Copyright 2008 Ayesha N. Hafeez, Anatas Chobanov,Kyle Sparger, Manh Vu Duc and Erin Young.

Do not excerpt or copy any material without explicit written permission from all the authors and Professor Mark Sharfman. Ignoring or otherwise not upholding this notice in addition to violating US copyright law is a violation of the University of Oklahoma student code concerning plagiarism.

2008

AcquisitionofChicos: MBACapstoneProject

AyeshaHafeez ErinYoung KyleSparger ManhVuDuc NaskoChobanov

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Table of Contents
EXECUTIVE SUMMARY INTRODUCTION 1. INDUSTRY ANALYSIS OVERVIEW 1.1 ECONOMIC ENVIRONMENT 1.2 REGULATORY ENVIRONMENT 1.3 TECHNOLOGY ENVIRONMENT 1.4 SOCIO-CULTURAL ENVIRONMENT 1.5 GLOBAL ENVIRONMENT 2. PORTERS FIVE FORCES FRAMEWORK OVERVIEW 2.1 THREATS OF NEW ENTRANTS 2.2 EXISTING COMPETITION 2.3 RIVAL PRODUCTS 2.4 BARGAINING POWER OF THE END CONSUMER 2.5 BARGAINING POWER BETWEEN THE COMPANY AND THE SUPPLIER 2.6 BARGAINING POWER OF SUPPLIERS CONCLUSION 3. COMPETITOR ANALYSIS OVERVIEW 3.1 DILLARDS 3.2 TALBOTS 3.3 ANN TAYLOR 3.4 COLDWATER CREEK 3.5 CHRISTOPHER AND BANKS 3.6 LIMITED BRANDS, INC., 3.7 OTHER COMPETITORS CONCLUSION 4. FINANCIAL RATIO ANALYSIS OVERVIEW 4.1 LIQUIDITY RATIOS 4.2 ACTIVITY RATIOS 4.3 PROFITABILITY RATIOS 4.4 LEVERAGE RATIOS 4.5 STOCK MARKET RATIOS 4.6 OVERALL STRENGTHS/WEAKNESSES AND FUTURE FINANCIAL CONDITION CONCLUSION 5. CHICOS SWOT ANALYSIS OVERVIEW 5.1 STRENGTHS 5.2 WEAKNESSES 5.3 THREATS 5.4 OPPORTUNITIES CONCLUSION 6. VALUATION OVERVIEW 5 6 8 8 8 10 11 16 17 18 18 19 26 28 29 30 31 33 34 34 34 36 37 38 39 40 42 43 44 44 45 48 50 52 54 55 57 58 58 60 64 65 67 71 71 71

6.1 DISCOUNTED CASH FLOW ANALYSIS 6.2 VALUE CREATION MODEL 6.3 COMPARABLES VALUATION 6.4 MERGERS AND ACQUISITIONS (M&A) PREMIUM 6.5 ACQUISITION PRICE 6.6 ADJUSTED DCF ANALYSIS AND IRR CONCLUSION 7. CHICOS FAS ACQUISITION STRATEGY OVERVIEW 7.1 AWWIS MERGER AND ACQUISITION (M&A) TEAM 7.2 ACQUISITION OBJECTIVES 7.3 CHICOS TAKEOVER PREVENTION MECHANISMS 7.4 APPROACH TO CHICOS SHAREHOLDERS 7.5 PLAN A - 100% CASH TRANSACTION 7.6 PLAN B - 100% STOCK BUYBACK AND SWAP 7.7 APPROACH TO CHICOS EXECUTIVE MANAGERS 7.8 OFFER PRICE AND EXPECTED RETURN ON INVESTMENT CONCLUSION 8. POST-ACQUISITION STRATEGY OVERVIEW 8.1 ALIGN PRODUCT MIX AND STRENGTHEN CUSTOMER SERVICE 8.2 IMPROVE MARKETING EFFECTIVENESS 8.3 HALT EXPANSION AND REFOCUS ON EXISTING STORES 8.4 INTEGRATE SOMA INTO CHICOS STORES 8.4 ESTABLISH AN OVERSEAS OFFICE IN ASIA 8.5 EVALUATE OPPORTUNITIES TO BUILD STRATEGIC RELATIONSHIPS 8.6 EXPLORE ACTIVE MANAGEMENT OF EXCHANGE RATE RISK 8.7 OTHER POSSIBLE LONG-TERM OPPORTUNITIES CONCLUSION 9. ALTERNATIVE ACQUISITION CANDIDATE ANNTAYLOR STORES, CORP. 9.1 COMPANY OVERVIEW 9.2 FINANCIAL ANALYSIS 9.3 ANNTAYLORS SWOT ANALYSIS 9.4 VALUATION 9.5 POTENTIAL ACQUISITION OF ANNTAYLOR STORES OVERALL PROJECT CONCLUSION APPENDIX A APPENDIX B APPENDIX C APPENDIX D APPENDIX E APPENDIX F APPENDIX G APPENDIX H APPENDIX I APPENDIX J CHICOS FINANCIAL RATIOS CHICOS DCF VALUATION CHICOS WEIGHTED AVERAGE COST OF CAPITAL CHICOS DCF VALUATION: SENSITIVITY ANALYSIS CHICOS VALUE CREATION MODEL CHICOS VALUE CREATION MODEL: SENSITIVITY ANALYSIS

71 73 75 76 77 78 80 81 81 81 82 83 84 85 86 87 88 89 91 91 91 93 95 98 99 100 101 102 103 104 104 105 110 116 118 118 120 121 122 123 124 124 125 126 127 128

CHICOS DIRECT COMPETITORS CHICOS COMPARABLES VALUATION

M&A PREMIUM ANALYSIS: GENERAL SEARCH M&A PREMIUM ANALYSIS: DETAILED SEARCH

APPENDIX K APPENDIX L APPENDIX M APPENDIX N APPENDIX O APPENDIX P APPENDIX Q APPENDIX R APPENDIX S

CHICOS PRO FORMA ADJUSTED DCF VALUATION CHICOS IRR CALCULATION AND SENSITIVITY ANALYSIS FIRMS ACQUISITION PROCESS, REGULATIONS AND RULES CHICOS INSTITUTIONAL OWNERSHIP BERKSHIRE HATHAWAY CLASS A AND CLASS B STOCK ANNTAYLORS FINANCIAL RATIOS ANNTAYLORS PRICE/EARNINGS VALUATION AND SENSITIVITY ANNTAYLORS DCF VALUATION AND SENSITIVITY ANALYSIS ANNTAYLORS IRR CALCULATION

129 131 132 142 143 144 145 146 147

Executive Summary
As the consulting team for Ace Whippo Widgets, Inc. (AWWI), a wholly-owned subsidiary of Berkshire Hathaway (BRK), we conducted a comprehensive analysis of Chicos FAS, Inc. (Chicos) and its industry to determine the financial health of the company and whether it represented a good acquisition candidate. In addition, we conducted an analysis of an alternative acquisition candidate, AnnTaylor Stores, Corp. (AnnTaylor), in the event that our attempt to acquire Chicos should fail. The retail apparel industry is characterized by rapid business cycles, vigorous competition, and low barriers to entry. The industrys product line changes every season as customer fashion preferences change quickly. Because of low barriers to entry, the industry is highly concentrated with many companies producing rival products. Companies are currently experiencing difficulties due to the declining economy, resulting in reduced revenue and same-store sales. The industry is characterized as having most of its manufacturing processes located in foreign markets in order to take advantage of their lower cost structure. This exposes the industry to exchange rate risks, extended supply chains, and international trade regulations. Chicos sells womens apparel and accessories through its brick-and-mortar stores and websites. The company operates multiple brands such as Chicos, White House| Black Market (WH|BM), and Soma Intimates (Soma) to target different market segments with mid- to high-income levels. Chicos has been performing well compared to its competitors. The company places special emphasis on customer service and building brand equity. Chicos manages inventories and receivables effectively, resulting in a short operating cycle. Financially, the company has a zero-debt capital structure and a strong liquidity position. This provides Chicos with the ability to take advantage of attractive investment opportunities that may arise. Chicos has historically generated strong operating results and profitability. Given these competitive strengths, the stock market has historically placed a high premium on Chicos. However, we have identified areas that need improvement, including a mismatched product mix, an ineffective marketing campaign, and declining same-store sales growth. We also found that Chicos has recently pursued an overly-aggressive expansion strategy. We found that Chicos market value is currently attractive. Its current market capitalization is roughly twice its one-year pro forma adjusted free cash flow. We believe that if Chicos were to halt its aggressive expansion strategy, it would save considerable capital investment which could then be redistributed to investors or other superior projects. We recommend that AWWI should acquire Chicos with an optimal offer price of $3.26 per share, resulting in a projected internal rate of return of 57%. AWWI should use a combination of cash and an open-market buyback and stock swap of Berkshire Hathaway Class B stock. If successful, we expect to implement our postacquisition strategy, which includes halting expansion, realigning product mix, improving marketing effectiveness, closing Soma Intimates as a separate store, and reintegrating the Soma product line into Chicos other stores. Should the acquisition of Chicos fail, we recommend that AWWI pursue AnnTaylor as an alternate candidate. The company is a direct competitor of Chicos and shares many common feature, such as similar market capitalization, a strong financial position, and strong performance indicators. These similarities make AnnTaylor an acceptable alternate candidate. 5

Introduction
Chicos started in 1983 as a small store, selling sweaters in Florida before adopting the Chicos name in 1985.1 The company has grown into 642 company-owned Chicos locations targeting women 35 and older with mid- to high-income levels. It also has 332 company-owned WH|BM locations targeting women 25 and older with mid- to high-income levels. Last, the company has 70 Soma locations targeting similar fashion conscious customers as Chicos and WH|BM.2 Chicos does not manufacture its

products but creates in-house designs and works closely with independent vendors to develop new designs in order to keep up with seasonality and changes in the fashion industry.3 Seasonality in the fashion industry refers to the fact that each year, there are four distinct fashion seasons requiring markedly different product characteristics. Chicos has a multi-faceted growth strategy that encompasses internal infrastructural adaptations and external expansion via acquisitions and new-store development.4 In order to prepare itself for future growth, the company has increased the number of direct-to-consumer and management employees. It has also developed technology systems to obtain SKU-data, information pertaining to loyalty programs, and point of sale data. Currently, the company does not plan to acquire any new subsidiaries but plans to continue introducing product extensions that align with its current product lines. Product extension is an important component of Chicos business strategy as the company focuses on maintaining its brand image of having distinctive clothing and

1 2

Chicos FAS, Inc. Website: http://www.chicos.com/store/page.jsp?id=39 Chicos FAS, Inc. 2007 Annual Report, pg. 2 3 Chicos FAS, Inc. 2007 Annual Report, pg. 2-3 4 Chicos FAS, Inc. 2007 Annual Report, pg. 4

complementary accessories.5 This approach, coupled with the companys customer service and loyalty programs, is viewed as a major advantage for Chicos. Sales

associates receive special training in order to create a pleasant experience for the customer. Training includes fashion advice regarding outfits and jewelry, and learning the preferences of repeat customers in order to serve them more efficiently. In addition, Chicos increases its repeat sales through customer rewards programs for Chicos/Soma and WH|BM, which had 2.4M and 2.1M members, respectively, in 2007.6 The following analysis discusses five aspects of the environment and the industry, in which Chicos operates; an analysis of Chicos closest competitors on the basis of product lines; a financial analysis evaluating the five ratio family trends; an evaluation of Chicos strengths, weaknesses, opportunities, and threats (SWOT); a valuation of Chicos as an acquisition candidate; AWWIs acquisition strategy and post-acquisition recommendations; and an evaluation of AnnTaylor as an alternative acquisition candidate.

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Chicos FAS, Inc. 2007 Annual Report, pg. 4 Chicos FAS, Inc. 2007 Annual Report, pg. 6-7

1. Industry Analysis
Overview
The retail apparel industry is highly competitive with many companies trying to steal market share by creating a product that is perceived by the customer as fashionable and trendy. In addition, companies have to find other ways to differentiate their product from the competition, such as customer service. Business strategies revolve around the customers wants, needs, and perception in this industry due to the potentially high bargaining power of the end consumer. The industry has fast-paced business cycles that make it difficult for companies with the wrong product mix to correct the problem. This is due to the fact that when winter clothes are in the stores, spring lines are being manufactured, summer lines have been designed and approved, and next years fall lines are being conceptualized. Thus, the wrong product mix can be detrimental to a

companys profitability during a particular season. Currently, retail apparel companies are operating in an economic recession. Consumer spending has decreased, which has caused decreased profitability for retail companies, who depend on consumer sales. Companies must find a way to continue to develop a coveted product while at the same time maintaining current expense levels.

1.1 Economic Environment

The state of the economy has a large impact on the retail apparel industry. When the economy does well, consumers spend money and buy new products, but, when the economy declines, consumers tend to spend less and save more. Based on 55

economists forecasts in The Wall Street Journal (WSJ), the Gross Domestic Product (GDP) is predicted to decline through the first half of 2009, with a small recovery 8

beginning in the second half of the year.7 The United States has a trade deficit, which means that imports into the United States are greater than exports from the United States. In fact, the deficit in the current account decreased to $56.5B in September 2008 from $59.1B in August 2008. Exports decreased by 6.0% from August 2008 to September 2008, while imports decreased by 5.6% over the same period. The trade deficit in goods slightly decreased by 2.1% over the same period. In addition, the trade surplus in services increased 9.2% over the same period. 8 Currently, the United States is in a period of deflation. The Consumer Price Index (CPI), which measures average price of consumer goods and services purchased by households, can give a measure of inflation by taking the percent change in CPI.9 In October 2008, the CPI decreased by 1%. However, WSJ economists expect inflation to end the year at 2.8% and forecast 1.2% by June 2009 and 1.8% by December 2009.10 The immediate deflationary environment can force a decrease in gross operating margin for companies. Companies have difficulty decreasing labor wages and other

contractually-defined costs, but they are forced by the market to decrease prices. In addition, consumer spending has declined and is expected to continue to decline. Further, projected increases in unemployment will continue to put pressure on the consumers ability to spend, as will increasing consumer interest rates. However, some of these problems may be offset by increased purchasing power from deflation as well as an increase in disposable income from lowered energy prices. Additionally, lower energy
The Wall Street Journal. Economic Forecasting Survey: November, 2008, http://online.wsj.com/public/resources/documents/info-flash08.html?project=EFORECAST07 8 U.S. Department of Commerce. U.S. Census Bureau U.S. Bureau of Economic Analysis, http://www.census.gov/foreign-trade/Press-Release/2008pr/09/ft900.pdf 9 The Wall Street Journal. Economic Forecasting Survey: November, 2008, http://online.wsj.com/public/resources/documents/info-flash08.html?project=EFORECAST07 10 The Wall Street Journal. Economic Forecasting Survey: November, 2008, http://online.wsj.com/public/resources/documents/info-flash08.html?project=EFORECAST07
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costs directly benefit industry because decreases in energy prices reduce transportation and other costs.11 Recently, the U.S. Dollar has been appreciating against other

currencies, potentially lowering the input costs for producers that outsource manufacturing to, or import from, other countries. Because Chicos sells commodity items, the continuing decline in the economy is likely to have a significant effect on Chicos operating results. The decrease in consumer spending is likely to translate to lower sales, and the deflationary environment is likely to put pressure on Chicos gross margins. A decrease in energy costs may buoy Chicos operating results but is unlikely to fully offset the aforementioned decrease in consumer spending.

1.2 Regulatory Environment

There are several trade regulations that are important to consider as part of the regulatory environment. The North American Free Trade Agreement (NAFTA) between the United States, Canada, and Mexico, signed in 1994, will remove the majority of trade barriers by the end of 2009.12 In 1995, the World Trade Organizations Agreement on Textile and Clothing phased in a reduction in import quotas. The Agreement fully matured in 2005, resulting in the removal of all restrictions on the import of textiles and clothing.13 Additionally, labor laws must be considered. The Fair Labor Standards Act in the United States specifies an employee minimum wage and regulates overtime pay

The Wall Street Journal. Economic Forecasting Survey: November, 2008, http://online.wsj.com/public/resources/documents/info-flash08.html?project=EFORECAST07 12 U.S. Department of Agriculture. North American Free Trade Agreement (NAFTA), http://www.fas.usda.gov/itp/Policy/nafta/nafta.asp 13 World Trade Organization. UNDERSTANDING THE WTO: THE AGREEMENTS, http://www.wto.org/english/thewto_e/whatis_e/tif_e/agrm5_e.htm
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and youth employment requirements.

These regulations, if violated, can result in

litigation and large penalties for companies.14 Because Chicos exports the entirety of its manufacturing processes, free trade without quotas is critical to the companys global supply chain and operations. NAFTA is also very important to Chicos operations because the company maintains cut and sew shops in Mexico, Guatemala, and the United States.15 The regulatory environment in which Chicos operates has the potential to be detrimental to the companys operations and profitability if trade restrictions were to increase.

1.3 Technology Environment

Technology has become a critical infrastructural component of operations within the industry. The ability of technology to automate record keeping, provide decision support or automate decisions, and provide communications within and without the company has forced even technology averse companies to invest in technology just to keep abreast of the competition. Other companies embrace technology and find ways to use it to create strategic advantage or to level the playing field. Because efficient supply chains are critical to companies operating within the retail apparel industry, Enterprise Resource Planning (ERP) systems are critical to a companys ability to remain competitive. In the context of a supply chain, ERP systems provide the ability to automate record keeping at selected points throughout the supply chain and then use business-specific rule sets to provide decision automation and support. A well-designed ERP system can provide a company transparency into its supply chain and speed up and improve decision making. Real-time data on the disposition of
U.S. Department of Labor. ComplianceAssistanceFairLaborStandardsAct(FLSA), http://www.dol.gov/esa/whd/flsa/ 15 Chicos FAS, Inc. 2007 Annual Report, pg. 22
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inventory, orders, transportation, accounts payable and receivable, and just about any metric the company has identified as relevant is made available with a simple database query. Modules can be implemented to provide dashboard style views of company health, providing managers instant understanding of the status of various parts of the company. Automated alerts can be generated when exceptions arise, increasing the speed with which the company becomes aware of and responds to problems. Certain decision processes can be automated, such as placing orders or making payments to suppliers, reducing workload and the probability of errors in the process. Power users can develop their own reports, providing real-time information to local managers in order to improve decision making. Additionally, historical data can be used to make forecasts (e.g.,

demand) which can improve supply chain efficiency. It should be noted that ERP systems are only as good as the processes with which they interact. When implementing and maintaining an ERP system, the company must make sure that there are processes in place which will ensure that pertinent data makes its way into the system on a timely basis. Without the appropriate data, an ERP system is virtually useless. Additionally, the company must ensure that there is a strong understanding of business processes in order to use the ERP system appropriately. Without this

understanding, the automation and decision support capabilities of the system will not function as expected. At best, this can lead to inefficiency. At worst, a poorly-designed or implemented ERP system could lead to or execute poor decisions, resulting in lost time and money for the company.

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There is danger that a company will assume that ERP systems are a magic bullet which will solve all of their problems. Companies that implement ERP systems often fail to recognize that such systems are only as good as the processes they support, and in turn are supported by. Companies often overlook the importance of processes in the implementation of ERP systems and find that their system does not provide the benefits they expect. The Internet poses a special problem and opportunity for retail apparel stores. The Internet provides companies operating in the industry with a new, low-cost channel to reach its customers. Because of this, companies can use the Internet to increase their sales with relatively little incremental investment. A company with a well-designed ERP system can easily tie the system into an Internet website and have a fully automated online catalog and ordering and shipping process available to its customers 24 hours a day. Additionally, a clever company could use such a website as an automated method for receiving customer feedback, recording customer interest in various products and which product combinations customers tend to buy. This would allow the company to learn which products are likely to cross-sell easily, which can increase sales. However, the Internet also provides potential competitors with an easy way of developing a new marketing channel. If one company can easily create an Internet catalog, others can too. This makes entry into the market easier in an industry that is already easy to enter, resulting in intensified competition. In the past, potential entrants would have to either make large capital investments to develop a physical presence or

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develop a mail-order business. The Internet allows entrants to bypass these steps and reach interested customers directly with relatively little investment. Additionally, because consumers can easily cross-check competitor websites, the Internet allows customers to drastically reduce their searching costs. Prior to the Internet, a customer would have to visit multiple stores or check multiple physical catalogs to compare prices and products. Now, the customer can easily browse multiple websites simultaneously and rapidly find the best deals. This fact requires companies to intensify their efforts to differentiate their products and provide the best value or suffer lost sales as customers flock to their competitors. Companies can also invest in infrastructure and processes that track customer purchases and preferences. The system could be part of an ERP or stand-alone. Once in place, the system can improve customer interaction or marketing campaigns or track and forecast customer demand. Such a system can provide a sales associate with customer-specific information that allows the associate to make informed decisions on how to interact with the customer. The associate can be made aware of past customer purchases, allowing the associate to present the customer products that are more likely to appeal to the customers taste. Knowledge of the customers past purchases increases the opportunity for crossselling, as the associate can provide recommendations that will complement or be complemented by those past purchases. Additionally, the sales associate can be made aware of special customer issues, such as past complaints, and react accordingly. All of these capabilities improve the ability of the sales associate to create revenue and improve

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the ability of the company to create a strong relationship with the customer in order to drive revenue in the future. With specific customer information in hand, such a system can allow the company to develop targeted marketing campaigns. Managers could mine the system for customers with certain characteristics, such as geographic region, demographics, visit frequency, purchase frequency, or specific products the customer has previously purchased. These characteristics can then be used to elicit specific responses from the targeted customer group. Finally, such a system can be used to improve management of the supply chain. While historical order information can be used as a good metric for forecasting future demand, knowledge of specific customer habits can be used to make better forecasts. For example, using simple historical order information can only tell the company which stores have historically demanded a product or type of product. However, tracking this information at the customer level can result in better decisions. For example, if a

customer moves, that customers demand is likely to change to a different store. Making decisions on the basis of this information would result in the appropriate product being redirected to the customers new store. Technology has become a critical component of any retail companys infrastructure. It is no longer just a source of competitive advantage; technology has become a cost of doing business. Retail companies with poor technology management will suffer from inefficiencies compared to their competitors and experience lower returns. As such, retail company management must pay special attention to their

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technology infrastructure, as well as industry and competitor trends, in order to remain competitive.

1.4 Socio-cultural Environment

People are moving from urban to suburban areas and micropolitans for the clean air, decrease in traffic, healthier environment, less noise, and less pollution.16 This results in changing demographics which companies must consider when determining marketing strategy and store placement. More companies are outsourcing manufacturing to take advantage of low-cost labor and raw materials. However, outsourcing occasionally creates public relations issues. Many people take issue with companies that outsource manufacturing jobs that had previously been held by Americans and sometimes specifically refuse to do business with companies that have done so. Additionally, increasing healthcare costs have become a major issue for the United States. A WSJ-NBC Survey reported that healthcare was seen as the number one concern for approximately 50% of the U.S. population.17 These increasing healthcare costs directly translate into decreased disposable income for consumers, which may lead to decreased profits for the companies that market to them. However, this issue may not affect Chicos as much as other companies because they serve a market which has relatively large amounts of disposable income and is likely to be less sensitive to these increases.

