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By Slydo
August 28, 2006

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Here are my notes from the CHS conference call. I had some technical difficulties near the end of the call, but these should cover most of the pertinent info. I won't rehash all of the numbers and guidance, which were laid out in fairly significant detail in their press release (http://tinyurl.com/p9yhn), but in summary, they were shy one penny on earnings versus estimates ($0.29 vs. $0.30) and shy $3.6M on revenues ($405M vs. $408.6M). They also revised same store sales, margins and earnings downward for the next four quarters. Much of the call and this review will focus on the reasons for the recent slowdown, the downward revision and what CHS is doing to address these things (I'm sorry if these notes might seem a bit disjointed).

Management Projections:


                                 3Q 06             4Q 06            FY06            FY07

Operating margin      17%-19%      14%-16%     17%-19%     16%-18%

Earnings per share   $.26-$.28      $.25-$.27    $1.10-$1.14   $1.28-$1.36


Note that 4Q operating margins and earnings will decline versus 3Q. They expect this trend to continue through mid-2007 due to subpar same store sales (SSS) at the Chicos brand and increased investments in Soma and Fitigues stores.

In contrast to the weakness at Chicos, management is very pleased with the performance of White House|Black Market, where margins are improving due to strong SSS growth and new store openings.

Regarding Soma, they expect it to become profitable in 2008 and contribute significantly to growth and earnings in 2009 and beyond. They say it is currently a drain on earnings, especially as they grow the store count 3-1/2 times in '06, with most of that growth in the 2nd half of the year. That drain will continue for the next two years as they continue to open stores in an effort to get it to the 100 store count where the economies for intimate apparel stores become much better.

They expect a similar story for Fitigues as they grow it from its current base of ten stores. But that should be it for growing pains in the near future, as they have no further acquisitions on the radar screen at present. These investments in WH|BM, Soma and Fitigues are all part of their long-term growth strategy to increase earnings and revenue without cannibalizing existing brands.

The reasons they gave for weak SSS at Chicos were essentially two-fold - unexciting merchandise and tired marketing programs. They are reviewing all merchandise at Chicos, eliminating under performing lines and revamping the remaining lines. Scott Edmonds complained that the August catalog was too dark and uninspiring. This changed with the new September catalog, the first to show the influence of new marketing director Michael Levy.

As part of the effort to address these areas (merchandise and marketing), they have shaken up both the merchandising and marketing teams. Michael Levy took over marketing in March and they just announced the hiring of Michele Delahunty Cloutier as EVP & General Merchandise Manager for the Chico's Brand.

In total, they expect to see earnings growth, not including options expense, of 13% in '06 and 18% in '07. Operating margins will decline through mid '07, but increase in the back half of the year as their investments in new stores begin to pay off.

They believe their forward guidance represents a worst-case scenario.

Regarding inventory, it increased from $59/sq foot to $68/sg ft., but much of this was in anticipation of new store openings and management claimed to be comfortable with these levels. In-transit inventory also increased due to new ocean transportation that, while increasing total inventory, will help to lower costs and improve gross margins.

They reported $148M in cash flow from operations, which represented a GAAP increase of 10%, but a non-GAAP increase of 23%.

A few more notes on advertising and marketing:

They are looking to improve the store front windows, of which they have 200,000 linear feet, hoping to drive shoppers into the store. One analyst questioned whether the 50-plus shopper is one to be "hanging out" in the mall like a teenager and thus influenced by such marketing, but Scott Edmonds said it was a tool at their disposal.

Scott Edmonds also said they were looking to revamp their tired TV advertising, saying even he didn't want to watch another "make it a Chicos day" ad. He said the catalogs and merchandise were just as tired, saying that recent books didn't look much different from those five years ago. [my note - this seems to be what many have been saying about Chicos of late, that they need new stuff].

They admitted that store sales drop when a Coldwater Creek store opens in the same mall but recover within two to three months. They are focusing much more energy on forensic research of their competitors.

When an analyst asked why they were predicting flat to low-single digit SSS for Chicos this quarter when August SSS to date are down, they answered that part of the problem in August was that they transitioned to fall fashions too early. They have short-term and longer-term confidence in the Chicos numbers due to the new look and imagery they are implementing for the chain, investment in store payroll to improve customer service and their revived focus on merchandise and marketing.

My take:

They are clearly unhappy - and in uncharted waters - regarding the slowdown at Chicos. But they appear to be confident in their plans to turn that around. Given the steps they are taking with the management team and the results of some those changes, this seems to be more than just talk. Of course, only time will tell. They also remain confident in and committed to their long-term growth strategy regarding their new brands, even if that means some short-term disappointment in margins and EPS.

This seems to be the typical retail challenge - to build upon your winning strategy and avoid the pitfall of becoming yesterday's news. There was nothing to really say that they know they have turned the corner. At this point, investors must decide whether they believe management is on the right track and capable of executing their plan. Past history suggests they can, but as always, there are no guarantees.

Thanks for reading,

Paul


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