last year. Its baggy jeans and other trendy merchandise just couldn't compete against the Gap (NYSE: GPS) basics juggernaut. Gadzooks resisted advances by Claire's management, and Chair Rowland Schaefer has said Claire's wants a friendly deal. Gadzooks' board recently booted president and COO David Mangini after bringing in two new top managers in January. So this firm doesn't yet look prepared to deal with the Schaefers. Still, Gadzooks would be a good fit for Claire's, which could probably hasten its turnaround.

Even though Claire's stock price has doubled in the last six months to $31 1/2, it still trades for just 19 times projected earnings, or 18 times if you figure earnings might hit $1.75 per share, up 20% for the year. Though not the bargain it was last fall, Claire's arguably should trade at a premium to its growth since management has proven it can deliver consistent, and increasingly profitable, results in a niche driven by mercurial trends. And it's otherwise a great niche. It's simply easy to find baby-sitters willing and able to spend $4 per item or just shy of $9 per ticket for fashion accessories. Investors looking for a solid play on Gen Y should get to know Claire's.

Claire's conference call starts at 10 a.m. Thursday, and is available live at www.clairestores.com.

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