16Killion,

Rick. Micropolitans - Life keeps getting better on the Northern Great Plains.Prairie Business Magazine. November 7, 2008.Online. Available: http://www.prairiebizmag.com/articles/index.cfm?id=9517&section=News 17 National Coalition on Health Care. Health Insurance Costs, http://www.nchc.org/facts/cost.shtml

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Also, increasing health care costs result in larger employee benefit expenses due to increasing health insurance premiums. Chicos must either suffer these additional increases in cost or decrease their employee coverage, which will either lead to decreased operating margins or increased employee dissatisfaction.

1.5 Global Environment

The United States will experience significant changes at the federal government level as it transitions from Republican President G.W. Bush to Democratic PresidentElect B.H. Obama. Additionally, the Democratic Party increased its hold on both houses of Congress, and now holds a strong majority in both the House of Representatives and the Senate. This change may result in the government taking a more hostile view of business activities. The Democratic Party historically takes a more populist view than the Republican Party and often implements laws that empower unions, increase consumer and worker protections, increase taxes, and otherwise increase government regulation of business activities. The new administration faces many challenges. The current financial crisis,

which began in the United States in 2007, involves many different parties. It has led to a decrease in consumer spending, lowered consumer confidence, a large number of foreclosures in the subprime mortgage sector, and increased unemployment. Additionally, many financial institutions have gone bankrupt or have had to be rescued by the federal government. The retail apparel industry has felt a large impact from the financial crisis as consumer discretionary spending has declined in a market where there is fierce competition and plentiful rival products.

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2. Porters Five Forces Framework

Porters Five Forces method relates companies to the environment in which they operate using what Porter feels are the forces driving industry competition.18 This allows companies to develop a competitive strategy based on their specific industry environment. Thus, to continue the analysis of the external environment, Michael

Porters Five Forces Framework provides a more in depth look at the retail industry, specifically apparel retail.

Overview
The retail industry is highly-concentrated with each company trying to steal market share from competitors by designing and producing a product that consumers perceive as trendy and fashionable. Companies compete on customer service, size, fit, quality, and price. If a company tries to enter the market and wants to be competitive, it must consider this criteria and work hard to differentiate its products from those of its competitors. Companies experience difficulty competing in this market because it is difficult to differentiate products, and the industry cycle turns multiple times per year, rapidly eroding any advantage gained. These market characteristics make the

achievement of consistent abnormal returns difficult, while permitting competitors the opportunity to steal market share at any time. Since the majority of the companies import their products to take advantage of lower input and labor costs, joining trade organizations such as Custom-Trade Partnership Against Terrorism (C-TPAT) is one way to gain an advantage. C-TPAT is a voluntary government-industry organization. Members are held accountable for the

18Porter,MichaelE.CompetitiveStrategy.NewYork:TheFreePress,1980.

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integrity of their supply chain with regards to security and sound practices. Member companies have a special relationship with customs agents and receive priority over nonmembers when inspections are required. More importantly, member companies have reduced inspections on imports. The following analysis will discuss each component of Porters five forces framework in detail. First, the analysis will look at the threat of new entrants and how Chicos is susceptible to companies entering its target market. Second, it will look at existing competition and how Chicos attempts to separate itself from the competition. Third, there will be a discussion of rival products and how Chicos focus on personalized customer service and product orientation makes it stand out against its competitors. Fourth, an analysis of bargaining power of the end consumer and between the company and the supplier shall be discussed along with Chicos position in each case. Last, there will be a discussion of the bargaining power of the supplier and how Chicos is less susceptible to it.

2.1 Threats of New Entrants

In the retail apparel industry, there is a constant threat of new entrants into individual market segments. However, there are large economies of scale that give established market participants a distinct advantage over new entrants. Entrants will have to make large investments to bring merchandise to market, including design, manufacturing, and the creation of a distribution channel. The type of distribution

channel selected will impact the magnitude of the capital investment necessary to make sales to the customer. Direct channels necessarily require less investment while retail store fronts will require considerable capital investment. As the channel matures, the

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company will experience increasing economies of scale as common infrastructure supports multiple points of sale. Another key investment is brand equity, which can be developed through advertising, high quality products, customer service, and other means. Marketing campaigns and promotions to entice traffic into new stores have the potential to be expensive and, if not conducted properly, ineffective. Founded in 1983, Chicos has developed a mature supply chain with its designers, manufacturers, and distribution center in place. The experienced management at the company understands the importance of having a sound supply chain and the cost of changes to any or all parts of the supply chain. Companies entering the market will have to compete with not only Chicos established supply chain, but also with Chicos highlyexperienced executive management. Because Chicos has over 1000 stores in the United States and 25 years of experience, a company trying to steal market share will have make considerable investments in developing a channel to compete and find a way to differentiate itself from Chicos established brand. Not only does Chicos have a

marketing strategy in place, they also have established relationships with media representatives. New companies will have to spend a large amount of money in finding the right medium to reach customers and obtaining prime ad locations. A new company with a small roll-out will have difficulty competing with the financial resources and mature supply chain that Chicos maintains. A first mover advantage is not likely to be sustainable in the retail industry, which revolves around constantly-changing fashion trends. Currently, the majority of retailers use manufacturers in foreign countries to obtain lower-cost raw materials and labor. However, if a company were to identify a new supplier market providing superior cost

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advantages, the move has the potential to be more sustainable, as competitors will take longer than a fashion season to match the move. Another non-sustainable advantage is membership in trade organizations that provide expedited customs processes for members. Membership in organizations, such as C-TPAT, is available for most U.S. importers, and provides an advantage only in so far as competitors do not join. As a member of C-TPAT, Chicos reaps the benefits that some of its rivals fail to obtain. Based on the understanding that Chicos will maintain integrity in its supply chain, U.S. Customs regulatory processes are less rigid. Because of this membership, Chicos receives preferential treatment in the customs inspection process. Membership in C-TPAT does not prevent companies from entering into Chicos target market, but it does allow Chicos an advantage in the import process. Product differentiation is the fundamental strategy in the retail apparel industry, but it is very difficult to achieve sustainable advantage due to rapid industry cycles. When winter clothes are in the stores, spring lines are being manufactured, summer lines have been designed and approved, and next years fall lines are being conceptualized. Thus, if a companys product is not in line with fashion trends, it is almost impossible to correct the problem without a long lag and considerable cost. Despite this fact,

companies can differentiate their product on the basis of quality, fit, color, size, brand, and customer service. Many consumers are loyal to certain brands, especially when customers receive personalized service or they feel that a companys brand is the it brand, as Victorias Secret is the it brand for lingerie. However, there are low

switching costs for consumers if new entrants offer an equal or superior product in this industry. As stated above, brand recognition and customer loyalty are important factors

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in this industry. Consumers have to determine if their searching costs related to finding another brand are lower than remaining loyal to the brand to which they have grown accustomed. Everything depends on which company is a step ahead of the competition in terms of its product offering and perceived fashion trends. Chicos strives to differentiate its product through personalized customer service. Its sales associates are trained to be able to determine and provide advice on the fashion needs of customers. With this training, the sales associates are able to cross-sell

merchandise by understanding how to combine different clothing pieces and accessories to meet the customers specific tastes. In addition, point-of-sale registers collect data on inventory, as well as provide information to the sales associates regarding repeat customers specific fashion styles and tastes. Chicos stores strive to provide high quality merchandise in many colors and styles with accessories to match. Over its 25 years of existence, Chicos has developed loyal customers and has had a continued increase in loyalty club members. In order to make it more difficult for competitors to enter its market, Chicos must maintain and enhance its customer service and ensure that it has the correct product mix to offer to customers. New entrants face large capital requirements and non-capital investments, which are important to consider. Large capital investments in real estate for store locations or the capital to lease and/or remodel property is a major cost to new entrants. Stores are built or space is rented in prime locations, which can be an expensive investment. In addition, remodeling existing rental property to meet specific needs can have high input and labor costs as well as opportunity costs for new entrants. Once the property has been developed, companies have to buy the materials that make up the infrastructure of the

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store, such as displays, manikins, and registers. Companies will also have to invest in technology and security systems to track the product and monitor the store and its occupants. The non-capital requirements include buying the merchandise to stock the store, hiring new administrative staff to oversee the design and manufacturing of the merchandise, setting up a distribution center to transport the merchandise, and launching an advertising/promotions campaign to increase foot traffic into the store. These are nontrivial tasks in a highly-competitive industry but are necessary to capture market share from existing competitors. Therefore, the up-front capital requirements are very

expensive and necessary to compete in this industry. As an alternative, a designer could sell their product to third-party department stores. However, in order to sell product in a department store, a fashion designer must make considerable investment in developing relationships with department store buyers, which can be a difficult and lengthy process. Leasing and developing a store within a mall might be difficult depending on the regulations and/or restrictions the leasing company has on that property. In addition, if the store is leased in a mall, the payment structure might be linked to store revenue. This could prove to be very expensive for a new entrant if, in fact, they have a variable rate attached to their lease. Entrants also have to be aware of whether or not there are restrictions on remodeling the leased property. Such restrictions can limit the entrants flexibility and require significant capital investment to meet the malls regulations. As stated above, when discussing economies of scale, there are large monetary costs to opening a new apparel store to compete against Chicos. New entrants must find suppliers, buy or lease a distribution center for its merchandise once it arrives in the

23

United States assuming they outsource their manufacturing, develop a logistics method, and lease or build store fronts to sell the merchandise. Since Chicos is already an established brand with a liquid financial position, it will be expensive for a new entrant to compete against the company in the short-term and, with brand loyalty in place for Chicos, continue to be expensive in the long run. The industry has several cost advantages independent of scale, such as low input costs due to the utilization of foreign suppliers, who purchase lower-cost raw materials and manufacture the product with cheaper labor than if the product was manufactured domestically. In addition, many companies have already acquired favorable locations to build stores, but, with the population migrating from urban to suburban areas and micropolitans, there are still locations that new entrants can capitalize on in the future. The growth of Internet usage is another potential distribution mechanism for new entrants. As more people become accustomed to shopping on the Web, the Internet will reduce entry and selling costs. However, most people buy products on the Web from companies with which they are familiar. Therefore, it is vital to have a recognized brand which customers associate with quality and fashion. Chicos launched a website for Chicos clothing in 2001, WH|BM in 2005, and Soma in 2006. In addition, the company has evolved its website design to be easily browsed by customers. With the Internet operations, Chicos has established a call center in which customers can directly talk to a company representative and place an order. Any entrant can create a website to compete with Chicos, but, without an established brand name, it is less likely to gain considerable sales from the Internet.

24

Any entrant can outsource their manufacturing to foreign suppliers like Chicos; however, establishing the relationships with the suppliers and making sure the product is of sufficiently high quality is a more difficult task. As stated before, Chicos has an established and effective supply chain in operation. In order to receive the benefits of low input and labor costs, new entrants would first have to establish a working and efficient supply chain. Government regulations do not present a barrier to entry into the industry. The United States has laws regarding labor and compensation for hours worked. The Free Labor Standards Act provides the guidelines for minimum wage, overtime pay, and youth employment under the law. This rule should not be a barrier to new entrants, but regulations regarding trade, specifically import regulations, might have the potential to be a large barrier if the current rules or regulations were to change in the future. There are no import quotas on textiles and clothing from foreign countries, nor are there significant tariffs. In the future, trade restrictions or increases in tariffs would potentially prevent new entrants into this industry, as most manufacturing of clothing occurs outside of the United States. Despite being a member of C-TPAT, which is not a sustainable advantage, Chicos does not have any advantage to new entrants in terms of government regulations. None of the regulations would treat either party different than the other. Thus, Chicos is not in a better position than companies trying to enter the market in this respect. There is very little that stops new competitors from entering the industry, but Chicos has established many advantages which provide some insulation from this threat. The fact that Chicos has a mature supply chain, experienced management, a large

25

number of operational store locations with sales associates that provide personalized service for the customer, and brand equity make it more difficult for a new company to steal market share. The investment for a new company would be very large, considering it would have to create a supply chain, develop and open new stores, and find a niche that differentiates its product from that of Chicos.

2.2 Existing Competition

Currently, the growth in the highly-concentrated retail apparel industry is stagnant and companies within this industry are competing to maintain and grab additional market share from existing competitors. Due to declines in consumer discretionary spending, companies find themselves struggling to adjust to decreased revenues. Consumers are shopping at discount stores rather than at up-scale specialty stores, causing declines in revenue, which in turn make high fixed costs more difficult to cover especially when debt is less-readily available. Fixed costs arise in the supply chain from actually storing the merchandise. Additionally, one can model obsolescence as a storage cost because every day the store has extra merchandise is one more day that the company might have to mark down the product or send it to an outlet store. Thus, the company would not receive full price for the item and, in reality, may only sell the item at a highly-discounted price. In addition to storage costs, the existing competition has to cover other essential operating costs, salary, technology, and distribution costs (warehousing and logistics) to compete in the industry. There are relatively few fixed manufacturing costs due to the utilization of foreign suppliers, who provide their own machinery and tools. With each company having the same goal of producing and selling the most fashionable brands each season, it is difficult to differentiate products, and switching

26

costs are low among existing competitors. However, as stated previously, differentiation can be established though brand recognition, customer loyalty, and customer service. Consumers tend to shop at the stores in which they receive prompt and genuine service under a brand they feel is synonymous with quality. In addition, consumers tend to be creatures of habit and shop at the same stores time and again, especially if the company portrays the qualities specified previously. There is an exception when the economy is in recession, and consumers find themselves with reduced discretionary spending. When this occurs, perceived switching costs vanish as consumers shop where they can get a quality product at a discount price. Increasing production capacity in this industry is relatively inexpensive. Contracting third-party manufacturers involves lead time, due diligence, and line retooling but requires little capital investment on the part of companies doing the contracting. By outsourcing the manufacturing of merchandise, companies can decrease capacity needs or transfer capacity to different producers to cut costs. There are costs for staffing associated with developing product lines, but these costs are manageable and small relative to the large costs throughout the rest of the companys operations. The exit barriers are lower than those in other industries but more substantial to companies that are highly leveraged than to those that have no financial leverage. Companies will have to buy out of leases, let their leases run out, or, if they own stores, find a way to sell the property in the currently-declining real estate market. Companies also have to continue to pay the fixed costs related to the building until they have reached an agreement for the sale or lease. Companies seek to extract as much profit as possible from the remaining items left in the store after they close. Thus, they may choose to

27

liquidate the infrastructure, displays, manikins, and registers, with or separate from the property. The difficulty of this task can depend on the location of the store. For example, if the store is leased in a mall, it will be easier to dispose of the infrastructure materials because the next lessee will most likely be in need of some of the materials. In addition, a company that wishes to leave the market has to dispose of excess inventory while at the same time earning as much as possible from the sales on the discounted products. Because all of the companies in this industry have rival products, Chicos faces vigorous competition. The company maintains its business strategy of producing high quality, fashionable products that can be sold in store fronts by trained sales associates at a premium price. In addition, Chicos continues to place emphasis on its target

demographic and has attempted to successfully market its product using several different media avenues. Basically, Chicos focuses on what it does best: purchase and/or design a product that is perceived by its target demographic as the it product and continually enhance customer service in the store. This focus provides Chicos with the advantages it needs to remain competitive within the industry.

2.3 Rival Products

Competition on the basis of rival products is a constant threat in this industry. As previously discussed, each company has the same goal: produce and distribute the most fashionable apparel and accessories. Thus, a major source of competition for the target demographic is related to the designs of current and future product lines and their alignment with consumer tastes and perception of fashion. Maintaining high margins is

28

difficult in this industry due to the ready availability of rival products. Companies must differentiate themselves in order to preserve their margins. Chicos focus is to design, purchase, and develop the most desirable product mix as perceived by the customer. To distinguish itself from rival products that are not qualitatively different from its own product, Chicos spends time training its sales associates to understand fashion dynamics and be able to offer advice, as well as outfit ideas to customers in order to meet customers needs. Since rival products are perfectly substitutable, maintaining a high level of personalized customer service distinguishes the Chicos brand from its competition.

2.4 Bargaining Power of the End Consumer

The individual customer has low bargaining power alone but, collectively, they can be a potent force. Consumers are price sensitive and will switch to rival products if they feel the price is too high or even too low. This is magnified during economic declines but is less noticeable when the economy is booming. Several qualities that attract customers to a company are brand image, quality, fit, and customer service. These characteristics can increase customer loyalty to a particular brand of clothing. The information available to consumers today allows them to have more power than in previous decades. Consumers can run price checks through the Internet before buying the product as well as see which store has the product they are looking for in stock. The increase in information gives the consumer power to seek out and buy the highest quality product at the cheapest price. considerable power. Thus, the consumer is price sensitive and wields

29

Chicos is very susceptible to the bargaining power of the end consumer in that the end consumer provides the financial resources that allow the company to continue to operate. If consumers do not demand the product Chicos provides, the company will be left with excess inventory and little revenue to pay its expenses. In addition, due to fastpaced fashion cycles, excess inventory will have a higher obsolescence rate as time passes. Chicos entire business strategy revolves around the customers perception of the product and its characteristics, as well as the service provided to them at the store level and by other representatives of the company. The fact that Chicos entire strategy revolves around the customer magnifies the power of the end consumer.

2.5 Bargaining Power Between the Company and the Supplier

Merchandise is a large fraction of the buyers costs, so the buyer will be price sensitive if a lower-cost supplier is readily available. Many companies use short-term contracts with independent vendors to get the best deals. If the vendor wants repeat business, they must adhere to the quality control requirements of the buyer because the buyer can and will switch vendors rather easily. There are several non-monetary

switching costs that must be considered. First, it takes time to set up contracts even if they are short-term. Second, it takes time to go over quality control and shipping requirements. The main non-monetary expense relates to time. By switching vendors a company loses valuable time in which its merchandise would have been produced. Thus, there might be delays in orders which could ultimately affect the bottom line. When switching costs are low, it favors the buyer, and, if they are high, it favors the supplier.

30

In this industry, there is little threat of backwards integration.19 Companies do not have the access to cheap labor, low cost raw materials, nor do they have the capacity to manufacture their own merchandise. In fact, most companies do not wish to develop this capability as it would distract them from their core competencies of designing and selling the latest fashions. Since there is little threat of backward integration, suppliers gain a small advantage over the buyer. However, both groups are privy to all information available in the market, and, thus, neither group has an advantage over the other due to informational asymmetries. Chicos is less susceptible to the bargaining power of the supplier in that the company maintains a diverse set of suppliers, including manufacturers in Peru, Guatemala, Turkey, China, and India. In addition, it has cut and sew locations in Mexico, Guatemala, and the United States.20 Chicos purchases the raw materials and provides them directly to the cut and sew operations. If one supplier is unable to meet production levels or has quality control issues, Chicos should be able to maintain production levels by distributing the desired quota among already established suppliers. Thus, due to Chicos mature supply chain and diverse manufacturing channels, it is less susceptible to the power of suppliers.

2.6 Bargaining Power of Suppliers

Suppliers, including manufacturing and labor, do not have a lot of power over buyers because companies can find suppliers anywhere, especially in a global market. Because many suppliers are foreign, buyers have to be aware of import laws, regulations, and quotas than might increase costs or delay shipments of inventory. The product
19 20

Backwards integration is the act of a company taking over upstream supply chain operations. Chicos FAS, Inc. 2007 Annual Report, pg. 22

31

produced by the suppliers is extremely important to the buyers whose profitability depends on the success of that product. Normally, this would provide the supplier with power over the buyer, but, as mentioned before, there are many rival suppliers for the companies in this industry to choose from which nullifies the power. A company will

incur several switching costs when changing suppliers, such as the opportunity cost of lost time and various setup costs. If the company chooses to switch suppliers, it can be easy or difficult depending on how similar the operations and manufacturing processes are to the previous supplier used. If the supplier has different operations, then the company will have to spend time working with the supplier to obtain the quality product it desires. This will incur additional costs and delays in shipment of the product to the store. Thus, there are many rival suppliers which decrease the power of the supplier, but the switching costs involved can mitigate this to some degree. As stated in the preceding section, Chicos is less susceptible to the bargaining power of suppliers due to the fact that there are numerous global suppliers with which it could do business. Additionally, Chicos already has a mature supply chain with a large number of manufacturers in diverse locations. However, Chicos works hard to maintain quality control within its supply chain. If a manufacturer does not comply with the companys policy, the company may begin to search for a new supplier. The fact that the supplier market is highly concentrated is advantageous to Chicos. However, trying to find a supplier that meets Chicos requirements may be time consuming and less cost effective than retaining the current supplier. This provides the supplier with some power, however Chicos retains a considerable advantage in terms of bargaining power.

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Conclusion
The retail apparel industry is highly concentrated, competitive, and is currently facing stagnant growth. Existing companies with rival products are constantly competing to steal market share from other companies in the industry. To complete this task, companies work hard to carry inventory that is perceived by the customer as the latest fashion. Since end consumers have significant bargaining power in the industry,

companies must be aware of what the customer demands in order to survive each fiscal year. Like many companies within the industry, Chicos focuses on its core business and outsources it manufacturing. To differentiate itself from the competition, Chicos pays special attention to specialized customer service in which sales associates are trained to offer advice, style types, and cross-selling ideas to the customer. In addition, using its customer database, sales associates are provided information on color, style, and pattern preferences of repeat customers. Chicos business strategy revolves around customers wants and preferences. This provides the end consumer with considerable bargaining power. However, with regard to suppliers, Chicos has a mature supply chain in place with a diverse group of manufacturers located in multiple countries. This makes the company less susceptible to supplier power. Chicos is part of an industry with few barriers to entry, but it positions itself well within its target market and focuses on its core business.

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3. Competitor Analysis
Overview
In addition to considering the environment and industry in which Chicos operates, one must understand its direct competitors. These firms operate in the same markets and target the same consumers. The firms included in this analysis are Dillards, Talbots, AnnTaylor, Coldwater Creek, Christopher and Banks, and The Limited. Understanding of the competitors within the market is necessary to evaluate the strength of Chicos position within the industry. To further this understanding, we evaluate the size, financial position, and competitive strategy of each of the companies analyzed. It is important to note that the market is addressed by both traditional department stores, such as Dillards, and specialty boutiques like AnnTaylor. In general, competitors of each format tend to have similar strategies and initiatives with the primary competitive difference being the ability to consistently execute. As such, it should be understood that the below selection of

competitors is not comprehensive, but many of the issues discussed are readily applicable to competitors of the appropriate format.

3.1 Dillards21
Dillards is a traditional department store incorporated in 1964. Run by the Dillard family, Dillards had $7.5B in revenue in fiscal year 2007, has a nationwide presence, and, as a traditional department store, serves multiple target markets from under one roof. Major identified lines include cosmetics, ladys apparel and accessories,

21Dillards,

Inc. 2007 Annual Report

34

juniors and childrens apparel, mens apparel and accessories, shoes, and home furnishing. Dillards primarily operates as a buyer-based retailer; it sources and resells nonDillards branded products within all of the above-mentioned product lines. In 2002, Dillards changed this strategy to include Dillards private-label products, which have grown to make up 20% of Dillards overall sales. In an effort to improve results and limit exposure to credit risk, Dillards sold its credit arm to GE Money Bank in 2004. This move reduced Dillards exposure to bad consumer debt and allowed it to focus on its core operations. The agreement was structured in a way that Dillards would continue to market the Dillards store credit card and receive residual income from GE Money Bank from consumers that continued to use the card. In recent history, Dillards has experienced minor gains in revenue but increasing profitability due to reduced interest payments stemming from the retirement of $560M in debt. These increased efficiencies contributed to a trend of improved profitability for several years. However, in fiscal year 2007, Dillards was hit hard by the recent market downturn posting net income 80% lower than in fiscal year 2006. As a retail department store that serves multiple market segments, Dillards is not a focused competitor in the 35 and older upscale womens apparel market. While

Dillards seeks to target customers seeking upscale products, its multiple product lines and buyer-based strategy reduce its direct impact on the womens apparel market. Because it sources external brands, Dillards has difficulty building the brand loyalty that is critical in this market; primarily, its competitiveness is based on its ubiquitous presence

35

in the regions in which it operates and its reputation for selling higher-quality products than traditional department store competitors such as JC Penney.

