This review of Chico's (NYSE: CHS) earnings quality is the second of four commentaries looking at specialty retailers listed in the S&P 400 index. Last time, I looked at Ascena Retail Group (Nasdaq: ASNA). I selected four companies: Ascena, Chico's FAS, Fossil (Nasdaq: FOSL), and Saks (NYSE: SKS) because all have exhibited poor earnings quality over the past few months. While they may have excellent sales and/or income trends (income statement metrics), I specifically selected these stocks for a review of their cash management issues.

Earnings quality is reflected in the financial statements
The Motley Fool offers two databases -- EQ Scan and EQ Score -- that are used to uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important for investors to understand before hard-earned money has been lost.

The EQ Score database assigns an index rank to the company from one (lowest quality) to five (highest quality). As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward.

Is there an EQ trend for these specialty retailers?


EQ Score January 2012

EQ Score February 2012

EQ Score March 2012


Likely Issue

Ascena Retail Group 1 1 3 Up Cash flow
Chico's FAS 4 4 1 Down Cash flow
Fossil 1 1 1 Flat Cash flow
Saks Not ranked Not ranked Not ranked Flat Cash flow

Source: Fool EQ Score (week ending March 9).

Ascena's EQ score has trended up, Fossil and Saks have shown no trend, and Chico's trend is down. All exhibit cash management issues. Regarding Ascena, I recently commented that its income statement and balance sheet metrics were very positive, and its cash management and cash flow, while showing signs of improvement, have been the reason holding this stock back until recently. A brief look at Fossil shows that its cash flow is affected by seasonality: Fossil's FCF is down 48% year over year and has been negative the last three quarters. Days in inventory, or DSI, has grown 31% and its cash conversion cycle has increased 6% YOY. Seasonality also affects Saks, a high-end specialty retailer. Revenue grew slightly YOY (7%), but inventory levels increased 8%. Saks' DSI metric is high at 114 days, and its cash conversion cycle is 126 days.

Trouble could be ahead for Chico's

Chico's FAS operates under the Chico's, White House|Black Market (WH|BM), and Soma Intimates brand names. Late in 2011, Chico's added a fourth brand, Boston Proper. Chico's brands attract women 25 years old and over.

Chico's FAS Revenues Chart

Chico's FAS Revenues Chart by YCharts

Chico's FAS Gross Profit Margin Chart

Chico's FAS Gross Profit Margin Chart by YCharts

To the casual stock picker, Chico's paints a rosy picture of increasing revenues. This is partially due to Chico's increase in same-store sales of nearly 8.2% for the year ended Jan. 28, 2012, as well as the addition of 110 stores during the year, from 1,150 to 1,260 stores (about a 9% increase). But the second chart (inventories and gross margin) underscores issues that have caused this stock's earnings quality score to drop from a score of four in January to one in March.

Remember, revenue minus cost of sales (inventory) equals gross margin. Because of the seasonality associated with the holidays, Chico's inventory levels generally rise before year's end and then decline because of increased seasonal purchases. However, this chart illustrates that inventory levels over the past two years have grown from about $140 million in January 2010 to $194.5 million in the latest quarter while gross margins have trended down. In the last 12 months, inventory levels have grown 21.7%. Up until mid-2011, gross margins had generally kept pace with inventory levels, but GM has dropped precipitously over the last nine months because of the increased inventory drag. DSI four-quarter average increased from 71 days to 79 days YOY. In other words, more stores are carrying proportionately more inventory per store for a longer period of time. Price reductions at the registers will reduce inventory but will also continue to pressure margins going forward.

On Feb. 22, Chico's reported year-end cash and marketable securities totaling $247.9 million versus $548.9 million a year ago. Of this amount, only $58.9 million was in cash. Chico's used cash to purchase Boston Proper for $213 million, make $132 million in capital expenditures, repurchase 3.4 million shares for $183 million, and pay dividends of $34 million. Total shares outstanding decreased by 9.29% from 176.5 million shares to 163.9 million shares. Chico's stock buybacks created a 31% increase in diluted EPS, but net income only grew by $29 million. The company's spending spree also affected working capital, which decreased during each of the last two quarters YOY, with the latest quarter decreasing 52% YOY. Associated with its increased inventories, Chico's cash conversion cycle jumped from 23 days to 32 days, or 40%. The four-quarter average free cash flow decreased significantly over the last two years -- from $34.59 million to $24.27 million.

What does this all mean? Revenue and EPS increases don't tell the whole story and are often misleading metrics.

Fool contributor John Del Vecchio is co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF. You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article. The Motley Fool owns shares of Fossil. Motley Fool newsletter services have recommended buying shares of Fossil. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.