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Stock Strategist

Two Off-the-Rack 5-Star Stocks

Recent events have made bargains out of these two women's apparel stocks.

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In this challenging retail environment, retailers have been luring customers into stores with heavy promotions and markdowns. This is happening particularly in women's apparel, which has been hit not only by macro headwinds facing consumers, but also by a lack of compelling merchandise. These recent events have driven some retailers' stock prices down, creating what we see as a great buying opportunity for two specialty retailers:  Coldwater Creek (CWTR) and  Chico's (CHS). Put simply, we think the market is overlooking Coldwater Creek's future growth prospects and Chico's loyal customer base.

The macro issues--like declining housing prices, rising energy costs, and tightening credit conditions--are largely out of retailers' control. However, merchandising missteps have compounded the problems for apparel retailers that target baby boomer women. On its analyst day in November, Coldwater Creek described a lack of fresh designs in women's apparel. Other specialty retailers have echoed similar sentiments, taking full responsibility for missing fashion trends. Our view is that Coldwater Creek and Chico's will reconnect with their consumer in the long run. While we don't expect this to happen overnight, we do believe that the retailers' long-term prospects remain bright.

Coldwater Creek Still Has Room to Grow
Let's first take a look at Coldwater Creek. To justify the current stock price, we'd have to make a number of pessimistic assumptions in our discounted cash-flow analysis. For example, we would need to assume that the store base stays at around 300 locations, with same-store sales growth in the low single digits over the next 10 years, as compared with the mid-single-digit growth we've seen over the past 10 quarters. We'd also have to project average long-term operating margins just below the 8% the company delivered from 2004 to 2006.

We believe this is an unlikely scenario, and we're convinced that Coldwater Creek has plenty of room to grow. Thanks to the company's catalogs, which have been around for more than 20 years, we think that brand familiarity and loyalty still exist. Its store base of 300 locations is only half-built, in our opinion. Not only do we like the growth prospects, but we also like the opportunities for margin improvement as the store base expands and matures. Management has targeted mid-teens operating margins in the long run, and while this isn't immediately achievable, we believe that the company can reach this goal in five years through a combination of gross margin improvement and operating leverage. We think the firm can expand gross margins by increasing the amount of merchandise that is directly sourced. Additionally, Coldwater Creek can gain operating leverage by spreading fixed costs over a larger sales base as the chain grows.

Devoted Customers Boost Chico's Long-Term Prospects
Although we think that the market is overlooking Coldwater Creek's growth prospects, we also believe that the market is ignoring Chico's presence among its loyal fan base. We have faith in this established retailer's ability to lure its customers back into stores. To reach the current share price, we'd have to assume in our discounted cash-flow analysis that the company slowed its average annual square footage growth to the low single digits over the next 10 years, and that the Soma brand shut down completely. Additionally, we'd have to project that the company's operating margin remained in the low double digits over that same time frame, down from its historic levels north of 20%.

We don't think this is a likely scenario. We recognize the company is maturing and its high-growth days are probably over. However, we believe it can still achieve modest growth. We think Chico's can increase its annual square footage in the mid single digits over the next 10 years, down from around 20% over the past three years. In our opinion, Chico's namesake chain can support an additional 100 stores on top of around 640 current locations. Also, we think its two newer chains, White House | Black Market and Soma, are viable concepts with ample room for growth. We expect the number of White House | Black Market stores to double over the next 10 years, and we think Soma will nearly triple its store base over that same time period. While the promotional environment and merchandising mishaps will weigh on Chico's performance this year, we don't think these issues will persist indefinitely. We believe that same-store sales will return to positive levels, helping to restore operating margins to the mid-teens in the next five years.

Because both Coldwater Creek and Chico's have strong balance sheets with no debt, we believe that they can weather the current storm. Additionally, we remain confident in the favorable long-term demographic trends in the baby boomer segment. Although the next few quarters may be rough, we think the market will more accurately reflect these companies' future prospects when conditions improve and shoppers return.

Equity analyst Kimberly Picciola contributed to this article and does not hold a position in either of the stocks featured in this article.

Michelle Chang does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.