3.2 Talbots22
Talbots is a womens apparel company incorporated in 1947. It targets women aged 35 and older seeking upscale, high-quality apparel and accessories. Talbots seeks to deliver a current-classic look with its private label product lines and makes a deliberate effort to ensure that products are complementary to maximize cross-selling opportunities. Talbots operates its retail presence as a boutique format store, which allows it to expand beyond the confines of a mall and operate on Main Street. This is in line with Talbots more upscale strategy, allowing it to target upscale consumers that may find shopping in a mall undesirable. Additionally, Talbots operates a successful direct

marketing division which contributes 19% of revenue and allows Talbots to directly track some of its customers preferences for internal evaluation purposes. In recent years, Talbots has experienced stagnant or declining revenues. Making matters worse, operating efficiencies have declined due to increasing costs stemming from increased warehousing costs, supplier costs, and costs associated with replacing executive level management in an effort to improve performance. Talbots attempted to address the issue of revenues, in part, with its acquisition of J. Jill in 2006. The J. Jill acquisition was primarily intended to increase market share and revenues as it operates in approximately the same market as Talbots (albeit slightly upscale); however, the acquisition has not turned out as planned. In the most recent fiscal year, Talbots had to
22The

Talbots, Inc. 2007 Annual Report

36

write down assets related to the J. Jill acquisition. In addition, the J. Jill acquisition was financed heavily by debt. operating results. Due to these difficulties, Talbots has begun an internal re-evaluation process in an attempt to revitalize the company. As a result of this process, Talbots has expressed a commitment to becoming a more design-led company in an effort to differentiate its products in the market and to drive sales. The resulting interest payments have further depressed

3.3 Ann Taylor23

AnnTaylor Stores Corporation is a womens career and casual wear retailer established in 1945. Started as a primarily East Coast brand, the company has grown into a national brand and generated $2.4B of revenue in fiscal year 2007. AnnTaylor targets affluent women and provides them with updated classic products. AnnTaylor operates multiple brands, including Ann Taylor, LOFT and Ann Taylor Factory. Its product line is comprised of suits, separates, footwear and

accessories. Although AnnTaylor has an Internet storefront, it is primarily a brick-andmortar presence with 929 retail stores. To differentiate itself from other competitors, AnnTaylor focuses on updated classic, yet stylish, professional and special occasion dressing.24 It also pays special attention to strengthening its brand names. Like other companies in the industry, AnnTaylor is experiencing difficulties and negative same-store sales growth due to poor macroeconomic conditions. In reaction, the

23AnnTaylor 24

Stores, Corp. 2007 Annual Report AnnTaylor Stores, Corp. 2007 Annual Report, pg 2

37

company initiated a restructuring program that includes reviewing the cost structure of the company, closing underperforming stores, and streamlining organizational structure. We have selected AnnTaylor as our back-up acquisition candidate. An in-depth analysis of AnnTaylor is located in the alternative acquisition candidate section.

3.4 Coldwater Creek25

Coldwater Creek is a womens casual wear company founded in 1986. It

provides casual wear and accessories to women aged 35 and older. Founded as a direct marketing company, Coldwater Creek has a penchant for sales innovation, expanding as both a traditional retail presence and by experimenting with unusual retail formats. Although historically a direct marketing company, Coldwater Creeks expansion strategy has resulted in the majority (70%) of its $1.15B per year revenues coming from its brick-and-mortar retail stores. Coldwater Creeks product line is made up of privatelabel casual wear, and the company seeks to differentiate itself with unique designs and high-quality apparel. Additional efforts to differentiate include early-stage experimental format stores, such as Coldwater Creeks Spa concept, which co-locates a spa with a Coldwater Creek retail presence. The strategic importance of nationwide marketing to Coldwater Creek is unique among its competitors. It places a high emphasis on its ability to effectively place advertisements in national publications and allocates resources that reflect this emphasis. Like the rest of the industry, Coldwater Creek has experienced difficulties in recent years. Increasing costs have cut into its bottom line, as has a large decrease in same-store sales in recent years. Coldwater Creek is attempting to address its increasing
Creek, Inc. 2007 Annual Report

25Coldwater

38

supply chain costs by cutting out middlemen.

Historically, Coldwater Creek used

intermediaries to source its products, but it has recently made a strategic decision to begin dealing directly with upstream suppliers. Coldwater Creeks main strength is its willingness to experiment with growth strategies to grow beyond its current position. It has grown from a direct marketing company to a primarily retail company, and continues to experiment with sales models in an attempt to attract new customers.

3.5 Christopher and Banks26

Christopher and Banks is a womens apparel company founded in 1956. It targets women aged 40 to 60 seeking casual fashion and accessories for work and leisure. It generated $575M in revenue in fiscal year 2008. Christopher and Banks operates

multiple retail brands, including Christopher and Banks, CJ Banks (which focuses on plus-sized clothing), and Acorn. Christopher and Banks primarily operates a brick-and-mortar presence, with relatively little direct-marketing revenue. It only recently opened a Web storefront in February 2008. The majority of its stores are located within traditional mall spaces. For all of its stores, Christopher and Banks uses a combination of externally branded and private label products, attempting to provide a variety of coordinated products, which are easily combined into complete outfits. To differentiate itself, Christopher and Banks seeks to provide distinctive products in line with the current years fashion trends. Like the rest of the industry, Christopher and Banks is experiencing difficulties due to the macroeconomic environment, with stagnant same-store sales and decreasing
and Banks, Corp. 2007 Annual Report

26Christopher

39

margins across its brands. This led to a recent announcement to close all Acorn stores by the end of 2008. Management primarily hopes to address the issue through

improvements to operating efficiencies, with programs in place to improve supply chain efficiencies, improve direct marketing initiatives, and increase conservatism in store expansion. Additionally, Christopher and Banks will expand select product lines (e.g., petites) in response to proven customer demand. The initiatives to improve the supply chain may experience unexpected difficulties. Christopher and Banks sources the majority of its products overseas through third-party agents. The company is in the unenviable position of sourcing 47% of its products through a single agent, who has recently informed Christopher and Banks that it intends to cease operations. Christopher and Banks is working to prepare for this

eventuality but should expect problems resulting from this event. Management additionally recognizes that it must improve same-store sales performance. In addition to its efforts to realize increased efficiencies, Christopher and Banks intends to increase its marketing expenditures from 1% to 1.5% of sales. It is hoped that this increase in marketing will drive additional traffic to existing stores and to Christopher and Bankss new websites, resulting in increased sales.

3.6 Limited Brands, Inc.27,28

Limited Brands, Inc. was originally founded as The Limited in 1963, specializing in young womens apparel. Over the years, Limited Brands has developed, acquired, and

Brands, Inc. 2007 Annual Report discussion of Limited Brands, Inc. has been primarily restricted to the Victorias Secret segment, which comprises over 50% of Limited Brands net sales. Victorias Secret represents a special issue for Chicos FAS with respect to the Soma Intimates line, and is the major reason why Limited Brands, Inc. is discussed.
28The 27Limited

40

occasionally divested itself of multiple specialty retailers, including The Limited, Express, Victorias Secret, Bath & Body Works, Abercrombie & Fitch, and La Senza. As currently constituted, Limited Brands primarily operates Victorias Secret and Bath & Body Works. In fiscal year 2007, Limited Brands generated $10B in net sales. Victorias Secret and Bath & Body Works collectively constitute over 80% of Limited Brands total net sales. In 2007, the company divested itself of the underperforming Express and The Limited segments and acquired La Senza. The Victorias Secret segment sells womens intimate apparel, personal care, and beauty products. Recently-acquired La Senza is organized under the Victorias Secret segment. Victorias Secret dominates the womens intimate apparel market in North America. In 2007, the segment had net sales of $5.6B across 1,300 store-fronts. The Victorias Secret brand has tremendous mindshare in North America and is one of the strongest brands in womens intimate apparel. The company has prominent advertising campaigns featuring fashion supermodels, direct catalog marketing (Victorias Secret Direct), and a nationally televised, prime-time fashion show. Despite Victorias Secrets strong position, Limited Brands does not escape the macroeconomic downturn that is plaguing the fashion industry. Net income increased for fiscal year 2007, but the increase is primarily attributable to the acquisition of La Senza. Same-store sales declined by 2% compared to 2006. Additionally, Limited Brands has been plagued by serious supply chain management issues. It recently implemented new supply chain systems at Bath & Body Works and had to build up inventory as a hedge against supply chain disruptions during the conversion from the old system. Additionally, Victorias Secret Direct has had issues

41

with a new distribution center, resulting in significant shipping delays and additional costs to address the issue. Limited Brands makes considerable use of debt to finance its activities. It

currently has $2.9B outstanding, a $1.5B revolving credit line, and $300M of debt that can be issued from an outstanding shelf registration. This reliance on debt exposes Limited Brands to interest rate risk and the need to redirect some of its operating income to both servicing debt and potentially having to repay principal (e.g., over $1B in principal is due in 2012). This, however, is a remote risk for the company.

3.7 Other Competitors

There are many other competitors within the industry that might serve Chicos target demographic. Almost all major department stores will have floor space dedicated to serving adult females of all ages. However, department stores do not consider Chicos target market to be their mission. Their business models are fundamentally different, with the companies operating under a big tent philosophy, where they attempt to attract customers of all kinds. Most of these department stores are roughly comparable to Dillards in terms of strategy and the threat they pose to Chicos. Additionally, there are targeted retailers that have some overlap with Chicos. Abercrombie & Fitch and American Eagle Outfitters might best be described as overlap competitors. Both target customers younger than 25 years of age, while

WH|BM targets customers older than 25 years of age.29,30 There is necessarily some overlap in customer taste and some competition for customers at these edges, but the primary focus is different.
29Abercrombie&Fitch,Co.2007AnnualReport 30AmericanEagleOutfitters,Inc.2007AnnualReport

42

There is constant threat of entry from new competitors or established brands seeking entry into Chicos target market. For example, Abercrombie & Fitch has

established two new brands RUEHL and Gilly Hicks specifically targeting women in WH|BMs 25-40 range.31 These new competitors are always lurking, eager to steal market share at the smallest misstep.

Conclusion
Due to constant competition and ease of entry, companies in the fashion industry are always a season away from disaster. Success is dependent primarily on two factors: the ability to create the perception of a qualitative difference in the customers mind and simple execution. To this end, companies seek to build a strong brand identity and a consistent process for identifying and delivering what the customer wants, when they want it.

31Abercrombie

& Fitch, Co. 2007 Annual Report

43

4. Financial Ratio Analysis

Overview
After analyzing Chicos competition, one must consider Chicos financial health. The following will analyze financial ratios for the years 2003 through 2007 for Chicos and for its industry. The selected ratios cover the major financial areas of liquidity, activity, profitability, leverage, and stock market. For each family of ratios, we will explain the general trend for Chicos over the five-year period, isolating any individual ratios by year that vary from this trend. We will also discuss the reasons for the overall company trend. Second, for each year of the analysis, we will compare Chicos ratios to that of the industry and discuss whether family or individual ratios are materially different than the industry standard. To obtain a good representation of each family of ratios, we will use a materiality of at least two times (2X). In other words, Chicos ratios will be considered materially different if they are at least 2X above or below the industry average. Finally, we will discuss the strategic, operational, and/or tactical implications of the firms position relative to the family of ratios. Analyzing the aforementioned ratio families will help to understand Chicos overall strengths and weaknesses and will allow one to speculate on the companys future financial condition. For the purposes of this analysis, our group selected five companies to comprise a comparables/competitor basket for Chicos. The five companies selected were:

Christopher & Banks Corporation, Coldwater Creek Inc., Dillards Inc., Talbots Inc., and AnnTaylor Stores. These companies were selected based on similarities in industry, market capitalization, target customer demographics, pricing points, and identification in

44

Chicos annual report.32 The stock market ratios for each company were found using the Bloomberg terminal; the remaining ratios were found using Research Insight Web and Whartons Research Data Services. The industry average for each ratio within each family was calculated as a simple average of all five companies, with outlier data excluded from the calculations. The data for the ratio families for Chicos and the industry averages can be found in Appendix A.

4.1 Liquidity Ratios

From 2003 through 2007, the trend of the liquidity ratios increased with a peak in 2005 and a subsequent decline through 2007. Generally, this resulted in a relatively flat, five-year change in liquidity with the exception of the working capital per share and cash flow per share ratios. These ratios ended at a higher level than 2003. Working capital per share followed the family trajectory from 2003 through 2005 but declined at a slower pace from 2005 through 2007. Cash flow per share followed the family trajectory but at a slower (or flatter) pace. With the exception of 2003 and 2005, Chicos cash and short-term investments remained stable in the $265 - 275M range. Likewise, operating cash flows remained in the $210 - $290M range for most of the period. Accounts receivable and inventory, however, grew with average five-year growth rates of 27% and 21%, respectively. Accounts payable and accrued expenses grew 25% and 24%, respectively, from 2003 through 2007. Likely, these increases in working capital accounts were a result of Chicos growth-through-acquisition strategy and its ability to increase sales and operations over the five-year period as it continued to grow in the industry.
32

Resources used: Bloomberg, Chicos 2007 10K, Hoovers Pro, and Google Finance

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Compared to the industry, Chicos quick ratio, working capital per share, and cash flow per share statistics were materially different. From 2004 through 2007, Chicos quick ratio ranged from 2X to 2.5X that of the industry. The five-year quick ratio average for Chicos was 2.3 versus 1.3 for the industry; Chicos five-year average was almost 2X that of the industry. Related, the five-year average for the Chicos current ratio was 3.4 versus 2.6 for the industry, a difference of 1.3X. With the exception of higher values in 2003, both the industry working capital per share and cash flow per share ratios were 2X those of Chicos. From working capital per share and cash flow per share perspectives, Chicos liquidity position depends on its working capital management. Since 2005, Chicos working capital declined. Over the five-year period, receivables and inventories grew because of increased demand and sales in stores and through the internet. Additionally, Chicos acquired WH|BM in 2003 and launched Soma Intimates in 2004. The company also opened 592 new stores and acquired 15 stores from franchisees over the five-year period.33 This growth also contributed to increased accounts payable over the period. Increasing receivables is good if it means increased sales. However, it could be negative if attributed to lower turnover of sales into cash, too-relaxed credit policies, and ineffective monitoring of overdue client accounts, all of which reduce access to cash. Increasing inventories is likewise good if it means increased demand and sales, but it could be negative if attributed to slowing turnover or conversion to sales, which ultimately leads to cash. Also, rising inventories could be an indication of obsolescence, a key risk factor in the fashion industry. Finally, increasing accounts payable is good
FAS, Inc. 2007 Annual Report, pg. 36

33Chicos

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from a cash management perspective of delaying cash out the door, if the company ensures that it is not incurring late fees on invoices or harming vendor relationships. In addition to affecting the working capital per share and cash flow per share ratios, inventory and receivables levels factor into the current and quick ratios. From both an absolute and relative perspective, Chicos current and quick ratios were strong. Additionally, the analysis in the activity ratios section below will show that Chicos overall activity management was better than that of the industry. Given that analysis, we have confidence in concluding that Chicos liquidity position overall is strong. Strategically, Chicos better liquidity position gives it several advantages over its competitors. This liquidity position allows the company, going forward, to pursue

positive NPV projects and to take on additional projects or investments if attractive opportunities should arise. For example, Chicos can more aggressively pursue the strategy of remodeling its existing stores as stated in its 2007 annual report and even add more creative changes to its original plans. Chicos liquidity position coupled with stronger-than-industry price multiples (discussed later in the analysis) gives Chicos advantageous payment alternatives (cash and/or stock) for potential acquisitions. These same payment alternatives allow the company to incentivize existing employees and to attract key outside personnel to the company. Abundant liquidity allows the company the option of implementing a dividend-paying policy, a favorable movement from an investors or analysts viewpoint. Strategically, a dividend-paying stock is more

attractive to the market because it indicates the companys ability to generate cash flows to pay dividends. Also, in addition to stock appreciation, dividends are another form of

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return on investment. Finally, Chicos, with access to liquidity, is in a better operational position than competitors to get through the current economic crisis. A potential downside of a strong liquidity position is that a company may not be as critical when evaluating projects and investments or may not be as cost-effective operationally. Chicos should be aware of these potential risks and mitigate by effective internal controls on the capital review and allocation process and on cost management.

4.2 Activity Ratios

From 2003 through 2007, Chicos activity ratios, for the most part, remained relatively flat with one major exception. The average collection period, the days to sell inventory, and the operating cycle ratios ended with a slight increase in 2007, while the inventory turnover and total assets turnover ratios ended with a slight decrease. The largest outlier was the receivables turnover ratio, which showed a material, overall decrease over the five-year period. Although rising from about 179 in 2003 to 186 in 2004, receivables turnover declined every year thereafter through 2007 to end at a ratio of about 68. The trend of the receivables turnover ratio implies that Chicos credit policies were tighter in 2003 and became more relaxed over the time period 2004 through 2007. Given that the average collection period remained relatively flat for most of this same time period indicates that Chicos credit policies, although changing, remained effective for the company and, in fact, relative to the industry as will be discussed later. When compared to the industry, Chicos ratios were materially different over the five-year period for the following ratios: receivables turnover, average collection period, days to sell inventory, and operating cycle in days. Regarding the receivables turnover

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ratio, Chicos was more than double the industry standard for years 2003 through 2005, greater than 1X the industry in 2006, and in line with the industry in 2007. Related to the receivables turnover ratio is the average collection period in days. As expected from the previous analysis, the industrys average collection period was materially over that of Chicos. In 2003, the industrys average was approximately 11X that of Chicos and decreased year-by-year ultimately to 2X in 2007, as Chicos credit policies relaxed over the five-year period. The industry averages for both days to sell inventory and operating cycle in days were higher than that of Chicos. Days to sell inventory was about 2X Chicos in all five years, while the operating cycle steadily declined from 2.6X in 2003 to 2.4X in 2005 to almost 2X in 2007. Operationally, a higher receivables turnover ratio for Chicos relative to the industry indicates that, historically, Chicos payment terms for its customers may have been more effective than that of the industry and that Chicos credit policies were tighter. As a smaller company relative to its comparables basket, Chicos may have enforced tighter credit policies to manage collection of sales (cash management). The fact that Chicos receivables collection period was shorter further supports the fact that Chicos may have been more effective in its receivables policies, resulting in a higher turnover and a shorter collection period. On the other hand, Chicos tighter credit terms, historically, may have been a disadvantage relative to other competitors who may have been able to offer more attractive credit terms and generate more sales as a result. Additionally, accounts

receivable accrues no interest and is, in effect, an interest-free loan to customers. The

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decline in receivables turnover over the five-year period through a relaxation of credit terms could mean that Chicos was less effective at managing client accounts and, therefore, collection of cash. Strategically, relaxed credit terms could have contributed to increased sales. However, the slow-down in receivables turnover could have resulted in lost investment opportunities for the company with cash tied up in receivables. Given both historical points of view, the company is in line with the industry receivables turnover ratio as of 2007 but has a faster collection period than the industry. Going forward, this means that Chicos credit and collection policies are more effective than the industry, contributing to better cash management with respect to receivables. Within this five-year period, the industry took longer than Chicos to convert inventory to sales, and this contributed to longer operating cycles. Again, this is an operational advantage for Chicos in that it is more effective at managing the conversion of inventory to sales and ultimately cash through a shorter operating cycle.

4.3 Profitability Ratios

From 2003 through 2007, the overall trend of Chicos profitability ratios was a decline, with relatively little movement between 2003 and 2005 but a more rapid decrease afterwards. All company profitability ratios closely exhibited this behavior. From 2005 to 2007, Chicos net income decreased 54% over the two-year period, while sales, assets, and equity increased 22%, 25%, and 13%, respectively. Specifically for 2006 to 2007, Chicos net income decreased 47%, with corresponding increases in sales, assets, and equity of 5%, 18%, and 14%, respectively. From 2005 to 2006, Chicos experienced declines in profitability due to a product offering that did not keep up with fashion demands, inadequate marketing, and

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inconsistency in applying its most amazing personal service strategy.34 Reasons cited for profitability declines from 2006 to 2007 were similar: clothing that was not compelling enough to the consumer, inadequate marketing, and consumer reaction to a slowing economy.35 The industrys trend over the same time period had the same overall result as that of Chicos a decline. However, the industrys decrease was slower, with the more rapid decline occurring after 2006 versus 2005. When compared to the competitor basket, Chicos profitability ratios were materially over industry averages for all ratios and all years. Chicos operating margin after depreciation ratio moved from 2.5X the industry in 2003 to a peak of 3X the industry in 2004 and 2005 and to a subsequent decline to 2.7X in 2007. Over the five-year period, Chicos ROE was generally 2.1X the industry average. Although Chicos net profit margin, on average, was 2.5X that of the industry from 2003 through 2006, the ratio spiked to 46.7X the industry in 2007. Likewise, Chicos ROA showed a four-year average of 2.1X the industry before spiking to 74.4X the industry in 2007. Comparing Chicos 2006 to 2007 percent changes in net income, sales, assets, and equity noted above to the industry explains the behavior of the 2007 spikes in net profit margin and ROA and why ROE was not as materially impacted.36 Generally, the

industry had much larger declines between 2006 and 2007 in net income, specifically Coldwater Creek, Dillards, and Talbots. In the cases of Coldwater Creek and Talbots, a net income position in 2006 swung to a net loss position in 2007. Regarding sales, the industry showed declines in some cases, Talbots and Dillards, while the remaining
34Chicos 35

FAS, Inc. 2006 Annual Report, Letter to Shareholders Chicos FAS, Inc. 2007 Annual Report, Letter to Shareholders 36 Analysis using Google Finance financial statement data

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comparables and Chicos showed an average increase of 5%. The industry comparables also had smaller increases in total assets and, in some cases, declines in assets, as was the case for both Talbots and AnnTaylor Stores. All comparables had declines in equity versus Chicos increase in equity over the same period. A slowing economy was cited as the main reason for the decline in profitability among the comparables various annual reports. Strategically, although Chicos experienced declines in profitability for macroeconomic reasons affecting the entire retail apparel industry, it is in a better position relative to its comparables. Higher profitability increases the likelihood of positive operating cash flows and the liquidity to be able to invest in positive NPV projects both planned and unexpected. Additionally, the company is in a better position to invest resources necessary to manage operations effectively. Profitable firms gain favor with Wall Street analysts and potential investors. This is supported by Chicos better-than-industry stock market ratios discussed later. With profitability and liquidity, the company could take the opportunity to implement a dividend-paying policy. Dividend-paying stocks are attractive to shareholders and analysts. Finally, higher

profitability gives Chicos the advantage of being able to withstand price wars or significant variation of input costs.

4.4 Leverage Ratios

For the five-year period analyzed, Chicos did not have debt in its capital structure, which is significantly different than that of the industry average. The industry utilized both debt and equity as components of capital structure. The industry pattern

over the five-year period showed a dip in leverage from 2003 through 2005 with a

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subsequent rise through 2007. Generally, this trend produced relatively little change in leverage levels in 2007 versus 2003. Industry debt levels as a percent of equity were below 25% over the five-year period; the industry relied more heavily on an equity capital structure. Chicos total assets-to-common equity ratio remained stable over the five-year period 2003 through 2007. This ratio was slightly below, but in line, with both the trend and level of the industry. Strategically, Chicos is in a better leverage position relative to its industry. Because of its ability to generate positive net income and strong cash flows, Chicos has been able to finance projects internally without reliance on debt capital markets or cash flows dedicated to interest payment requirements. Going forward, the company has the option to utilize its lines of credit and/or take on additional forms of debt for unexpected, positive NPV projects, for example. If Chicos chooses this option, it will likely be able to meet interest payments, as supported by Chicos strong liquidity position discussed above. Chicos strong liquidity and financial position will likely allow it to obtain debt at better rates than its competitors, giving it yet another strategic advantage in minimizing financing costs. A potential downside of maintaining a purely equity structure is a tradeoff between using cash for certain projects when debt obtained cheaply may have proven to be more beneficial. In other words, were projects materially accretive to earnings

foregone to maintain a no debt policy and, instead, other projects undertaken that were less accretive?

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4.5 Stock Market Ratios

For the time period 2003 through 2007, Chicos stock market ratios followed the same overall trend. This trend exhibited a peak-and-valley movement with increases from 2003 to 2004, declines or remaining flat between 2004 and 2005, with the pattern repeated in 2006 and 2007. Ratios in 2007 were not materially different, per the 2X criteria, than those in 2003. Chicos stock market ratios were materially over the industry for price/book, price/sales, price/cash flow, and price/EBITDA. Regarding the price/book ratio, Chicos was almost 4X the industry in 2003, about 3X from 2004 through 2006, and a little over 2X in 2007. Price/sales differences were larger with over 4X during years 2003, 2004, and 2006, and 3X and 2.4X differences in 2005 and 2007, respectively. Price/cash flow followed the same trajectory as price/sales, with larger differences in 2003, 2004, and 2006. Finally, price/EBITDA remained in the 2X to 2.5X range from 2003 through 2006 and declined to 1.4X in 2007. Strategically, Chicos has a competitive advantage over its industry - all stock market ratios for Chicos exceeded the industry averages. This shows that investors placed a higher value on Chicos stock relative to its competitors on the variables of earnings, EBITDA, sales, book value, and cash flow. For example, a high price/earnings or price/EBITDA ratio (as in Chicos case) relative to the industry means that, at roughly equal or even lower earnings, the market recognizes value and rewards accordingly through a higher demand, resulting in a higher stock price. On the other hand, a low price/earnings or price/EBITDA ratio may mean higher earnings per share, but the market penalizes or undervalues the stock for other reasons, for example, low confidence

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in the companys ability to generate future operating cash flows. The higher price/sales ratio indicates that the market believed Chicos was better able than competitors to obtain a profitable return on sales. Chicos higher price/book ratio indicates that the market believed management was making productive use of the companys assets as compared to competitors. Finally, the higher price/cash flow ratio was a signal of the markets confidence in the companys ability to generate cash flows. Going forward, Chicos strong stock market ratios give the company more edge in being able to use its stock for potential acquisitions. Additionally, Chicos stock can be an attractive tool for compensation, relative to its competitors, for both existing employees and as an incentive to attract key personnel from outside the company. Finally, Chicos favorable stock market ratio position may allow the company to obtain external capital, if necessary, at lower costs than its competitors.

4.6 Overall Strengths/Weaknesses and Future Financial Condition

The financial analysis above indicates that Chicos has several competitive advantages over its industry but still has room for improvement from an absolute perspective. From a liquidity standpoint, Chicos has strong current and quick ratios in both an absolute and relative sense. However, working capital per share and cash flow per share are lower than the industry. Chicos working capital had an overall decline over the five-year period due to increasing accounts receivable, inventories, and accounts payable. The growth in these accounts was attributable to Chicos growth through acquisition and new store expansions during this same time period. Going forward, Chicos needs to ensure effective management of working capital accounts to mitigate inefficiencies in collection of cash and obsolescence of inventory. The review of the

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activity ratios shows that Chicos appears to be very capable at managing both receivables and inventory, with better turnover ratios, receivables collection periods, and shorter operating cycles than the industry. Given the strong current and quick ratios, the explanation of growth in the working capital accounts over the five-year period, and the overall positive position regarding activity ratios, we believe Chicos liquidity position is strong. This gives the company the flexibility over its industry to take on strategic initiatives in addition to meeting operational requirements. Although Chicos profitability measurements exceed those of the industry, the companys declining performance in an absolute sense is a concern. The entire industry has been and will continue to be affected by a degrading economy. However, Chicos has repeatedly cited an incorrect product offering and inadequate marketing as contributors to its declining performance. In one case, degradation in customer service was also cited. These variables are key competitive points in the fashion industry, and the fact that Chicos is a repeat offender is disturbing and could be detrimental if not addressed going forward. The fact that Chicos has no debt and has been able to outperform its competitors is its strongest point. With its liquidity position, Chicos has been able to rely on itself to finance its growth-by-acquisition strategy. Going forward, the company is in a good position should the need for debt arise for attractive projects or for operational purposes. Likely, the companys strong liquidity and price multiples will allow the company to obtain debt more cheaply than similar actions by competitors. As discussed earlier, Chicos profitability measures are materially over the industrys average. Most notably, Chicos ROE and ROA are very strong relative to the

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industry. ROE is a highly-valued statistic reviewed by investors and Wall Street and, as a result, is a key driver of stock price and the companys price multiples. Furthermore, Chicos ability to generate high operating cash flows, along with its ability to generate highly-positive returns, gives investors the expectation that the company will continue to be profitable relative to competitors in the future. With the strengths and weaknesses noted above, Chicos has more strengths than weaknesses and, going forward, appears to be in a better financial position overall as compared to its industry. The economy is hitting the retail apparel industry very hard, and the consumers reaction is decreased demand. Economic forecasts predict that the economy will get worse before it begins its rebound. Although Chicos has strategic and operational advantages relative to its industry, it must pay attention to the profitability issues cited in the last two years annual reports. If Chicos is not able to offer the right product mix or service to the fashion consumer or if marketing continues to be inadequate, Chicos will lose critical sales and its strategic/operational advantages. In the current state of the economy, the company must be able to control costs and to figure out how to cut prices to try to boost demand. Failure to do so will erode the companys income, cash flows, and liquidity position, with a resulting decline in Chicos stock market value and confidence levels.

Conclusion
The above analysis reviewed the financial ratios for the years 2003 through 2007 for Chicos and its industry for the ratio families of liquidity, activity, profitability, leverage, and stock market. For each family of ratios, we explained the general trend for Chicos over the five-year period, isolating any individual ratios by year that varied from

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this trend; we also discussed the reasons for the overall company trend. Second, for each year of the analysis, we compared Chicos ratios to that of the industry and discussed whether family or individual ratios were materially different than the industry standard, using a materiality level of 2X over/under the industry average. Next, we discussed the strategic, operational, and/or tactical implications of the firms position relative to the family of ratios. Finally, after analyzing the aforementioned ratio families, we

indentified Chicos overall strengths and weaknesses and speculated on the companys future financial condition.

5. Chicos SWOT Analysis

Overview
Based on the retail apparel industry and Chicos-specific analyses thus far, we conducted a comprehensive analysis in order to assess Chicos strengths, weaknesses, threats, and opportunities.37 This analysis helped us to identify the challenges Chicos faces going forward and to determine specific strategic recommendations. The SWOT matrix is shown in Table 1. The specific points within each section and their strategic impacts are discussed in more detail in the subsections that follow. Post-acquisition strategic initiatives derived from the SWOT analysis will be discussed later in the strategy section.

37

We changed the order because we felt the information flowed better to lead up to opportunities.

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Table 1. SWOT Matrix

STRENGTHS Customer interaction process o Loyalty programs o Customer service training program o Customer tracking database Strong financial position o Debt free o High liquidity o Effective inventory and receivables management o Strong stock market ratios Brand equity Experienced leaders Strategic outsourcing (foreign suppliers) Outlet stores Efficient supply chain distribution

OPPORTUNITIES Increased focus on core strategy of personalized attention o Strengthen customer service o Realign merchandise and marketing Halt expansion and focus on existing stores Integrate Soma into Chicos stores Overseas offices in Asia to oversee manufacturing and quality control Build strategic relationships More actively manage exchange rate risk

WEAKNESSES Inappropriate or mismatched product mix (last 2 years) Marketing ineffectiveness (last 2 years) Declining profitability Dependence on foreign suppliers Dependence on single distribution location Low value-added acquisitions

THREATS Consumer reaction to current economic crisis Changing consumer tastes/fashion trends Competition Dependence on foreign suppliers and third-party manufacturers Internet Significant increases in costs 59

Exchange rate risk Changes in government regulation

5.1 Strengths
Chicos has a strong, formalized customer interaction process. Chicos and

WH|BM loyalty programs include the Passport Club and Black Book, respectively. Operating as in-store credit cards, these programs provide perks, such as periodic discounts, to encourage demand from new customers and to retain existing ones. Chicos formalized customer service training program emphasizes personalized attention through its Most Amazing Personal Service standard.38 The goal for the companys employees is to customize a persons shopping experience by establishing a relationship with the customer through understanding her fashion needs and preferences. Chicos seeks to make the customer happy by making her feel unique! This approach will increase the likelihood of customers returning to the store and sharing their positive experiences through word of mouth, which will, in turn, increase traffic into the store. The use of a customer-tracking database helps Chicos to better understand customer preferences and the popularity of various inventory items. The database is a tool to further allow Chicos to enhance an existing customers shopping experience through offering suggested items, discounts, advanced sales, free shipping, etc.39 The loyalty programs, the focus on personalized attention, and the benefits from maintaining a customer database incentivize existing customers to return to the store, a key motivator given the current declining trends in consumer spending.
38 39

Chicos FAS, Inc. 2007 Annual Report, pg. 6 Chicos FAS, Inc. 2007 Annual Report, pg. 7

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Based on the ratio analysis discussed earlier, Chicos is very strong financially. Chicos has been able to fully fund growth and operations with operating cash flow. Having no debt is a strategic advantage to Chicos relative to its industry in that Chicos does not need to forego operating cash flows to service debt. However, Chicos could obtain debt at a lower cost, if needed. Chicos strong liquidity position allows the company to remain debt-free and to access cash for attractive, positive NPV projects. Additionally, with high access to liquidity, the company is in a better operational position than competitors to get through the current economic crisis. Also detailed in the financial ratio analysis earlier in the paper, Chicos is managing inventory and receivables activities more efficiently than competitors. This contributes to a faster conversion of inventory and receivables to cash, further supporting Chicos strong liquidity position and the advantages mentioned above that this allows. Chicos strong financial position in the aforementioned areas contributes to higher stock market ratios relative to competitors. The market is placing a higher value on Chicos with regards to price/earnings, price/EBITDA, price/sales, price/book value, and price/cash flow. This position improves the companys visibility and reputation on Wall Street and to potential investors. In turn, these reputation effects allow Chicos stock to be more easily used for potential acquisitions. Additionally, the companys stock can be an attractive tool for compensation, relative to its competitors, for both existing employees and as an incentive to attract key personnel from outside the company. Through the efforts of its customer service, brand equity has become one of Chicos main strengths. The company has been able to attract and maintain a loyal customer base within its target market. As discussed previously, Chicos has been able to

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consistently post higher profits than its competitors, and its stock market ratios have shown the markets tendency to place a higher value on Chicos relative to the industry. Strategically, brand equity gives Chicos more visibility in the marketplace. The

resulting reputation effects increase the chances of new customers visiting the store and existing customers continuing to return both of which are very favorable actions, especially as customers become more price sensitive in the current economic crisis. Chicos leadership base is solid. The top leaders have years of experience with the company; have held various positions within the retail apparel industry, such as AnnTaylor Stores, The Gap, and Macys; or have leadership experience at other companies.40 For example, CEO Scott Edmonds started with the company as an

operations manager in 1993. Before coming to Chicos, he was President of Ferguson Enterprises, Inc a plumbing and electrical wholesale company.41 With combined years at the company and through retail industry experience, Chicos leaders are familiar with the industry and its historical ebbs and flows. They are well positioned to see the company through the current economic crisis. The company has a brand president for both Chicos and WH|BM with prior experience holding high-level positions at the aforementioned retail apparel companies. Appointing high-level executives to brand management shows the companys emphasis on investing in its reputation and building brand equity. In addition, this structure allows brand value and equity to be managed more holistically rather than being a by-product of operations management.

40 41

Chicos FAS, Inc. 2007 Annual Report, pg. 30-31 Chicos FAS, Inc. 2007 Annual Report, pg. 30-31

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Strategic outsourcing is a strength of the company. Chicos uses foreign suppliers and third-party manufacturers in China, India, Guatemala, Peru, and Turkey for its clothing in order to take advantage of lower manufacturing cost structures in these localities relative to the United States. Strategically, this allows Chicos to maintain high gross margins and effectively manage its pricing strategy. The use of outlet stores is a strategic strength, especially given the current state of the economy. Outlet stores allow for the disposal of slower-moving merchandise from main stores and provide the opportunity to generate revenues from this merchandise. Currently, approximately 5% of net sales are generated from the outlet stores; this number may increase as consumers are more thrifty and looking for deals in the current economy.42 The use of outlets reduces the potentially negative perception for certain upscale customers of markdowns in the main stores. Finally, Chicos supply chain distribution is efficient with quick turnaround43 times, contributing to faster inventory turnover relative to the industry. Chicos has one distribution center in Winder, Georgia, and turnaround averages approximately 24 to 48 hours for nearby stores and two days to one week for stores further away.44 This is impressive given that only one distribution center meets the needs of stores across the United States (California, Texas, Florida, other states across the Western, Midwestern, and Northeastern states), including the U.S. Virgin Islands and Puerto Rico.45

42 43

Chicos FAS, Inc. 2007 Annual Report, pg. 11 Turnaround means the time from products leaving the distribution center to arriving at Chicos and WH|BM stores. 44 Chicos FAS, Inc. 2007 Annual Report, pg.12-13 45 Chicos FAS, Inc. 2007 Annual Report, pg. 9

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5.2 Weaknesses
Chicos has areas in which improvement is possible. One such area is

profitability. Although Chicos profitability has been better than that of the industry as a whole, Chicos has experienced declining profitability over the past five years. The declines in the last two years have been due to a slowing economy, a product mix mismatched with customer demand and fashion trends, and ineffective marketing. The latter two are more directly controllable by the company and have detrimental strategic impacts if not corrected. Ineffective product mixes and marketing strategies have yielded negative same-store sales growth, reduced cash flow, potential degradation of brand value, and deterioration of the financial strategic advantages (mentioned in the financial ratios analysis) over the competitor basket. Recommendations on how to correct

inappropriate product mix, improve marketing, and reverse declining profitability are discussed in the opportunities section below and further detailed in the strategy section. Chicos dependence on foreign suppliers and third-party manufacturers was mentioned as a strength from a cost-savings perspective. However, this dependence is also a weakness and a threat for the company. Due to geographic distance from Europe and Asia, the company has difficulty exercising control over the quality of the inputs to the products. Political or economic instability could lead to major disruptions in the supply chain. The results could be detrimental to Chicos reduced flexibility, pricing power, and market share. Although currently efficient, Chicos single distribution center concept is a weakness for the company. Any disruption to the single location will be highly

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detrimental to the supply chain. Such a disruption could yield lost sales, negativelyimpacted customer relationships due to stock-outs, and diminished brand equity. Chicos recently engaged in a low-value added acquisition. Chicos purchased the Fitigues brand in January 2006. The brand operated through 12 free-standing retail stores, catalog, and the Internet. By March 2007, Chicos decided to no longer support this brand because it did not meet internal expectations.46 Significant company time and resources were invested in acquiring Fitigues and integrating it into existing operations. The Fitigues failure was due to an incorrectly-defined target market and to poor due diligence, especially in a time when the economy was in decline. As discussed in the external analysis, economists are not predicting a rebound in the current economic crisis until mid to late 2009. In a normal economy, misallocation of resources is harmful, but it can be fatal during a declining economy. Thorough due diligence and analysis is more critical now than ever failure to do so will mean deterioration in Chicos strategic advantages discussed in the financial ratios analysis.

5.3 Threats
Chicos is faced with many threats and challenges as it attempts to move forward in the current economic crisis. Consumer reaction to the current crisis is a threat to the entire retail apparel industry. The consumers disposable income has decreased and has translated into decreased demand and sales, especially within the upscale fashion market. This situation further stresses the importance of Chicos being able to differentiate itself in order to attract new customers and, more importantly, retain existing customers.

46Chicos

FAS, Inc. 2007 Annual Report, pg. 2

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As a high likelihood in the retail apparel industry, changing consumer tastes and fashion trends can have significant impacts on a company. If a company is not wellpositioned to understand or forecast fashion demand, costs could increase unexpectedly and significantly through lost sales, high levels of inventory, unsatisfied customers, and degradation of brand equity. As mentioned earlier, an inappropriately-designed product mix has been a recent concern for Chicos and must be addressed going forward to mitigate the aforementioned detrimental impacts. As discussed earlier in the Five Forces analysis, the retail apparel industry operates in a highly-competitive environment. There are relatively low barriers to entry and the products are easily replicable. For the company to maintain its strategic

advantages and to improve its profitability, it is critical that Chicos be able to differentiate itself along one or more of the competitive points, such as customer service. Our strategy recommendations, discussed later, will explore this point in greater detail. As explained in the weaknesses section, Chicos dependence on foreign suppliers and third-party manufacturers also qualifies as a threat. Related to this dependence is exchange rate risk. Exchange rate risk can affect Chicos even if transactions are

conducted in U.S. Dollars, which is the case in most of the companys business. Foreign suppliers, manufacturers, and other third-party vendors may resort to cheaper materials and other attempts to reduce their own costs because of exchange rate impacts on them if the U.S. Dollar appreciates against their respective currencies. This may result in supply chain disruptions or quality assurance issues for Chicos with an additional impact of customer dissatisfaction.

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The Internet is another threat to Chicos. The Internet provides ease in comparing costs across companies and generally competitive products. This threat may challenge Chicos strategy of personalized attention and opportunities to cross-sell items within the store. Todays economy serves as a catalyst for companies to become even more costconscious than they have been before. Significant increases in input costs or logistics costs, for example, could interfere with Chicos ability to effectively maintain appropriate pricing levels. Given Chicos dependence on one distribution center, increased logistics and fuel costs could have a material, negative effect on profitability. Finally, the U.S. will be led by a new presidential administration starting in January 2009. Changes in government regulations regarding import/exports and trade relations could potentially impact Chicos costs associated with those activities.

5.4 Opportunities
Several opportunities arise from the various analyses on Chicos and the summary of the companys strengths, weaknesses, and threats. First, Chicos has the opportunity to increase focus on its personalized attention strategy. This increased focus can be accomplished through aligning the product mix with customer demand, strengthening customer service, and improving marketing effectiveness. As stated earlier in the

financial ratio analysis, weaknesses in these areas led to a decline in Chicos profitability since 2005. Although more details will be provided in the strategy recommendation section, the following will briefly explain the opportunities in these areas and the overall strategic implications.

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To align the product mix and understand customer service issues, Chicos needs to study the reasons for the mismatch between product mix and customer demand. For example, given that the winter product line is designed in the spring and produced in the summer, were designs based on faulty data? Were fit/size, fabric, color, and/or

availability a problem? To help answer these and other questions, Chicos could call customers who stopped or decreased shopping at Chicos since 2005. Focus groups of current and past customers could be formed to obtain feedback on product offering and customer service. Feedback from sales associates who work directly with the consumer could provide additional insight on customer product and service needs. To additionally address customer needs, Chicos can develop relationships with other companies to add or enhance complementary products such as shoes, handbags, and jewelry to its existing product mix. The strategic advantage of this is the ability to provide a more holistic product offering to its customers without incurring the full spectrum of operating costs (design, manufacturing, etc.). As Chicos implements a deep internal review and if unprofitable stores are closed, Chicos should contact customers from those stores and help them find a nearby location. Excellent customer service should be emphasized as a continuous process and tied to management compensation. This will help to ensure excellent customer service, which is part of Chicos differentiation strategy. From a marketing perspective, Chicos should better utilize email, mail, print, and broadcast advertising. Using loyalty club member lists and expansion in the

aforementioned mediums, Chicos can broaden exposure to existing and potential customers. Specific details are explained in the strategy section.

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Strategically, aligning the product mix with customer demand, strengthening customer service, and improving marketing effectiveness will result in several benefits to Chicos. Chicos products and customer service will gain more visibility in the More satisfied

marketplace, which will build up brand equity and create demand.

customers will increase loyalty and the probability of repeat same-store sales. These increased sales will improve Chicos profitability. Additionally, Chicos can improve profitability by halting any expansion and conducting a deep internal review on many levels to essentially clean house. This point will specifically be explained in further detail in our strategy recommendations later in the report. Soma was launched in 2004. Per Chicos 2007 Annual Report, the Soma brand was initially positioned towards Chicos target consumer but was repositioned in 2007 to target a broader customer base.47 Currently, the Soma brand is sold in stand-alone stores. Our team believes that it would be an inefficient use of resources for Soma to attempt to directly compete with market-leader Victorias Secret as a stand-alone brand given Victorias Secrets dominant mindshare and branding position within the industry. As will be detailed further in the strategy section, Chicos has the opportunity to integrate the Soma brand into the Chicos stores. This will require eliminating certain Soma products to be more in line with Chicos current target market of women ages 35 and over. The benefit of bringing the Soma brand back into the Chicos stores will be opportunities to cross-sell and better address the clothing needs and personalized attention of Chicos target demographic. Another opportunity for Chicos is to test out and eventually establish an overseas office in Asia to help in monitoring manufacturing and quality control. This does not
47

Chicos FAS, Inc. 2007 Annual Report, pg. 2

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mean a significant capital investment but rather a lease of office space and the hiring of one or two employees. This would help mitigate risks from potential issues such as quality, consistency of fabric, fit, color, etc. with foreign suppliers and third-party manufacturers. In addition, this office could work to establish relationships with various suppliers to create a network which currently does not exist. Based on the success of this concept in Asia, offices could be extended to Europe and/or other geographic regions depending on Chicos expansion efforts in the long-term. Chicos should evaluate the opportunity to build strategic relationships. For

example, Chicos should consider expanding relationships with suppliers in Mexico. These relationships would serve as a hedge against rising costs and quality concerns in China and potential American protectionism policies with a new upcoming presidential administration. Finally, since we are recommending that Chicos halt store expansion including outlets, the company should take advantage of closeout merchandise stores like Tuesday Morning, Nordstrom Rack, and/or third-party channels to sell slow-moving merchandise. The advantages of using third-party channels are that they reduce the potentially negative perception for certain upscale customers of markdowns in the main stores and reduce inventory storage costs. More details on building strategic

relationships are discussed later in the strategy recommendation section. Also further detailed in the strategy recommendation section is an opportunity Chicos has to more actively manage exchange rate risk. As mentioned earlier, the company pays all overseas manufacturing expenses in U.S. Dollars and is, therefore, perfectly hedged. However, the company should investigate implementing a more active currency risk management strategy. The strategic advantage of this is a better position in

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handling exchange rate risk from potential overseas expansion and indirect cost savings by not paying suppliers to manage the risk.

Conclusion
As demonstrated in the SWOT analysis above and weighing the probabilities of each point, we feel the strengths and opportunities outweigh the weaknesses and threats. With numerous strengths, Chicos is in an advantageous position to capitalize successfully on its opportunities and to address weaknesses and threats. With an

understanding of Chicos industry, its financial position, and its strengths, weaknesses, threats, and opportunities, the next section will show that Chicos is a strong candidate for purchase.

6. Valuation
Overview
Having evaluated Chicos strategic position and having confirmed it is a strong competitor in the retail apparel market, we must verify that the purchase of Chicos will provide an acceptable return on investment over the next five years. The investment must generate an internal rate of return (IRR) greater than Chicos cost of capital. The

following analysis describes three valuation methods and provides a calculation of minimum, optimal, maximum acquisition premiums, and IRR.

6.1 Discounted Cash Flow Analysis

To value Chicos using the discounted cash flow valuation (DCF) method, we determined the free cash flow (FCF) growth rate and the weighted average cost of capital (WACC). Using Chicos annual reports, we obtained operating cash flows and capital

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expenditures for the period 2002 through 2007. We determined an average FCF growth rate of 2.32%. See Appendix B for a detailed DCF analysis. Historically, Chicos has had zero debt in its capital structure. Therefore, the WACC is equal to Chicos cost of equity. From Bloomberg, we obtained a market return of 11.98%, and, from Google Finance, we obtained a beta of 1.65. We calculated a riskfree rate of 3.78% by taking the average of 10-year Treasury note yields in October 2008.48 Using the Capital Asset Pricing Model (CAPM), the cost of equity was

calculated at 17.30%. We then projected Chicos FCF for the next five years and the terminal value. Using the sum of the discounted cash flows, total shareholders equity, and the total shares outstanding, we calculated a book value per share (BV/S) of $5.39 (see Appendix C). Then, we conducted a sensitivity analysis on the four drivers of the DCF valuation - the risk-free rate, the market return rate, the FCF growth rate, and the beta. When the risk-free rate was increased by 1.22% to 5%, the WACC decreased to 16.51% and the BV/S increased to $5.41, while all other parameters remained the same. These changes are the result of the WACC formula. When the risk-free rate increases, both the risk premium and the WACC decrease. In addition, when the WACC decreases, the present value of the discounted future cash flows increases. If the risk-free rate was decreased to 3%, the WACC increased to 17.81%, but the BV/S did not change from $5.39. When we increased the FCF growth rate to 5%, the BV/S increased to $5.42. By decreasing the FCF growth rate to 0%, the BV/S decreased to $5.38. The same trends were seen when we increased the market return rate to 15% and decreased it to 7%. Increasing the rate
48

U.S. Treasury Department. Daily Treasury Yield Curve Rates, http://www.ustreas.gov/offices/domesticfinance/debt-management/interest-rate/yield_historical.shtml

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caused the WACC to increase to 22.29% and produced a BV/S of $5.34, while a WACC value of 7.00% produced a BV/S of $5.68. As stated above, by discounting the FCF at a higher WACC value, BV/S was lower. Last, when we decreased beta from 1.65 to 1.00, the WACC decreased to 11.98%, and the BV/S was $5.51, while the reverse was seen when we increased beta to 2.00. In this case, the WACC increased to 20.17%, and the BV/S value dropped to $5.36. Therefore, BV/S is more sensitive to the WACC than to the FCF growth rate because the higher the WACC, the lower the sum of the DCF and BV/S. Since the beta, risk-free rate, or the market return either cause an increase or decrease in the WACC, the BV/S is sensitive to a high beta or market return and a low risk-free rate, when all other parameters remain the same. See Appendix D for a detailed sensitivity analysis.

6.2 Value Creation Model

Value creation models attempt to quantify the contribution of management to returns. The model used in our analysis was derived from Rappaports Creating

Shareholder Value.49 Various parameters, including inflation, real return rate, expected return, sales growth, operating margin, and incremental fixed and working capital investment were estimated from sources, such as the companys 10-K SEC filing. Based on these parameters, cash flows were generated and discounted, and the contribution of management was estimated. Sensitivity analysis was done by varying selected

parameters to estimate the impact of errors in the original parameter estimates, as well as estimating the value of changes in management performance.

49

Rappaport, Alfred. Creating Shareholder Value, The Free Press, Macmillan, Inc., New York.

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Our initial parameters (see Appendix E) resulted in an estimated value created of $22M. Varying parameters resulted in the following dominant drivers (sales growth and operating margins) of value created (see Figures 1 and 2).
Figure 1. Sales Growth v. Value Created

SalesGrowthv.ValueCreated (millions)
$70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $ 1% 2% 3% SalesGrowth 4% 5%

Sales growth rate was found to be the dominant driver of increased value for Chicos. Value was increased at approximately the following rate ( increase over 1%): is percentage point

The sales growth rate represents the single parameter which results in the strongest potential for value creation. In addition, it is a variable over which management has significant influence. Management can invest in marketing and other initiatives, which result in increased sales, thereby creating value along these lines. Using the above mathematical model, management can compare the cost of creating sales growth to the value created and make decisions regarding the appropriateness of the investment.
Figure 2. Operating Margin v. Value Created

ValueCreated

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OperatingMarginv.ValueCreated (millions)
$140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $ 5% 10% 15% 20% 25% 30%

ValueCreated

OperatingMargin

Operating margin was the next largest factor in driving Chicos performance. Value was increased at approximately the following rate ( over 1%): is percentage point increase

Like sales growth, operating margin represents a variable that makes a considerable contribution to the companys results and can be influenced by management actions. Good management decisions can result in lowered costs or better capital

investments, yielding increased operating margins. Using the above mathematical model, management can estimate the gains from an initiative to improve operating margin and thereby determine whether the return on the initiative is sufficient to make it worth pursuing. See Appendix F for a detailed sensitivity analysis.

6.3 Comparables Valuation

To construct a basket of Chicos competitors, we gathered data from the companys 2007 annual report, the Hoovers Pro database, Google Finance, and Bloomberg. Chicos competes with three types of companies department stores,

specialty stores, and direct consumer retailers. Because the direct consumer retailers, 75

suggested by the data sources, were private companies, we focused on the first two types. Our selection of direct competitors in the United States was based on target demographic markets, product price points, SIC codes (5621: Retail Womens Clothing Stores), current market capitalization, and low debt-to-equity structures (Chicos has no debt). Using Bloomberg, Chicos 2007 10K, and Internet databases (e.g., Google Finance and Wall Street Journal), we identified five direct competitors Christopher & Banks, Coldwater Creek, Dillards, Talbots, and Ann Taylor Stores (see Appendix G). The companies are all mid- to upscale womens retailers, which primarily target professional and fashion conscious women over the age of 35. A general price/product search on the competitors websites yielded an average price point of around $100 to $120, which is in line with the prices Chicos charges on its apparel products. To find Chicos intrinsic value, we used common current market multiples, such as price/earnings, price/sales, price/book value, price/cash flow, price/EBITDA and calculated average values for the comparables basket. The multiples valuation method yields an intrinsic value of $2.44, which is lower than the current market price. See Appendix H for a detailed multiples valuation.

6.4 Mergers and Acquisitions (M&A) Premium

To decide the appropriate premium to use in Chicos acquisition transaction, we completed a historical M&A premium analysis for the apparel industry. Based on deals with available premium data, we calculated an average premium for the entire period from 2005 to 2008 and for each of these years. The average premium was negative in 2005 and increased to 11.12% in 2008. On average, target companies were acquired at a lower price than their market value. However, this trend changed in the last two years.

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The maximum premium was 54.39% in 2007, and the lowest one was negative 94.81% in 2005 (see Appendix I). This data provided us with a broad picture of global M&A markets. However, because we primarily intend a 100% cash transaction, we looked for more specific M&A deals in retail apparel in the last five years. We found there were many deals without premium details. The average premium for the period was 19.10%, while the highest and the lowest ones were 62.08% and negative 8.83%, respectively. Average acquisition premiums declined sharply from 31.38% in 2005 to 10.79% in 2007 (see Appendix J). We faced limitations on the cash-only set of data. It lacked details on deal premiums in addition to the fact that the average values may not have been representative of the whole population. We do not have premium details for 2008. Therefore, for the purposes of our analysis, we used the broad set of data to determine Chicos acquisition premium.

6.5 Acquisition Price

As discussed previously, M&A premiums varied in the last five years. Therefore, we took a conservative approach and decided that the 11.12% average M&A premium in 2008 be used as the optimal premium we would pay to acquire 100% of Chicos outstanding shares. Because of the huge decline in the current stock market, many stocks are very cheap. If we apply a negative premium to the transaction, we may face

resistance from shareholders, causing a delay or a halt in the acquisition process. Thus, we determined a minimum premium of zero percent (buy Chicos at its current market value). Based on the M&A premiums data in 2008, we also determined a maximum acquisition premium of 41.55% (see Table 2).

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Table 2: Chicos Acquisition Premium Sensitivity Analysis

Premium Suggested purchase price Current stock price Minimum 0% $2.93 $2.93 Optimal 11.12% $3.26 As of Oct 24th 2008. Maximum 41.55% $4.15

6.6 Adjusted DCF Analysis and IRR

We believe that Chicos rapid expansion and its associated expenses resulted in FCF that did not fairly represent the value of the company. In recent years (2006 and 2007), Chicos spent as much as $150M per year on expansion projects. If desired, Chicos could slow down expansion and redirect these funds and start paying dividends. We also believe that valuing Chicos on the basis of an adjusted FCF statement excluding expansion costs is both sufficiently conservative and appropriate. We created a pro forma FCF model for Chicos. It is based on adjusted cash flows, an average same-store sales growth rate of 8.47% that the company experienced prior to the recent market downturn, and capital investments pegged to the average historical proportion of operating income (20%). We chose to use the historical same-store sales growth rate, excluding the last two years, because we believe that the recent same-store sales growth rate for the past two years is an issue created by correctable mismanagement. Additionally, we chose to peg capital investments to the historical proportion of operating income because we believe that it is representative of ongoing capital investment requirements to maintain the company at the current size. See Appendix K for a detailed pro forma DCF analysis. Under the base assumptions in the pro forma model, we found that the IRR is higher than the WACC at the minimum premium (61.86%), optimal premium (57.27%), and maximum premium cases (47.81%). At the optimal premium, we set a target value

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of $18.85 per share. Appendix L for results.

See Appendix K for IRR calculations and highlighted cells in

We did two sensitivity analyses under each of the determined acquisition premiums: 1) we changed the sales growth rate and maintained a 20% growth in capital expenditures; 2) we maintained a sales growth rate of 8.47% and changed the capital expenditures growth rate because it is the dominant factor in operating margin other than sales growth. In addition, operating margin is the dominant factor in value creation. By changing the sales growth rate at the minimum premium case to 0%, the IRR decreased to 49.22%, but, when we increased the sales growth rate to 10%, the IRR increased to 64.14%. The same trend was seen in both the optimal and maximum premium cases. In the optimal premium case, when the sales growth rate was 0%, the IRR was 44.99%, and, when the sales growth rate was 10%, the IRR increased to 59.49%. With the maximum premium case, the IRR was 36.27% and 49.89% for 0% and 10% sales growth rates, respectively. However, the opposite trend was seen when the sales growth rate was held at 8.47% and the capital expenditures growth was changed to 10% and 30%. With the minimum premium of 0%, the IRR was 67.30% and 56.13% for respective 10% and 30% capital expenditure sales growth rate changes. For the optimal premium, the IRR was 62.37% and 51.88% for respective 10% and 30% capital expenditure growth rate changes. Finally, for the maximum premium, the IRR was 52.28% and 43.06% for respective 10% and 30% capital expenditure growth rate changes. Therefore, IRR is more sensitive to the sales growth rate and less sensitive to the percentage change in capital expenditures. An analysis of the models IRR sensitivity to sales growth rates and capital expenditure requirements may be found in Appendix L.

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Conclusion
In our analysis, we provided a brief overview of Chicos; described three valuation methods, assumptions and results; calculated minimum, optimal, and maximum acquisition premiums and prices; and calculated the IRR on the investment. We

recommend purchasing 100% of Chicos outstanding shares at a price of $3.26/share for a total acquisition value of $575.2M. Chicos has a zero-debt capital structure and a strong liquidity position as discussed in the financial ratio analysis section, and we believe the company will successfully withstand the economic recession. In addition to a strong balance sheet, the company generates high gross and operating margins and positive FCF. From the valuation analyses, Chicos creates value and can significantly increase FCF by slowing down its current expansion strategy. Depending on the

magnitude of the slowdown, Chicos can be expected to produce an IRR as high as 57.27% (optimal premium case), without considering the effects of any sales growth due to additional stores. This IRR greatly exceeds Chicos cost of capital of 17.30%. In addition, slowing down growth will give Chicos the opportunity to realize returns on investments in new stores and approach market saturation points slowly, thereby reducing the risk of over-expansion.

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7. Chicos FAS Acquisition Strategy

Overview
Based on the internal and external analysis in the previous sections of this document, we believe that the acquisition of Chicos is a good opportunity for AWWI to create value and to achieve an IRR well above Chicos current cost of capital. Chicos has historically had very positive financial and operational results and performed above many of its direct competitors in the upscale apparel industry. In the current economic recession, the company is able to generate substantial cash from operations and to fund its growth strategy without financial leverage. Under the umbrella of conglomerate Berkshire Hathaway, Chicos can continue to operate with a zero-debt capital structure and absorb major economic shocks due to its strong financial position as discussed in the financial ratios analysis section. Through the acquisition, we will not make any major changes to the current business operations and will keep the executives on board. We believe we can provide Chicos with a sound strategic turn-around plan, discussed later, that will increase the market capitalization levels seen in 2006 and generate an optimal 57% IRR for AWWI. The following section describes in detail the implementation of the friendly acquisition of Chicos, and the proposed post-acquisition strategy. Details of a companys acquisition process, including SEC regulations and filings, can be found in Appendix M.

7.1 AWWIs Merger and Acquisition (M&A) Team

An essential element in any acquisition project is the people involved in the negotiation. We have formed an M&A team of young professionals with diverse backgrounds and expertise that increase the likelihood of a successful outcome. These 81

diverse backgrounds include finance, accounting, marketing, and IT. The people in the team have worked together on many corporate projects and have proven they can be extremely critical and disciplined to avoid overexcitement in Chicos due diligence and pricing.

7.2 Acquisition Objectives

Our M&A team has developed Chicos acquisition strategy based on several fundamental principles. First, the proposed transaction is a friendly acquisition in which AWWI will acquire 100% of Chicos outstanding shares. Currently, the companys vast majority of shares are institutional ownership (95%), which can be both a positive and negative issue in regards to convincing shareholders to tender their shares and the speed at which the transaction can occur. Second, AWWI will either use 100% cash in the proposed transaction, or implement a stock buyback and swap between Berkshire Hathaways Class B shares and Chicos common shares. This will prevent the dilution of existing holdings of

shareholders by not issuing new stock to use as a currency in the transaction. We will also send a strong message to the investor community that AWWI is confident in achieving financial, operational, and management synergies from the proposed acquisition.50 Third, based on the long-standing tradition of Berkshire Hathaway acquisitions, we will maintain the current management and will mutually revise the existing strategy to take advantage of Chicos competitive advantage in the retail apparel market. The main

50

Note: the expected synergies with existing companies in the portfolio are subject to thorough due diligence, and this discussion is not part of the current project.

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reason for this strategy is to avoid any operational disruptions and to use the expertise and knowledge of Chicos executive directors and regional managers.

7.3 Chicos Takeover Prevention Mechanisms

To prevent a hostile takeover attempt, Chicos has two anti-takeover mechanisms in place. First, Chicos has a staggered three-year Board of Directors. Chicos Board consists of eight directors elected for three-year terms. The Class I directors (two) serve until 2009, Class II directors (three) serve until 2010, and Class III directors (three) serve until 2011, respectively.51 In publicly-held companies, staggered boards have the effect of making hostile takeover attempts more difficult. When a board is staggered, hostile bidders must win more than one proxy fight at successive shareholder meetings in order to exercise control of the target firm. More importantly, in combination with a poison pill, a staggered board that cannot be dismantled or evaded is one of the most potent takeover defenses available to U.S. companies. Although, from a corporate governance perspective, having a

staggered board can have both positive and negative implications; in our case, ousting the Board would be very difficult. Second, Chicos executive directors have golden parachutes in their labor contracts if they lose their jobs in the event of a change in corporate control. Based on Chicos latest proxy statement, as of April 30, 2008, in the event of a change in control with executive employment termination, the acquiring company must pay an extra $15M in total executive severance packages. This preventive anti-takeover practice aims to protect the interests of the target companys shareholders and will lead to significant
51

Chicos FAS, Inc. 2008 Proxy Statement

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increases in the initial offer. Our M&A teams friendly acquisition approach avoids the anti-takeover provisions of the company structure in order to capture all expected value of the transaction and achieve our high IRR. We believe we have a strong postacquisition strategy that, supported by the industry experience of current executives, will help Chicos increase same-store sales growth and emerge from the economic recession as a key player in the upscale apparel industry.

7.4 Approach to Chicos Shareholders

The cornerstone of the proposed acquisition of Chicos is the negotiation with current shareholders. As of August 30, 2008, Chicos had 176.51M outstanding common shares, of which 95% were held by institutional investors. Please refer to Appendix N for detailed information about Chicos major shareholders. Rather than approaching

institutional investors individually, we will meet and negotiate with Chicos Board of Directors. They represent the interests of shareholders, and we must convince them that the acquisition will be successful. Paying for the outstanding stock with 100% cash means that AWWI assumes the whole pre- and post-transaction risk of failure. We feel confident that the acquisition will be successful, and potential synergies with existing portfolio companies and operational efficiency will be achieved. It is expected that we will face strong resistance from institutional investors. These are very sophisticated investors, who have decided to retain their Chicos stock despite the fact that Chicos stock has slumped by 96% in the last two years. It is likely that investors see Chicos stock trading at a discount and feel its market price does not fairly capture the intrinsic value of the company; otherwise, we expect that there would not be 95% institutional ownership of the company.

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The companys strong balance sheet and the effective asset and supply chain management are not appropriately leveraged to address the declining profitability, ineffective marketing, and mismatched product mix in the last two years. In the current situation, Chicos shareholders cannot expect to enhance the market value of their holdings and achieve return on investment above the level Chicos currently provides. In order to convince the Board of Directors and Chicos shareholders, our team recommends offering a premium above the current stock market price. The 11.12% optimal control acquisition premium is based on the analysis of the historical M&A transactions in the retail apparel industry. To increase the probability of a successful negotiation, we have prepared two acquisition plans.

7.5 Plan A - 100% Cash Transaction

Our first bid in the negotiation is 100% cash for all outstanding shares of Chicos. At the time of the initial valuation, the offered purchase price was $3.26, representing a control premium of 11.12% over the market price. However, since the initial company valuation, Chicos stock price declined from $2.93 to $1.89 on November 20, 2008.52 Applying the same initially-offered purchase price gives shareholders an acquisition premium of 55% over the current market price. The offered premium is still conservative and does not incorporate the full potential of Chicos intrinsic value. It is also high enough to compensate Chicos shareholders for the capital gain taxes they have to pay if they decide to tender their shares. It is expected that the proposed premium is reasonably high to induce shareholders to sell. However, we are prepared to increase the bid up to a

52

Google Finance

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41.55% control premium above the market price in the initial valuation. As an additional negotiating point, we present the option of a stock swap in Plan B.

7.6 Plan B - 100% Stock Buyback and Swap

The stock buyback and swap bid entails exchanging Berkshire Hathaway Class B (BRK.B) shares with 100% of Chicos shares. Please, refer to Appendix O for details on BRK.A and BRK.B shares. We will repurchase a number of BRK.B shares with a value equal to the acquisition transaction value and use these shares in the exchange deal. Effectively, we will use 100% cash to buy back shares, and there are multiple benefits to this transaction structure. First, by repurchasing BRK.B shares for use in the transaction instead of issuing new shares, we will not dilute existing Berkshire Hathaway shareholders equity. Second, we offer Chicos shareholders the opportunity to acquire the more stable BRK.B stock, which in the last two years dropped only 26% in comparison with Chicos stock, which slumped 96% during the same period. Berkshire Hathaway is a greatly-diversified company that is less vulnerable to economic shocks. Historically, Berkshire Hathaways Class A and B stock have outperformed the S&P 500 index and have delivered an annualized return of 25% since 1976.53 Last, Chicos shareholders will be able to defer paying capital gain taxes until the time they decide to sell their newly-owned BRK.B stock. The potential risk of this bid comes from the fact that stock swap transactions usually generate negative market reaction. The markets perception is that acquiring companies will only choose this type of transaction when the stock is overvalued, in
53

Portfolio.com. Berkshire Hathaway, Incorporated Class A (BRKA), http://www.portfolio.com/resources/company-profiles/Berkshire-Hathaway-Incorporated-Class-A-778

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which case, they use the cheapest source of capital to finance the acquisition. However, we expect that the market reaction will be favorable because this transaction is structurally different from other stock swaps. We are not diluting current equity stakes by issuing new shares to be used in lieu of cash. We are instead repurchasing existing shares to be used as a tax-advantaged means of transferring value. Because of the large difference in the market price of both Chicos and BRK.B shares, the proposed transaction will have two elements (1) We will exchange 219,627 BRK.B stock to acquire the majority of Chicos outstanding stock (exchange ratio of 0.001244). The fact that Chicos has 95% institutional ownership makes it easier to conduct the swap transaction. (2) To shareholders who own less than 2,000 shares of Chicos stock, we will offer to purchase the stock with cash for a control premium of 11.12% as already discussed in Plan A.

7.7 Approach to Chicos Executive Managers

Despite the fact that executive directors own a small percentage of Chicos outstanding shares, collectively, they are a significant stakeholder in the proposed transaction and an integral part of implementing the post-acquisition strategy. As already mentioned, executive directors have golden parachutes, which are intended to align their wealth more closely with shareholders interests. We face a situation where Chicos executives, once faced with an acquisition attempt that might lead to a loss of their jobs, are likely to oppose AWWIs bid, even though this bid would increase shareholder wealth. Therefore, we will approach them in a friendly manner offering them several key opportunities.

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First, we will offer Chicos executive managers the opportunity to stay with the company and take part in implementing the proposed post-acquisition strategy. Current executives have underperformed in the past two years, making inappropriate acquisition decisions (e.g. Fitigues), following an overly aggressive expansion plan, and allowing a product mix that has resulted in negative same-store sales for two consecutive years. However, we should also give them credit because Chicos has historically outperformed its direct competitors. We would like to take advantage of the directors experience and expertise and work together to increase the value for shareholders. Second, our bid to executives includes access to abundant capital resources under the umbrella of Berkshire Hathaway. In the future, Chicos managers will not have to worry about how to finance new projects because they will have easy access to capital; they will also have the chance to communicate closely with executives from other companies in the conglomerate and gain know-how. Last, we will perform a thorough due diligence along with the compensation committee and tie executive compensations more closely to Chicos performance. In particular, we will increase the proportion of their above-base compensation and reevaluate the stock option and restricted stock plans. According to our reasonably-

conservative financial projections, already discussed in the first part of this document, the executives will be able to reap great benefits under the new company ownership.

7.8 Offer Price and Expected Return on Investment

Based on our initial valuation, we will take a conservative approach and recommend purchasing 100% of Chicos outstanding shares for $3.26 per share, which represents an 11.12% control premium. Because of recent declines in the stock market,

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many stocks are trading at a discount relative to their recent prices. If we apply a negative premium to the transaction, we will face strong resistance from shareholders, causing a delay or halt in the acquisition process. Thus, we determined a minimum premium of zero percent (buy Chicos at its current market value). Based on the M&A premiums data in 2008, we also determined our walk-away price of $4.15, which represents a control premium of 41.55% over Chicos current market price (see Table 3).
Table 3. Chicos Acquisition Premium Sensitivity Analysis
Premium Suggested purchase price Current stock price Minimum 0% $2.93 $2.93 Optimal 11.12% $3.26 As of Oct 24th 2008. Maximum 41.55% $4.15

Based on our initial valuation model of Chicos, AWWI will achieve an IRR considerably higher than Chicos cost of capital. In our optimal offer of 11.12% control premium, the IRR is 57% over the next five years. A sensitivity analysis of the IRR and Chicos purchase price yields a minimum rate of return of 48%, assuming we offer Chicos shareholders a maximum premium of 41.55% over the current share price.

Conclusion
Our main goal is to pursue a friendly acquisition of Chicos. A hostile takeover would be very expensive and extremely hard to accomplish because, first, Chicos has a three-year staggered Board of Directors and, second, executives have golden parachutes in their employment contracts. To better position ourselves in the negotiation process, our team has prepared two major deal propositions, which based on the initial valuation analysis, will provide returns above Chicos cost of capital. In particular, we offer an 11.12% control premium for all Chicos outstanding shares based on the market price as of October 24, 2008. This premium can be achieved through (1) purchasing Chicos 89

outstanding shares with 100% cash, or (2) repurchasing BRK.B shares and exchanging them for 100% of Chicos outstanding shares. Both approaches have advantages and disadvantages, and we will use them to convince Chicos shareholders to sell. In addition to the acquisition premium, we will offer Chicos executive directors the opportunity to stay with the company and help execute our proposed post-acquisition strategy (see post-acquisition strategy section below). The abundant resources under the Berkshire Hathaway conglomerate, which can be used for future strategic initiatives, would be a strong motivation for these executives to agree to the proposed merger. We not only strive to avoid any disruption in operations, but also to avoid overpaying for Chicos. The fact that many acquisitions fail to create the expected value for the

acquiring company gives us strong motivation to walk away from a potentially unfavorable deal. Our goal is to ensure an acquisition price that provides optimal return to Berkshire Hathaway. To achieve this goal, we have set a maximum per-share

acquisition price of $4.15, representing a premium of 41.55% over Chicos stock price as of October 24, 2008. Even if we pay this high price for Chicos, we expect that we would still achieve a high return on investment of 48% over the next five years. Should the negotiation with Chicos Board fail, our M&A team will be ready to approach the Board of Directors of our back-up acquisition candidate AnnTaylor. Please refer to the alternative acquisition candidate section for a detailed analysis of AnnTaylor.

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8. Post-Acquisition Strategy
Overview
Based on the previous analyses thus far, our team has developed a set of postacquisition business strategy initiatives. All elements of the strategy are based on the SWOT analysis and include marketing, financial and business development initiatives. These initiatives require full commitment from current senior management and are intended to create value for Berkshire Hathaways shareholders.

8.1 Align Product Mix and Strengthen Customer Service

Chicos must be very careful about what messages it sends to clients, whether its product lines correspond to market trends, and how it handles client requests. In this respect, one of the major points in our post-acquisition strategy is aligning Chicos product mix with customer demand and strengthening customer service. This is

particularly important, given the fact that between 2005 and 2007, Chicos same-store sales growth declined, and its worsened financial position led the decline in the apparel retail industry. While total sales revenue increased due to expansion of store fronts, existing same-store sales decreased as customers were switching to competitive brands. We have identified several lines of due diligence, which will help us identify the reasons for the decline in same-store sales and, based on this, to develop a turnaround strategy. First, we have to find out what Chicos did well until 2005 and what went wrong after that time. The big question is what changed from 2005 to 2007. A possible reason is incorrect product design that was not in line with industry trends. Given the fact that the fashion industry has quick-paced business cycles, Chicos will not be able to respond if its merchandise is not in line with customer demand. Also, we will analyze the ERP 91

system of the company, the process of capturing data from customers, and most importantly, the measurement and application of this data in developing new products. We will call Chicos pre-2005 repeat customers, who purchased less product between 2005 and 2007 to determine what they liked or disliked about Chicos products, why they stopped buying, why they switched to a competitive brand, and how they think we can improve so that we win back their business. In addition, we will create focus groups with our target customers and provide rewards for participating in the discussion. Potential problems that could be identified in the marketing research are: design choices, fit/size, fabric, color, and lack of product availability. We will not only seek our clients opinion, but also that of our employees. Chicos sales associates are the people who have constant contact with our clients, and they can give us valuable feedback on product mix/design preferences at the store level and help us bring lost clients back. Second, in many organizations, leaders and managers express that they want continuous improvement, but they fail to implement a process that will ensure it. We must take care to ensure that our post-acquisition strategy is implemented. In this

respect, we have to focus on excellent customer service and continuously train our staff, in particular sales associates, in delivering this service. Getting Chicos employees involved in the marketing research process, as mentioned above, organizing regular workshops at successful stores, and tying their compensation to sales results will not only empower them to deliver outstanding customer service, but it will also be reflected on Chicos income statement. Next, the mismatched product mix has led to negative same-store sales growth in the last two years. Usually, when people visit a fashion retailer, they not only look for a

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single item, but also for a collection of apparel and other accessories like jewelry, shoes, hats, and bags. Customers can choose any combination of existing clothes and

accessories that fit their fashion tastes. The availability of an appropriate product mix will increase the opportunity to cross-sell and improve the companys sales and brand equity. Therefore, we believe that Chicos should improve its product lines by adding more complementary products to the existing mix. It should hire style experts to find the matching combinations of apparel and accessories to help sales associates guide customers. More importantly, the company should collaborate with other apparel accessory producers in a strategic relationship to add suitable styles of shoes, hats, jewelry, and bags to Chicos existing collection. Finally, we will have to reach out to displaced customers from closing Chicos stores. To avoid a sales disruption, we will contact all loyal clients by email, mail, or telephone; notify them about the location of the nearest Chicos store; and offer coupons or other promotional incentives. We will also reach out to customers, who have

relationships with specific store employees and offer a transition plan to nearby stores, ideally matching the customers with their traditional salespeople. Rather than being part of a one-time marketing research initiative, the activities discussed above will be integrated in a continuous process that will align Chicos product mix with clients needs and will help the company build long-term relationships with its clients.

8.2 Improve Marketing Effectiveness

Following the acquisition of Chicos, we plan to improve marketing effectiveness by restructuring the current marketing strategy to better utilize email, mail, print, and broadcast advertising. Our overall goal is to significantly improve same-store sales

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which have been declining over the past two fiscal years despite the use of these previously-mentioned media channels. Using loyalty club member lists for both Chicos and WH|BM and catalog sign-up lists from individual stores, we plan to send out monthly store catalogs and weekly email newsletters. Before mailing out catalogs, the two lists will be cross-checked to make sure the same person does not receive more than one catalog. This will keep our print costs down and save money on excess postage fees. The catalog for Chicos will contain the newest merchandise and accessories, while the weekly newsletter will be specific to the customer and provide promotional information for the nearest store locations. The catalog for WH|BM will contain the newest

merchandise and accessories as well as contain inserts with promotional information and discount cards. We plan to implement a print campaign in popular womens magazines that service Chicos target demographic. As of fiscal year 2007, the advertising budget was $82.7M or 4.8% of net sales.54 We plan to increase marketing expenses in an attempt to address negative same-store sales growth. Once acquired, Chicos will conduct an

analysis to determine the appropriate amount of the increase. Chicos will explore placing full page, color Chicos ads in O, The Oprah Magazine and Good Housekeeping and full page, black and white WH|BM ads in Cosmopolitan magazine. In addition, we will explore placing half page, color ads for Chicos and half page, black and white ads for WH|BM in Elle, In Style, and Vogue magazines. We make the distinction between full page and half page advertisements in these magazines due to advertising cost and the expected effectiveness of the individual magazines in reaching our target customers. We will also explore the purchase of
54

Chicos FAS, Inc. 2007 Annual Report, pg. 18

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advertising space on the Cosmopolitan and O, The Oprah Magazine websites to display a WH|BM and Chicos promotion, respectively. Last, we will explore a broadcast commercial campaign targeting our intended demographic. We considered the demographics of the viewers of certain daytime

programs and compared those to our target demographic to come up with a list of programs during which we will run Chicos commercials. Two Chicos commercials will be produced to highlight the unique, quality products and accessories found in multiple colors and sizes. These commercials will be approximately 30 seconds long and run in conjunction with the following programs: The View, Oprah Winfrey, Rachel Ray, and Live with Regis and Kelly.

8.3 Halt Expansion and Refocus on Existing Stores

It is our opinion that over the last two years, Chicos has pursued an ill-advised rapid expansion of its retail locations. In these last two years, the company has invested $300M to open additional retail locations while losing focus on its core mission. This loss of focus has led to negative same-store sales growth, and therefore cannot be wholly attributed to the downturn in the macroeconomic environment. Part of our post-acquisition strategy is to halt expansion and refocus the companys attention on its historical strengths of customer service and delivering the right product mix. We believe that such an effort will result in a return to positive samestore sales growth and allow the company to resume reasonable expansion activities in the future. As part of this process, we will establish a store benchmarking system to evaluate the performance of stores over the past two years. These benchmarks will include a

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comparison of the individual stores growth rate to the local economic environment, measures of store efficiency based on per square foot results, overall operating income, and expected future capital investments in the store as discussed below. Each store must be evaluated in the context of its local economic environment. By evaluating whether the store is under- or overperforming its local economic environment, it is possible to evaluate the performance of management and personnel at the location. If a store consistently does better than its local economic environment would suggest, Chicos should attempt to retain the staff irrespective of whether or not the store is retained. Similarly, if a store consistently underperforms the local economic environment, the stores staff should be restructured even if the store is retained. Additionally, the stores overall efficiency must be evaluated. Per square footage results would indicate whether a store is efficiently using its floor space compared to its peers. Stores that vary significantly from the benchmark should be given special

attention; overperformers should be studied to determine if the keys to their success are replicable elsewhere, and underperformers should be studied to see if the problems can be remedied. Overall operating income must also be considered. A store which underperforms in terms of efficiency may still be worth keeping if it nonetheless provides significant operating income. Similarly, a store which overperforms in terms of efficiency may not be worth keeping if its operating income is negligible. Expected capital expenditures in the near future should also be considered. A high-performing store may not be able to meet hurdle rates in the future if large capital improvements are necessary for its continued success. However, a low-performing store

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may be worth retaining if it is providing positive operating income and will require few capital investments in the foreseeable future. Using these metrics, Chicos should determine a set of stores that are overall underperformers and consider them as candidates for closure. These candidates should be further evaluated for shutdown costs and the potential for each stores underperformance to be corrected. Stores with appropriate shutdown costs with little prospect of sufficient performance improvement should be closed with all reasonable haste. Additionally, among those stores targeted for shutdown, management and staff should be evaluated for individual performance capability. Chicos should make an attempt to relocate overperformers to nearby stores wherever possible. Examples of such overperformers would be managers who outperform the local market but whose local market is so bad that the store must be shut down and salespeople who have unusually high customer ratings or sales figures. Negative same-store sales growth is a major problem for Chicos company-wide. In an effort to address this issue, managers of the remaining stores will be required to develop and submit a plan for improving store sales in their local market. It is believed that each store has localized problems and opportunities that a centralized plan may not be able to remedy or exploit. Utilizing local talent is the best way to address these issues. Regional managers will then evaluate each plan and allocate resources to implement these plans as appropriate. Both store-level and regional manager performance will be evaluated based on the success (or lack thereof) of each stores plan.

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Finally, halting expansion presents a potential problem in terms of outlet stores. By having a general expansion freeze, we preclude the possibility of opening additional outlet stores which might be beneficial if Chicos has the need to dispose of more inventory than existing outlet stores can support. To plan for this possibility, we will have Chicos explore possible partnerships with third-party closeout retailers, such as Tuesday Morning and Nordstrom Rack. These third-party stores provide essentially the same function as Chicos outlet stores but will allow Chicos to dispose of excess inventory without having to make large capital investments in outlet stores.

8.4 Integrate Soma into Chicos Stores

Based on the companys own questioning of the long-term sustainability of Soma and our teams assessment, we recommend that Chicos integrate the Soma brand into Chicos stores over the next two years. We do not believe Soma can effectively compete with Victorias Secret as a stand-alone store. Victorias Secret operates on a significantly larger scale than Soma and has the advantage of dominant brand equity and market share in the intimate apparel sector. However, the benefits of cross-selling Soma products through personalized attention at the Chicos stores can help boost sales and increase brand equity for Soma/Chicos. Additionally, Chicos will experience operational

savings from shutting down Somas separate storefronts. Of Somas current apparel line, Chicos should focus on undergarments, shapewear and sleepwear and discontinue activewear and swimwear. This re-defining of the Soma portfolio will help Chicos focus on its classy, more formal-to-business-casual image versus a casual, athletic one. This reduction in product line and the fact that Chicos was already renovating stores will facilitate integrating the Soma brand into

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existing retail store space and the Chicos outlets as necessary. A variety of colors and styles should be offered to the Chicos customer. The company should consult with individuals experienced in the intimate apparel industry to make these decisions. As most retail space is leased, the company should look for opportunities to shut down Soma stand-alone stores as leases expire. Additionally, the company should

perform a cost-benefit analysis on lease breakage fees versus costs of operating standalone stores. If fees are less than operating costs, Chicos should terminate Soma leases. From a reduction in force standpoint, Chicos should retain top-performing Soma management and sales associates.

8.4 Establish an Overseas Office in Asia

As discussed in the SWOT analysis section, to create a process to oversee manufacturing and quality control, Chicos should establish an office in Asia. This does not need to be a significant investment leasing a small office and hiring or assigning one or two employees should suffice to determine the acceptability of the concept. Given recent concerns in manufacturing quality in China, the primary purpose is to enable continuous evaluation and local enforcement of Chicos quality standards with regards to cost, style, fit, fabric, color, etc. Additional benefits include exploration of new suppliers in the region as a contingency plan. Based on the lessons learned from the office in China, this concept can be expanded to Turkey and other geographic regions, as necessary. The company should also evaluate if the one/two-employee office is sufficient or if there is a need for additional employees and infrastructure.

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8.5 Evaluate Opportunities to Build Strategic Relationships

One of the threats to Chicos we have indentified is the change in trade regulations as the new presidential administration takes office in Jan 2009. Given the current economic recession and the U.S. trade deficit, the new government may apply quotas, new tariffs, or other trade restrictions to Asian countries, in particular China. If this happens, it would negatively affect Chicos overall business. In the meanwhile, the United States has a free trade agreement with Canada and Mexico under NAFTA, so it is highly unlikely that the U.S. government will apply any trade restrictions to those countries. Hence, in order to deal with this contingent threat, Chicos should start building strategic relationships with apparel suppliers in Mexico. It takes time to identify reliable suppliers, make agreements and integrate into the supply chain, so the earlier Chicos starts looking for new suppliers, the better it will be able to address this threat. As discussed in the financial ratio analysis section, Chicos financial position is better than the industry baskets; however, Chicos profitability has declined in recent years. In order to improve profitability in this recessionary period, we recommend Chicos reduce capital expenditures in the short run. As part of the general freeze on expansion, Chicos will not open any new outlet stores. However, as Chicos operates in the fashion industry with high inventory turnover, Chicos also needs to liquidate excess inventories. Chicos should take advantage of closeout merchandise stores, such as Tuesday Morning, Nordstrom Rack, and/or other third-party channels to sell its obsolete merchandise. Therefore, the company needs to establish relationships with these stores as soon as possible, agree on merchandise pricing, frequency, and methods of disposing excess inventory.

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8.6 Explore Active Management of Exchange Rate Risk

Chicos currently structures all of its overseas manufacturing contracts so that Chicos pays all expenses in dollars. This provides Chicos with a perfect understanding of its expenses going forward. All of its revenues are matched with its expenses in terms of currencies. In essence, Chicos has created a perfect hedge with an all-short U.S. dollar position. In terms of a passive hedging strategy, Chicos current implementation is very effective. Chicos simply agrees to the contracts and lets its suppliers manage all However, this presents a lost opportunity for Chicos not only

exchange rate risks.

does Chicos have the supplier manage all exchange rate risks, but Chicos also permits the supplier to reap all of the benefits of good risk management practices. In the short-term, we believe that this is appropriate as it permits Chicos to focus on its core business activities. However, we will recommend that Chicos explore minor international expansion by opening stores in select locations in Canada and have recommended establishing an office in Asia. These choices will increase Chicos

exposure to exchange rate risk in the intermediate term. Additionally, we foresee a future in which Chicos may wish to engage in more aggressive international expansion in Canada and possibly Europe. Because of our near- and intermediate-term recommendations and our long-term expectations, we believe that Chicos should begin developing expertise in currency exchange risk management. By developing this expertise, Chicos will be well

positioned to handle exchange rate risk from international expansion. Additionally, development of this expertise will permit Chicos to take more nuanced exchange rate

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positions with respect to its suppliers. Suppliers do not take on the risk of exchange rate fluctuations for free. It is possible that Chicos will be able to develop more efficient risk management in-house and save money by not paying suppliers to manage the risk and by making better risk management decisions. To this end, we suggest that Chicos start a small risk management division consisting of two or three risk management professionals. These professionals should evaluate the potential contributions that a full-blown risk management division could contribute to the company in terms of cost savings and superior management capability. If the results of the evaluation are favorable, Chicos should develop a plan to implement a risk management division that takes into account its increasing exposure to currency risks.

8.7 Other Possible Long-Term Opportunities

We will not address Chicos single distribution location issue at this time because we are suggesting a no-growth strategy. However, when Chicos does resume growth, the company must evaluate the risks associated with a single distribution point and determine if additional locations would better serve stores and customers. Given the current state of the economy, Chicos should maintain the proposed nogrowth strategy for at least two years. A cross-functional team should be formed now to begin evaluating the opportunity for the company to resume expansion after two years. In addition to domestic U.S. expansion, this team should look into the possibility of expanding into Canada, in particular, the metropolitan cities of Toronto and Vancouver. With geographic proximity, similar culture and demographic to the United States, we believe Chicos product offering and focus on personalized attention will transfer

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successfully. Strategically-placed distribution centers could help mitigate international logistics costs.

Conclusion
Chicos is a strong company experiencing difficulties due to the recent market downturn and managerial missteps. Additionally, Chicos has considerable opportunities going forward to improve and solidify its position. We believe our aforementioned strategy will permit Chicos to address the managerial missteps, specifically the aggressive expansion and incorrect product mix that led to over-expansion in a declining economy and declining same-store sales growth. Additionally, we believe our strategy will allow Chicos to take advantage of opportunities going forward by improving customer service, reintegrating Soma to take advantage of cross-selling opportunities, and laying plans for a larger international presence in the future.

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9. Alternative Acquisition Candidate AnnTaylor Stores, Corp.

We have decided to acquire Chicos; however, should that acquisition fail, our alternative acquisition candidate is AnnTaylor Stores Corporation. The following sections will present our analysis of AnnTaylors financial position, SWOT, and valuation.

9.1 Company Overview

AnnTaylor is a womens career and casual wear retailer established in Connecticut in 1945. Started as a primarily East Coast brand, the company has grown into a national brand with 929 retail stores nationwide and annual sales revenues of $2.4B in 2007.55 AnnTaylor targets affluent women and provides them with updated classics products that are feminine, stylish, versatile, and polished.56 AnnTaylors product line is comprised of womens apparel, shoes, and accessories under the Ann Taylor, LOFT, and Ann Taylor Factory brands. The LOFT brand contributes the most significant part of the companys sales revenue.57 The

company has a total wardrobing strategy that helps its clients choose the appropriate merchandise mix and wardrobe coordination based on their personal styles.58 Like other companies in the industry, AnnTaylor does not manufacture its apparel merchandise but develops designs in-house and then outsources the production process to independent manufacturers, primarily in Asia. The company experienced declines in profitability due to the economic downturn that started in 2007. In an effort to enhance profitability and improve overall operating effectiveness, the company initiated a multiyear restructuring program. The program is expected to include reviewing companys
55 56

AnnTaylor Stores, Corp. 2007 Annual Report, pg. 2 AnnTaylor website: http://www.anntaylorstorescorp.com/ 57 AnnTaylor Stores, Corp. 2007 Annual Report, pg. 2 58AnnTaylor Stores, Corp. 2007 Annual Report, pg. 2

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cost structure, closing underperforming stores over three years, and streamlining corporate organization structure. Besides closing underperforming stores, the company expects to spend about $60M on new store openings and construction, store expansion or relocation, store renovation, and refurbishment programs. Furthermore, the company plans to invest in its information technology systems, corporate office, and distribution center.59 Management hopes that these actions will help increase corporate efficiency and attract new customers. With AnnTaylors current financial situation, it is expected that AnnTaylor will generate enough cash from operations to finance its capital needs. One of AnnTaylors strengths is its brand equity. This is a strategic advantage in that a strong brand name can command a higher price than a weaker brand name. Therefore, AnnTaylor pays special attention to strengthening its brands through effective marketing and top-tier client services.

9.2 Financial Analysis

In order to assess AnnTaylors financial health, we examined its performance over the past five years and compared it with that of the industry basket average. We followed the same procedures as in the Chicos financial ratio analysis section in order to understand AnnTaylors financial strengths and weaknesses and their strategic implications. Since AnnTaylor is one of the companies within the industry comparables basket used to assess Chicos, the only change made was a switch in position between Chicos and AnnTaylor in the basket. We added Chicos into the basket and removed AnnTaylor so that AnnTaylor could be compared to the basket. See Appendix P for the
59AnnTaylor

Stores, Corp. 2007 Annual Report, pg. 24

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financial ratios. The following analysis uses a materiality of 2X above or below the industry basket average. Liquidity Ratios AnnTaylors current ratio and quick ratio are slightly lower than those of the industry average; however, they fluctuated noticeably from 2003 to 2007 and declined last year. This trend is not present in the working capital and cash flow per share ratios. Compared to the baskets average, these ratios are materially higher. Therefore,

AnnTaylor is able to meet its current liabilities and generate enough cash from operations to self-finance. Strategically, this position allows AnnTaylor to pursue positive NPV projects and/or expand production should an attractive investment opportunity arise. Furthermore, with respect to liquidity, AnnTaylor is in a better position compared to its competitors to get through the current difficult economy. Activity Ratios In the past five years, AnnTaylor has consistently had a stable inventory turnover ratio, which results in a relatively flat trend in the days to sell inventory ratio. The trend of these two ratios is similar to that of the industry. However, there is a material difference in the receivable turnover ratio and the average collection period. While the industry has experienced a declining trend over the past five years, AnnTaylor has maintained a consistent advantage in these areas. The company has consistently

maintained collection periods of approximately 3 days, which is 2/3 faster than the industry basket. This results in a faster cash conversion cycle for AnnTaylor than the industry basket. However, the industry basket has narrowed the gap by nearly 50% in the past 5 years, eroding AnnTaylors advantage in this area.

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The similar inventory turnover ratio of both AnnTaylor and the basket shows that AnnTaylor has no comparative advantage in this respect. However, it has a real

advantage in other areas. For example, AnnTaylors high receivables turnover ratio implies that the company has tight credit policies. Operationally, it can be inferred that AnnTaylors credit terms applied to its customers may be more effective than those of AnnTaylors competitors. The tight credit policy has helped AnnTaylor to decrease its operating cycle with a faster conversion from sales to cash and enjoy higher profitability. However, it could also lead to losing customers in the economic recession period. Last year, the companys sales growth rate declined and caused a drop in profitability, which will be discussed later. Strategically speaking, AnnTaylors activity ratios are strong, supporting AnnTaylors solid position in liquidity and management of and access to cash. Profitability Ratios AnnTaylors profitability is very strong. Its operating margin was in line with the industry between 2003 and 2006; however, it was materially higher in 2007. The

companys profit margin is stable and also outperformed the basket average in the last two years. Other ratios in the profitability family have the same trend. In 2007,

AnnTaylor had a relatively stable ROA whereas the industry basket dropped almost 100%. AnnTaylors ROE has almost doubled in the last four years, while the industrys average ROE movement decreased by 66%. While the industry has experienced a declining trend in profitability, AnnTaylor has managed to avoid this trend and was materially higher than the industry last year. Strategically speaking, this suggests AnnTaylor has an advantage over its competitors, possibly due to better operational strategies. Its recent high profitability results from its

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positive free cash flow, which allows AnnTaylor to engage in strategic initiatives and increase the value to shareholders by buying back outstanding shares. Leverage Ratios From a financial leverage perspective, AnnTaylor has a zero debt to equity ratio, meaning that the company has operated with no debt in the last four years. It has a strong balance sheet with shareholders equity and internally-generated cash as a main source of financing. All other debt ratios in this family show this position. Low financial leverage is also a common characteristic of other companies in the womens retail apparel industry. Almost all of the companies in the basket have a low level of debt; on average, long-term debt to equity is approximately 20%. However, Talbots is the only competitor in the basket with a material difference in debt level and skews the data set. Talbots position is the result of the unsuccessful J. Jill acquisition. Because of this, Talbots is at a relative disadvantage compared to all other competitors within the basket. AnnTaylors debt-free position affords the company considerable flexibility in the current recession. This debt-free position and AnnTaylors ability to generate positive net income and strong free cash flow will help AnnTaylor to finance strategic projects without debt or other external sources of capital. Even if demand for capital exceeds its capacity, the company has the option to utilize its credit facility to take advantage of attractive investment opportunities. Another advantage arising from its strong liquidity and leverage position is that AnnTaylor can obtain debt at a better rate than other levered companies and thereby minimize the interest expense.

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Stock Market Ratios From 2003 to 2007, AnnTaylors price/earnings, price/cash flow, and price/EBITDA were not materially different from that of the industry. These three ratios followed the same trend - they were low in 2003, peaked in 2006, and dropped in 2007. However, there was a significant difference in the price/book and price/sales ratios. The industry average ratios are 2X higher than AnnTaylors between 2003 and 2006. This trend changed in fiscal year 2007 as AnnTaylors price/book and price/sales ratios were in line with those of AnnTaylors competitors. Strategically speaking, AnnTaylor does not have any competitive advantages over the industry basket regarding stock market ratios. Almost all of AnnTaylors price multiples, except the price/book and price/sales ratios, are similar to the basket averages. This trend shows that investors placed equal value on AnnTaylors stock and its competitors on variables, such as earnings, cash flow, and EBITDA. The positive market reaction to AnnTaylors stock last year, in terms of book value and sales, creates opportunities for improvement. The company could start paying dividends and continue repurchasing shares to increase the value to its shareholders. If this is successful, the market would have better expectations for AnnTaylors performance. Conclusion Overall, AnnTaylor has several advantages over its competitors. It has a strong liquidity position and generates enough cash to finance its operations. From an

operational perspective, the company has good credit policies, which allow it to collect receivables from customers quickly. AnnTaylor maintained high profitability in difficult

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times, while the industry experienced losses. The company also has a strong balance sheet with no current debt but a reserved credit facility. All these strengths provide AnnTaylor with flexibility to take advantage of positive NPV investment opportunities that might arise in the future. On the other hand, AnnTaylor has areas for improvement, such as inventory management and profitability. Its credit policies should also be reviewed to increase sales during these difficult economic times.

9.3 AnnTaylors SWOT Analysis

Based on the retail apparel industry and AnnTaylors specific analyses thus far, we conducted a comprehensive analysis in order to assess AnnTaylors strengths, weaknesses, opportunities, and threats. STRENGTHS Product mix Trained sale associates Brand equity Financial position o Debt free o Effective inventory and receivables management WEAKNESSES Declining profitability Underperforming stores Dependence on a single distribution facility Dependence on foreign 110 THREATS Economic downturn Licensing its brand name from thirdparties Changing client preference/fashion trend OPPORTUNITIES Restructuring program Increase in sales through Internet Debt financing Opening LOFT outlet stores

manufacturers

Competition Change in government regulations

Strengths First, AnnTaylor has a good product mix consisting of apparel and accessories. As it targets affluent women, the company focuses its attention on developing the right merchandise mix among suits, separates, tops, footwear, and accessories. With the

availability of products that are complementary by design, AnnTaylors customers find it easy to assemble coordinated outfits. This helps the company provide an updated classic look aligned with the consumers personal preference. Second, AnnTaylor has trained sales associates, who understand customers fashion tastes and preferences in respect to color, fabrics, and style. These associates give advice and help customers in selecting merchandise in order to reflect personal styles. The companys total wardrobing strategy has proven effective and helped increase client satisfaction and loyalty. Third, AnnTaylor has a strong and nationally-recognized brand name. This is a strategic advantage because a stronger brand can help a company command a higher price and gross margin than a weaker brand. In addition, a strong brand can provide more visibility for AnnTaylor in the marketplace, which could lead to repeat sales and additional demand from new customers. AnnTaylor has invested money in marketing, design, and customer service to strengthen the AnnTaylor and LOFT brands. Its brand name is an asset and helps it stay strong in a competitive market with quick changes in demand.

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Fourth, AnnTaylor maintains a strong financial position.

As discussed in

AnnTaylors financial analysis section, AnnTaylors profitability is superior to the industry basket. This means that the company is in a better position to generate positive cash flows and maintain a debt-free capital structure. Additionally, because the company has no debt it is likely to obtain better debt ratings and thereby have access to relatively inexpensive debt. Last, AnnTaylor manages its inventory and receivables effectively. The company enjoys high inventory and receivables turnover, which means the company has shorter operating cycles compared to its competitors. This also contributes to a faster cash conversion cycle, allowing the company to maintain a strong financial position. Weaknesses AnnTaylors financial position is a strength when compared to the industry; however, in the last year, declines in profitability present a weakness that must be addressed. In fiscal year 2007, the company experienced negative same-store sales growth. It also initiated a restructuring program, which cost over $32M. In a recession, the company should focus on stabilizing same-store sales revenue and decreasing costs where possible. AnnTaylor has identified a number of stores, which have underperformed over the past three years. As stated in the companys restructuring program, 117 stores have failed to yield acceptable long-term results. In response, the company will close those stores, invest in opening new stores, and renovate existing ones. The company has a single distribution facility in Louisville, KY. If there is a disruption at the facility, company profits will be negatively affected due to stock outs

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and increased customer dissatisfaction. In turn, this could damage the company image and ultimately decrease sales. Outsourcing production processes to foreign manufacturers can provide the company with low-cost merchandise. However, heavy dependence on foreign suppliers is a potential weakness and threat to the company. AnnTaylor has limited control over the quality of the raw materials and the resulting final product. This could lead to disruptions in the supply chain with results similar to those from a disruption to the single distribution facility described above. Opportunities AnnTaylors restructuring program provides an opportunity for the company to improve profitability and overall corporate performance. This program will examine AnnTaylors current retail stores, identifying and eliminating underperformers. Furthermore, the company will renovate and expand existing stores, and open new ones in attractive locations. The program will also review and streamline AnnTaylors cost organizational structures. If successful, AnnTaylor will drive sales and reduce overhead, ultimately leading to improved profitability. The Internet provides AnnTaylor with an additional low-cost sales channel. This channel has global reach and is available to consumers at any time, in any place, where there is network access. The Internet is constantly increasing the number of consumers to whom AnnTaylor can market. Additionally, AnnTaylors design process is uniquely positioned to take advantage of Internet automation in order to cross-sell products. AnnTaylors total wardrobing strategy ensures that each of its products can be easily combined with other

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AnnTaylor products to create a complete outfit. Because of this deliberate product matching, AnnTaylor has already internally identified which products fit together for maximum effect when presenting products to the customer. AnnTaylor can enable its Internet presence to take advantage of this information and present total wardrobing solutions to customers by immediately showing complementary products. This will enable AnnTaylor to transition its total wardrobing strategy to its Internet presence and provide a similar experience to its in-store and on-line customers. Another opportunity presented to AnnTaylor is debt financing. Currently, the company has no debt and maintains a strong financial position, as shown in the AnnTaylors financial ratios analysis. This gives AnnTaylor an advantage over its

competitors allowing it to obtain low-cost debt to finance potential investment opportunities. Opening new LOFT Outlets provides AnnTaylor with a good opportunity. Currently, all AnnTaylor merchandise is sold through Ann Taylor, LOFT, and AnnTaylor Factory stores. As we discussed in the industry and competitor analysis section, the womens retail apparel industry is characterized by high inventory turnover. Yet, this is an area for improvement, as discussed earlier in the financial ratios analysis section. Therefore, by opening LOFT outlets, AnnTaylor will be able to serve more customers, increase sales, and manage inventory levels even more effectively. Threats First, the current economic slowdown is the primary threat to the companys performance. Because consumer spending depends heavily on disposable income, people

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tend to spend less on apparel in an economic recession. Therefore, the companys sales are expected to be negatively affected as the U.S. economy declines. Second, AnnTaylor does not own the AnnTaylor brand in China; it licenses the brand from Guangzhou Pan Yu San Yuet Fashion Manufactory Ltd. for the right to use the AnnTaylor brand for manufacturing and exporting purposes in China. The license agreement was signed in August 2005 and expires in June 2015. Hence, if there are any disruptions in the agreement or the Chinese party stops licensing to AnnTaylor, the company will lose its ability to manufacture and export under the AnnTaylor brand name in China. Third, the frequent change in fashion trends may bring both opportunities and threats for the company. Should AnnTaylor fail to keep up with current fashion trends, the company will experience a disastrous loss in sales, negatively impacting the profitability and the brand name. Competition and low barriers to entry present a constant threat to AnnTaylor. Because strategic advantages erode rapidly in the industry due to rapid business cycles, AnnTaylor must consistently execute at a high level in order to maintain its competitive position. Additionally, AnnTaylor is forced to defend its market share against a wide variety of competitors, including international, national and regional department stores, specialty stores, and direct marketing businesses that offer similar products. Finally, the United States will be led by a new presidential administration starting in January 2009. Changes in government regulations regarding imports/exports and trade relations could potentially affect AnnTaylors costs associated with those activities.

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Conclusion As demonstrated in the SWOT analysis above and weighing the probabilities of each point, we feel the strengths and the threats outweigh the weaknesses and the opportunities. With numerous strengths, especially in its financial position, we feel AnnTaylor can capitalize successfully on its opportunities and work towards addressing its weaknesses and threats. Hopefully, going forward, the company's strengths can

provide the foundation to identify and take advantage of additional opportunities.

9.4 Valuation
Having evaluated AnnTaylors strategic and competitive position, we must verify that the purchase of AnnTaylor will provide an acceptable return on investment over the next five years. The investment must generate an IRR greater than AnnTaylors cost of capital. We used two methods to calculate AnnTaylors stock intrinsic value: We used financial

price/earnings (P/E) and discounted cash flow (DCF) model.

databases, such as Bloomberg, Google Finance, and Research Insight Web, to obtain the input parameters for our models. First, we performed a P/E valuation to determine the companys stock price. We obtained the industry average P/E multiple (19.41) from the data contained in our Chicos financial ratio analysis. We also used AnnTaylors fiscal year 2007 earnings per share (EPS) of $1.53 to estimate the current years EPS along with the EPS growth assumption of 2%. This method provided us with a value per share of $30.29. This P/E model has only two input variables: the industry average P/E and AnnTaylors EPS growth rate.60 We conducted a sensitivity analysis to see how the share price fluctuates as the two input
60

P/E valuation model formula: Stock price = P/E multiple*Expected EPS, where Expected EPS = EPSFY2007*(1+EPS Growth rate)

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parameters change. Please refer to Appendix Q for more details regarding the P/E valuation. To be conservative, we took into account a pessimistic scenario using a lower P/E and an EPS growth rate than those of the base model. Even with this pessimistic scenario, the lowest intrinsic value of AnnTaylors stock price was found to be $10.30, which is still higher than the market price of $5.58/share as of 11/19/2008. Second, we did a DCF valuation for AnnTaylor. We calculated the companys FCF, average growth rate, and WACC. Using information from AnnTaylors 2007 annual report and Research Insight Web, we obtained operating cash flows and capital expenditures from 2003 to 2007 to calculate FCF. The average FCF growth rate for the period was -0.22%. AnnTaylor has had no debt in the last four years; therefore, the WACC is equal to its cost of equity. We used the same DCF method as Chicos to value AnnTaylors stock. The input parameters, such as a market return of 11.98%, stock beta of 1.53, a risk-free rate of 3.78%, we obtained from the above-mentioned sources.61 Using the Capital Asset Pricing Model (CAPM), the cost of equity was calculated at 16.32%. We then projected AnnTaylor's FCF for the next five years and terminal value. Using the sum of the DCF, the total shareholder's equity, and the total shares outstanding, we calculated an intrinsic value per share of $25.45. Please refer to Appendix R for more details on the DCF valuation. We also did a sensitivity analysis to see AnnTaylors stock price variation by changing the FCF growth rate and the WACC.62 The lowest price calculated from the sensitivity analysis was $21.75, which was still higher than AnnTaylors market price as of 11/19/2008.

61 62

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml Note: for details regarding the rationale of the sensitivity analysis see Chicos valuation section

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9.5 Potential Acquisition of AnnTaylor Stores

AnnTaylor has been profitable over the last five years. It performed relatively well in comparison with the industry basket. AnnTaylors strong financial position, coupled with the similar market capitalization as that of Chicos, makes it our top choice for a back-up acquisition. Due to stock market declines, AnnTaylors market value and P/E have become attractively low. The companys solid strategy, stable performance, and strong balance sheet make it a strong competitor in the retail apparel industry. Because AnnTaylor is in the same industry and market as Chicos, the same acquisition premiums apply to both companies. The minimum, optimal, and maximum premiums would be 0%, 11.12%, and 41.55%, respectively. If successful, AnnTaylors acquisition will yield an IRR of 36.90%, compared to an IRR of 57% for Chicos, at the optimal premium (see Appendix S). Therefore, with a stock price of $5.58 (as of

11/19/2008), we recommend an optimal price of $6.20/share for the friendly acquisition of AnnTaylor. If the attempt to acquire Chicos should fail, AWWI should focus on AnnTaylor as a suitable alternative.

Overall Project Conclusion

The preceding analyses discussed five aspects of the environment and the industry, in which Chicos operates; an analysis of Chicos closest competitors on the basis of product lines; a financial analysis evaluating the five ratio family trends; an evaluation of Chicos strengths, weaknesses, opportunities, and threats (SWOT); a valuation of Chicos as an acquisition candidate; AWWIs acquisition strategy and postacquisition recommendations; and an evaluation of AnnTaylor as an alternative acquisition candidate. 118

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Appendix A

Chicos Financial Ratios

Chico's FAS 2007 2006 3.3 2.0 1.9 1.3 2005 4.4 3.4 2.3 1.3 2004 3.8 2.8 1.5 1.0 2003 2.8 1.8 0.7 0.7 2007 1.8 0.7 2.7 1.8 2006 2.4 1.1 4.0 3.2 Industry 2005 2.6 1.4 4.3 2.7 2004 2.6 1.3 3.6 2.4 2003 3.4 2.0 3.8 2.1

Liquidity Ratios Current Ratio Quick Ratio Working Capital Per Share Cash Flow Per Share Activity Ratios Inventory Turnover Receivables Turnover Total Assets Turnover Average Collection Period (Days) Days to Sell Inventory Operating Cycle (Days) Profitability Ratios Operating Margin Before Depreciation (%) Operating Margin After Depreciation (%) Pretax Profit Margin (%) Net Profit Margin (%) Return on Assets (%) Return on Equity (%) Return on Investments (%) Leverage Ratios Long-Term Debt/Common Equity (%) Long-Term Debt/Shareholder Equity (%) Total Debt/Invested Capital (%) Total Debt/Total Assets (%) Total Assets/Common Equity Market Ratios Price Earnings Ratio (P/E) Price to Book Ratio Price/Sales Price/Cashflow Price/EBITDA

2.7 1.7 1.7 1.0

13.4 68.4 1.5 5.0 27.0 32.0

16.0 124.3 1.6 3.0 23.0 26.0

16.66 161.8 1.6 2.0 22.0 24.0

16.65 186.0 1.8 2.0 22.0 24.0

15.4 178.9 2.0 2.0 24.0 26.0

8.3 64.6 1.7 10.4 50.0 60.6

8.9 72.1 1.8 10.2 46.6 56.6

8.9 71.0 1.8 12.0 46.8 58.6

8.9 77.9 1.9 16.6 45.6 62.2

9.3 86.0 2.0 22.4 44.0 66.4

12.5 7.1 8.1 5.3 7.3 10.0 10.0

19.9 15.8 15.9 10.1 15.8 20.7 20.7

24.7 21.2 21.8 13.8 19.4 24.1 24.1

24.8 21.4 21.3 13.2 19.7 25.2 25.2

24.3 21.3 21.0 13.0 21.3 26.7 26.7

7.2 2.6 0.4 -0.1 0.1 -4.2 5.0

11.3 7.0 7.8 4.4 7.2 12.1 11.1

11.6 7.5 8.5 4.4 7.3 12.1 11.3

11.0 7.1 8.0 4.3 7.3 11.9 11.0

12.2 8.8 10.3 5.1 9.0 12.4 11.6

0.0 0.0 0.0 0.0 1.4

0.0 0.0 0.0 0.0 1.3

0.0 0.0 0.0 0.0 1.2

0.0 0.0 0.0 0.0 1.3

0.0 0.0 0.0 0.0 1.3

22.4 22.4 19.0 10.8 2.1

21.3 21.3 16.9 10.7 1.9

14.2 14.2 11.0 7.2 1.8

16.7 16.7 11.4 7.6 1.7

24.8 24.8 17.6 12.4 1.7

22.3 4.8 2.4 13.4 11.7

39.8 9.5 5.4 28.4 21.9

31.7 8.1 4.2 20.2 17.4

32.3 8.6 4.1 21.9 17.3

23.3 6.5 2.9 13.9 12.3

19.4 2.1 1.0 11.3 9.0

22.1 2.9 1.3 8.3 12.5

22.3 2.8 1.4 10.0 9.5

21.3 3.1 1.0 7.7 9.4

13.0 1.7 0.6 5.1 6.2

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Appendix B
(in thousands) Operating Cash Flow* Capital Expenditure* Free Cash Flow Growth Rate Average Growth Rate *CHS 10-K

Chicos DCF Valuation

2008 $208,647 202,223 $6,424 -91% 2.32% 2007 $288,994 218,311 $70,683 -41% Year Ended February 2006 2005 $268,406 $223,620 147,635 93,065 $120,771 $130,555 -7% 40% 2004 $145,380 52,300 $93,080 111% 2003 $108,807 64,742 $44,065

Year 1 2 3 4 5 Terminal Value Sum DCF (000) Total Liabilities/Equity (000)* Sum DCF +Total Liabilities/Equity (000) Common Stock Outstanding (000)** BV Per Share *Chico's 10K 2007 **Yahoo! Finance

Free Cash Flow (000) $6,424 $6,552 $6,684 $6,817 $6,954

Discounted Free Cash Flow (000) $5,477 $4,762 $4,141 $3,601 $3,131 $18,079

39,191 912,916 952,107 176,540 5.39

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Appendix C

Chicos Weighted Average Cost of Capital

WACC Calculation Beta* 1.65 Rf** 3.78% U.S. Market Return (10/25/08)*** 11.98% Risk Premium 8.19% Cost of Equity^ 17.30% *Google Finance **Average of 10-year Treasury Yields in October, 2008 ***Bloomberg Data ^CHS has no debt --> WACC=Re (Bloomberg Value 15.08%)

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Appendix D

Chicos DCF Valuation: Sensitivity Analysis

Sensitivity Analysis FCF Growth Rate 2% 3% 5.67 5.73 5.60 5.65 5.55 5.59 5.51 5.54 5.48 5.50 5.46 5.47 5.43 5.45 5.41 5.43 5.40 5.41 5.38 5.39 5.37 5.38 5.36 5.37 5.35 5.36

W A C C

9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21%

0% 5.58 5.54 5.50 5.47 5.45 5.43 5.41 5.40 5.38 5.37 5.36 5.35 5.34

1% 5.62 5.57 5.53 5.49 5.46 5.44 5.42 5.40 5.39 5.38 5.36 5.35 5.34

4% 5.81 5.70 5.63 5.57 5.53 5.49 5.46 5.44 5.42 5.40 5.39 5.37 5.36

5% 5.93 5.78 5.68 5.61 5.53 5.51 5.48 5.45 5.42 5.41 5.39 5.38 5.37

6% 6.14 5.90 5.76 5.66 5.59 5.54 5.50 5.47 5.44 5.42 5.40 5.39 5.38

Sensitivity Analysis of Risk-Free Rate Risk-Free Rate* BV/Share (%) WACC (%) ($) 3 17.81 5.39 4 17.16 5.40 5 16.51 5.41 6 15.86 5.42 7 15.21 5.43 8 14.56 5.45 9 13.91 5.46 10 13.26 5.48 *All other parameters remain the same Sensitivity Analysis of Market Return Market Return* BV/Share (%) WACC (%) ($) 7 9.09 5.68 8 10.74 5.58 9 12.39 5.51 10 14.04 5.46 11 15.69 5.42 12 17.34 5.4 13 18.99 5.37 14 20.64 5.35 15 22.29 5.34 *All other parameters remain the same

Sensitivity Analysis of FCF Growth FCF Growth Rate* (%) BV/Share ($) 0 5.38 1 5.38 2 5.39 3 5.4 4 5.41 5 5.42 *All other parameters remain the same

Sensitivity Analysis of Beta Beta WACC BV/Share 1.0 11.98 5.51 1.1 12.79 5.49 1.2 13.61 5.47 1.3 14.43 5.45 1.4 15.25 5.43 1.5 16.07 5.41 1.6 16.89 5.40 1.7 17.71 5.39 1.8 18.53 5.38 1.9 19.35 5.37 2.0 20.17 5.36 *All other parameters remain the same

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Appendix E
Cost of capital

Chicos Value Creation Model

Weight Debt Equity Cost of capital Cost of Equity Expected inflation rate Real interest rate Risk-free rate Beta Expected return on Market Risk-free rate Risk Premium Risk free rate Equity Risk Premium Cost of Equity

Cost Weighted Cost 0.00% 12.00% 0.00% 100.00% 17.30% 17.30% 17.30% 2.80% 1.00% 3.80% 1.65 11.98% 3.80% 8.18% 3.80% 8.18% 17.30%

13.92%

7%

All currency numbers in thousands (currency numbers are in 1,000's) 5 1714326 2.00% (1) 7% 7.29% (2) 2% (3) 40% 60% 17% 260469 1063596 71146.566 Present value Cumulative Present Cumulative of Residual PV+ Residual Increase in Value Present Value Value Value Value $ 60,654 $ 60,654 $ 366,297 $ 426,951 $ 5,709 $ 52,742 $ 113,396 $ 318,519 $ 431,915 $ 4,964 $ 45,863 $ 159,258 $ 276,973 $ 436,232 $ 4,317 $ 39,881 $ 199,139 $ 240,846 $ 439,985 $ 3,754 $ 34,679 $ 233,818 $ 209,432 $ 443,249 $ 3,264 Total value Created => $ 22,008 $ $ $ $ 260,469 703,718 1,063,596 (359,878)

Business with the following Forecasts Number of periods in forecast Sales (last historical period) Sales growth rate Operating profit margin Incremental fixed capital invest. Incremental working capital invest. Cash income tax rate Residual value income tax rate Cost of capital = WACC Marketable secutities and investments Market value of debt and other obligations Cash flow in year 1

Year 1 2 3 4 5

Cash Flow $ 71,147 $ 72,569 $ 74,021 $ 75,501 $ 77,011

Marketable Securities and Investments Corporate Value less: Market value of debt Shareholder Value

The material and methods of this spreadsheet are according to the "Creating Shareholder Value" by Alfred Rappaport, The Free Press, Macmillan, Inc. New York (1) From management predictions in 10K -- negative or flat growth in same store sales, 4-7% increase in total stores; I estimate 2% growth from this (2) From 10K, 125 million in fixed capital investment in 2009 (3) From 10K, -30 million in working capital investment in 2009, and has been decreasing since 2006.

Appendix F

Chicos Value Creation Model: Sensitivity Analysis

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Risk Free Rate 3% 4% 5% 6% 7% 8% 9% 10%

Value Created (000) $ 23,791 $ 21,591 $ 19,661 $ 17,959 $ 16,448 $ 15,101 $ 13,895 $ 12,812

Sales Growth 1% 2% 3% 4% 5%

Value Created (000) $ 10,820 $ 22,008 $ 33,574 $ 45,530 $ 57,885

Operating Margin 5% 10% 15% 20% 25% 30%

Value Created (000) $ 12,451 $ 35,371 $ 58,291 $ 81,212 $ 104,132 $ 127,052

Appendix G

Chicos Direct Competitors

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Comparable Ticker Christopher & Banks CorpCBK Coldwater Creek, Inc. CWTR Dillard's, Inc.*** DDS The Talbots, Inc. TLB Ann Taylor Stores Corp. ANN Chico's CHS

Market Cap (in millions) Debt/Equity SIC Code* 10.38 0 n/a 4.6 n/a 48.7 n/a 92.7 9.64 0 22.38 0.31

5621 5621 5311 5621 5621 5621

Demographic market (age)** Professional women (40-60) Professional women (45-65) Professional women (35-55) Professional women (25-55) Professional women (over 35)

*Source: Hoover Pro ** Sources: Bloomberg, firm's annual reports, Forbes, Google Finance *** Listed as a direct competitor in Chico's 2007 annual report

Appendix H

Chicos Comparables Valuation

126

Comparable Ticker Christopher & Banks CorpCBK Coldwater Creek, Inc. CWTR Dillard's, Inc. DDS The Talbots, Inc. TLB Ann Taylor Stores Corp. ANN Average Basket Chico's CHS Multiples P/E P/S P/B P/CF P/EBITDA

P/E 10.38 n/a n/a n/a 9.64 10.01 22.38

P/S 0.29 0.3 0.06 0.2 0.35 0.24 0.31

P/B 0.67 0.98 0.15 1.03 1.02 0.77 0.54

P/CF 4.35 4.06 2.6 13.91* 3.44 3.61 3.99

P/Ebitda 3.03 32.45* 1.26 4.58 2.86 2.38 4.83

Basket Avg Chico's Intrinsic Value Current Price* 10.01 $ 0.13 $ 1.30 $ 2.90 0.24 $ 9.35 $ 2.25 $ 2.90 0.77 $ 5.37 $ 4.14 $ 2.90 3.61 $ 0.73 $ 2.63 $ 2.90 2.38 $ 0.61 $ 1.45 $ 2.90 Average Intrinsic Value $ 2.35

*For the purposes of our analysis we excluded the P/CF and P/EBITDA multiples of Talbots and Coldwater Creek, because they skewed the results. **As of Oct 24, 2008 Source: Bloomberg

Appendix I

M&A Premium Analysis: General Search

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Apparel Industry M&A average premium General Statistics

Source: Bloomberg Terminal Industry Apparel Period 45 months from Jan 05 to Sep 08 In which 6 months: no premium data available. We calculate Average premium based on available data only Total Deal Value: Total Companies' Market Value 65,397.00 US$ million 100,021.07 US$ million Overall -34.62% 54.39% -94.81% 2008 11.12% 41.55% -27.00% 2007 7.19% 54.39% -27.00% 2006 11.34% 20.31% -3.43% 2005 -69.37% 32.67% -94.81%

Average M&A Premium * Maximum Premium Minimum Premium

* suppose x is premium, D: Deal value, M: Company's Market value D = M*(1+x) => x = D/M -1 Pros: Cons: Large scale M&A activities, more representative information General information about M&A premium in Apparel Industry. There is no information about: Payment method (Cash, Stock); Deal Status (Pending, Completed or terminated)

Appendix J

M&A Premium Analysis: Detailed Search

128

Apparel - Retail Apparal Industry M&A Premium Detail Search Source: Bloomberg Terminal Period Criteria Search Jan 2003 to Sep 2008 Current Deal Status: Payment Method: Industry: Extend: Completed Cash Apparel & Retail (apparel) Global

Results: Total Deal value: Total Companies' market value: Overall 19.10% 62.08% -8.83%

14,383.60 US$ mil. 12,076.77 US$ mil. 2007 10.79% 55.10% -4.72% 2006 16.21% 30.52% 10.03% 2005 31.38% 37.97% -8.83% 2004 17.34% 35.22% -0.26% 2003 34.60% 62.08% 22.34%

Avg Premium * High Low

* suppose x is premium, D: Deal value, M: Company's Market value D = M*(1+x) => x = D/M -1 Pros: Cons: More matched with Chico's deal There are so many deals without premium information. The available data (deal with premium data) may be not representative for whole population

Appendix K

Chicos Pro Forma Adjusted DCF Valuation

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(000) Operating Cash Flow^^ Capital Expenditure** Same-Store Growth Rate*^ FCF Growth Rate

2012 $296,497 59,299 8.47% $237,198 8.47%

2011 $273,345 54,669 8.47% $218,676 8.47%

Year Ended February 2010 2009 $252,000 $232,323 50,400 46,465 8.47% -17% $201,600 $185,858 8.47% -18%

2008 $279,907 52,223 -8.1% $227,684 -5%

2007 $304,578 65,511 2.1% $239,067

*This is the same-store growth rate value if the company had forgone the 152.8M and 150M in capital expenditures on planning and opening of new, relocated, remodeled and expanded stores in FY2006 and FY 2007 respectively ^FY2008 same-store growth rate from CHS 10-Q filed August 26, 2008 and the FY2009-FY2011 same-store growth rate is an average of the same-store growth rates from FY2002-FY2006 found in CHS Annual Reports **Average of the proportion of capital expenditures to operating cash flows from FY2006-FY2007 multiplied to current year operating cash flow value ^^Previous years operating cash flow adjusted by the estimated same-store growth rate

Year 1 2 3 4 5 Terminal Value

Free Cash Flow (000) $201,600 $218,676 $237,198 $257,288 $279,081 $302,719

Discounted Cash Flow (000) $171,866 $158,928 $146,964 $135,900 $125,669 $1,315,975

Sum DCF (000) Total Liabilities/Equity (000) Sum DCF +Total Liabilities/Equity (000) Common Stock Outstanding (000)* Pro forma Value Per Share *Yahoo Finance

$2,055,302 912,916 2,968,218 176,540 $16.81

Initial Stock Price* Shares Outstanding (000) Market Cap (000) Premium 0.00% 11.21% 41.55% *As of Oct 24, 2008

$2.93 176,540 $517,262 Year 0 ($517,262) (575,247) (732,185)

Pro Forma Adjusted Free Cash Flow Model

1 $201,600 201,600 201,600

Values in Thousands 2 3 4 $218,676 $237,198 $257,288 218,676 237,198 257,288 218,676 237,198 257,288

5 $279,081 279,081 279,081

Terminal $3,428,299 3,428,299 3,428,299

IRR 61.86% 57.27% 47.81%

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Appendix L

Chicos IRR Calculation and Sensitivity Analysis

Minimum Premium IRR Sensitivity Analysis Capital Expenditures Growth Rate 10.00% 15.00% 20.00% 25.00% 54.23% 51.75% 49.22% 46.62% 65.03% 62.38% 59.66% 56.88% 66.57% 63.89% 61.15% 58.35% 61.86% 67.30% 64.61% 59.03% 68.12% 65.41% 62.65% 59.81% 69.66% 66.93% 64.14% 61.28% Optimal Premium IRR Sensitivity Analysis Capital Expenditures Growth Rate 10.00% 15.00% 20.00% 25.00% 49.69% 47.37% 44.99% 42.54% 60.17% 57.68% 55.14% 52.52% 61.67% 59.16% 56.59% 53.94% 62.37% 59.85% 54.61% 57.27% 63.16% 60.63% 58.04% 55.37% 64.66% 62.11% 59.49% 56.79% Maximum Premium IRR Sensitivity Analysis Capital Expenditures Growth Rate 10.00% 15.00% 20.00% 25.00% 40.38% 38.35% 36.27% 34.11% 50.21% 48.04% 45.80% 43.50% 51.61% 49.42% 47.17% 44.84% 52.27% 50.07% 45.47% 47.81% 53.02% 50.80% 48.53% 46.18% 54.42% 52.19% 49.89% 47.52%

0.00% FCF 7.00% Growth 8.00% Rate 8.47% 9.00% 10.00%

30.00% 43.94% 54.02% 55.46% 56.13% 56.90% 58.34%

0.00% FCF 7.00% Growth 8.00% Rate 8.47% 9.00% 10.00%

30.00% 40.02% 49.82% 51.22% 51.88% 52.62% 54.02%

0.00% FCF 7.00% Growth 8.00% Rate 8.47% 9.00% 10.00%

30.00% 31.89% 41.12% 42.44% 43.06% 43.76% 45.07%

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Appendix M

Firms Acquisition Process, Regulations and Rules

The following section includes rules and regulations stipulated by the U.S. Securities and Exchange Commission. Given the legal nature of these rules and

regulations, most of the text is directly from the following sources: SEC websites, Wikipedia articles on mergers and acquisitions, Harvard Business School cases, and other related sources as noted below. Overview of the Acquisition Process and Filings: All acquisitions usually follow a standard structure (1) initial valuation, (2) initial offer, (3) structuring the deal, (4) due diligence, (5) definitive agreement negotiation, (6) closing phase. Both parties, the acquirer and the target, are required to file various documents with the SEC at every step of the acquisition. The following is a brief description of necessary filings. Initial Offer63 After a company has identified a potential acquisition target and has done the initial valuation, it has to file a letter of intent with the SEC. This letter is often used in complex transactions, when the parties want to tie down the principal terms of the deal early in the negotiation. A letter of intent (sometimes referred to as a memorandum of intent, a term sheet, or merger proxy) is simply a document signed by all parties to a proposed transaction that states the general agreement to one or more key terms. These key terms comprise of both binding and non-binding agreements. Binding provisions:
63

Confidentiality;

Professor William E. Fruhan, Jr., The Company Sale Process, Harvard Business School, Case 9-206-108, April 10, 2007

132

Deal Termination i.e. Drop Dead; Break-Up Fee; Exclusivity; Non-Solicitation. Non-binding provisions:

Structure of transaction payment by stock, or cash, or both; transfer of assets, or stock, or both;

Purchase price; Additional due diligence; Employment contracts; Non-compete agreements; Steps to closing; Warrants/indemnities.

Definite Merger Agreement64 Once the due diligence process is completed by both parties, a definite merger agreement should be filed. The definite merger agreement is usually 50 to 100 pages (excluding exhibits), and includes the following sections: the purchase price, when the closing will occur, how the price will be paid, covenants including how the business will be conducted pre-closing, closing conditions, and what happens if the deal is terminated. There are some key negotiation points, such as: The material adverse change clause; The fiduciary out clause;

64Professor

William E. Fruhan, Jr., The Company Sale Process, Harvard Business School, Case 9-206-108, April 10, 2007

133

The breakup fee; Consummation of debt financing to be used in the acquisition; The antitrust out; Escrows, contingent considerations; Expense reimbursement caps; Voting agreement and irrevocable proxy for management and directors; Tail directors and officers liability insurance covering these individuals until the period of continued legal liability following the sale expires (approximately six years).

Pre-Merger Notification65 Before both parties close the deal, they have to arrange for certain U.S. Government antitrust provisions. The Hart-Scott-Rodino Antitrust Improvements Act provides that before certain mergers, tender offers or other acquisition transactions can close, both parties must file a Notification and Report Form with the Federal Trade Commission and the Assistant Attorney General in charge of the Antitrust Division of the Department of Justice. The filing describes the proposed transaction and the parties to it. Upon the filing, a 30-day waiting period then ensues during which time those regulatory agencies may request further information in order to help them assess whether the proposed transaction violates the antitrust laws of the United States. It is unlawful to close the transaction during the waiting period. Although the waiting period is generally 30 days, the regulators may request additional time to review additional information and the filing parties may request that the waiting period for a particular transaction be
65

Wikipedia. Hart-Scott-Rodino Antitrust Improvements Act, http://en.wikipedia.org/wiki/Hart-ScottRodino_Antitrust_Improvements_Act

134

terminated early. Early terminations are made public in the Federal Register and posted on the Federal Trade Commission website. Additionally, some types of transactions are afforded the special treatment of shorter waiting periods. The filing requirement is triggered only if the value of the transaction, and in certain cases, the size of the parties, exceeds certain U.S. Dollar thresholds. For the purpose of determining the "size of the parties" one assesses the size of the party to the transaction, its ultimate parent entity, and all subsidiaries of that ultimate parent entity. Rule 10b-5 of the Securities and Exchange Commission66 One of the most important regulations promulgated by the SEC is the antifraud provision known as Rule 10b-5. This rule is always invoked in insider trading cases and in fraudulent accounting practices. It also applies to the issuance of equity by the bidder in connection with a merger or acquisition. The rule itself is relatively short. The formal title is "Rule 10b-5: Employment of Manipulative and Deceptive Practices", and the complete text is the following: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business, which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

66

Carliss Y. Baldwin, Constance E. Bagley, James W. Quinn: M&A Legal Context: Standards Related to the Sale or Purchase of a Company, HBC 9-904-004, Feb 23, 2004

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The SEC or any damaged investor can sue a company and its officers for violation of the rule. In order for a defendant to be found liable in a civil case under Rule 10b-5, each of the following seven elements/conditions should be met: 1. 2. 3. 4. 5. 6. 7. Connection with the sale or purchase of securities Facts, not opinions Material misrepresentation or omission Belief and reliance Scienter (or knowingly or willfully) Causation Interstate commerce

Under the SEC rule, damages typically consist of out-of-pocket loss, or the difference between what the investor paid (or received) and the fair market value of the stock on the date of the transaction. Alternatively, investors can elect to rescind the transaction, returning what they received and getting back what they gave. Generally, it is difficult for plaintiffs to prove all conditions needed to obtain a finding of liability in Rule 10b-5. Regulation M-A67 Under the Code of Federal Regulations Title 17: Commodity and Securities Exchanges, Regulation M-A is the main framework for conducting mergers and acquisitions in the United States. There are several required documents:

U.S. Securities and Exchange Commission. Title 17: Commodity and Securities Exchanges, http://ecfr.gpoaccess.gov/cgi/t/text/textidx?c=ecfr&sid=20c66c74f60c4bb8392bcf9ad6fccea3&rgn=div5&view=text&node=17:2.0.1.1.11&idno= 17#17:2.0.1.1.11.11
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Summary term sheet. Provides security holders with a summary term sheet that is written in plain English. The summary term sheet must briefly describe in bullet point format the most material terms of the proposed transaction. The summary term sheet must provide security holders with sufficient information to understand the essential features and significance of the proposed transaction. The bullet points must crossreference a more detailed discussion contained in the disclosure document that is disseminated to security holders. Subject company information. This section includes the name and address of the subject company (or the issuer in the case of an issuer tender offer), title and number of securities, trading price, dividends information, and prior stock purchases. Identity and background of filing person. Name and address, business and background of entities, business and background of natural persons, current principal occupation or employment, material occupations, a statement whether or not the person was convicted in a criminal proceeding during the past five years, a statement whether or not the person was a party to any judicial or administrative proceeding during the past five years, and country of citizenship. Terms of the transaction. A brief description of the transaction; the

consideration offered to security holders; the reasons for engaging in the transaction; the vote required for approval of the transaction; an explanation of any material differences in the rights of security holders as a result of the transaction, if material; a brief statement as to the accounting treatment of the transaction, if material; and the federal income tax consequences of the transaction, if material.

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Past contacts, transactions, negotiations, and agreements. A brief statement of the nature and approximate dollar amount of any transaction; significant corporate events in the past two years; negotiations or contacts; potential conflicts of interest between the filing person and the subject company or its executives. Purposes of the transaction and plans or proposals. The purposes of the transaction; use of securities acquired; plans; subject company negotiations. Source and amount of funds or other consideration. Source of funds; material conditions; itemized statement of all expenses incurred or estimated to be incurred in connection with the transaction; borrowed funds. Interest in securities of the subject company. Securities ownership; securities transactions during the past 60 days. Persons/assets, retained, employed, compensated or used. Solicitations or recommendations; employees and corporate assets. Financial statements. Financial information; pro-forma information; summary information. Additional information. proceedings. The solicitation or recommendation. Solicitation or recommendation; reasons; intent to tender; intent to tender or vote in a going-private transaction; recommendations of other interested parties. Companies engaged in M&A activities should also file documentation in compliance with the following SEC regulations: Agreements, regulatory requirements, and legal

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Regulation S-X - governs the Form and content of and requirements for financial statements. Regulation S-K - provides standard instructions for filing forms under Securities Act of 1933, Securities Exchange Act of 1934 and Energy Policy and Conservation Act of 1975. Regulation S-T - governs the electronic submission of documents submitted to the Security and Exchange Commission together with EDGAR Filer Manual. Regulation C - provides registration and filing requirements. Williams Act68 The Williams Act of 1968 amended the Securities and Exchange Act of 1934 (15 U.S.C.A. 78a et seq.) to require mandatory disclosure of information regarding cash tender offers. When an individual, group, or corporation seeks to acquire control of another corporation, it may make a tender offer. A tender offer is a proposal to buy shares of stock from the stockholders for cash or some type of corporate security of the acquiring company. Since the mid-1960s, cash tender offers for corporate takeovers have become favored over the traditional alternative, the proxy campaign. A proxy campaign is an attempt to obtain the votes of enough shareholders to gain control of the corporation's board of directors. Because of abuses with cash tender offers, Congress passed the Williams Act in 1968, which purpose is to require full and fair disclosure for the benefit of stockholders, while at the same time providing the offering party and management equal opportunity to fairly present their cases.
U.S. Securities and Exchange Commission. Williams Act, http://law.jrank.org/pages/11330/WilliamsAct.html
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The act requires any person, who makes a cash tender offer (which is usually 15% to 20% in excess of the current market price) for a corporation that is required to be registered under federal law to disclose to SEC the source of the funds used in the offer, the purpose for which the offer is made, the plans the purchaser might have if successful, and any contracts or understandings concerning the target corporation. Filing and public disclosures with the SEC are also required of anyone, who acquires more than 5% of the outstanding shares of any class of a corporation subject to federal registration requirements. Copies of these disclosure statements must also be sent to each national securities exchange where the securities are traded, making the information available to shareholders and investors. The law also imposes miscellaneous substantive restrictions on the mechanics of a cash tender offer, and it imposes a broad prohibition against the use of false, misleading, or incomplete statements in connection with a tender offer. The Williams Act gives the SEC the authority to institute enforcement lawsuits. Schedule 13-D69 Schedule 13D is commonly referred to as a beneficial ownership report. The term "beneficial owner" is defined under SEC rules, and includes any person who directly or indirectly shares voting power or investment power (the power to sell the security). When a person or group of persons acquires beneficial ownership of more than 5% of a voting class of a companys equity securities registered under Section 12 of the Securities Exchange Act of 1934, they are required to file a Schedule 13D with the SEC. Schedule 13D reports the acquisition and other information within ten days after the purchase. The schedule is filed with the SEC and is provided to the company that issued 69 U.S. Securities and Exchange Commission. Schedule 13D, http://www.sec.gov/answers/sched13.htm 140

the securities and each exchange where the security is traded. Any material changes in the facts contained in the schedule require a prompt amendment. The schedule is often filed in connection with a tender offer. Section 280 G of the IRS Code (Excess Golden Parachutes)70 In acquisitions of public companies, an increasing amount of attention is focused on the executive severance arrangements that are triggered upon a change in control. The change in control payments may result in the application of the IRS Section 280G golden parachute provisions. To the extent Section 280G applies, the target corporation may not deduct from its taxable income change in control payments made to an executive, and 20% excise tax is imposed on the executive, who receives the payment. This excise tax is in addition to normal payroll withholding tax and income tax and is also non-deductable. From a acquisition target perspective, companies should plan for Section 280G ahead of time and to ensure that the executive severance packages accomplish their intended purposes in a tax efficient way. The important thing for potential acquirers, in pricing the deal, is to understand several issues: the extent of the change in control payments, the potential for disallowance of deductions and for the obligation of the target company to make substantial payments to executives, and the opportunities for planning to reduce any potential adverse impacts.71

70

Tax Almanac. Internal Revenue Code:Sec. 280G, http://www.taxalmanac.org/index.php/Internal_Revenue_Code:Sec._280G 71 Christian McBurney. Golden Parachute Planning a Key in Acquisitions of Public Companies, Nov 2003

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Appendix N

Chicos Institutional Ownership

Total Number of Shares Outstanding (Apr 30, 2008) Number of Institutional Holders % Institutional Ownership

176,510,956 283 95%

Top 15 Institutional Shareholders as of Apr 30, 2008 Institution Name Columbia Wanger Asset Management, L.P. Snow Capital Management, L.P. Barclays Global Investors, N.A. Deutsche Asset Management Americas UBS Global Asset Management (Americas), Inc. Franklin Templeton Investments Corp. Templeton Investment Counsel, LLC State Street Global Advisors (US) Vanguard Group, Inc. UBS Global Asset Management (Switzerland) PRIMECAP Management Company Fidelity Management & Research Mazama Capital Management, Inc. Schneider Capital Management Corporation Frontier Capital Management Company, LLC TOTAL:

# Shares Held % Outstanding 10,197,000 5.8 9,458,811 5.4 9,289,052 5.3 7,485,690 4.2 7,412,424 4.2 7,093,180 4.0 6,630,177 3.8 6,509,103 3.7 5,578,919 3.2 5,512,927 3.1 5,256,183 3.0 5,005,697 2.8 4,663,314 2.6 4,644,900 2.6 4,564,706 2.6 99,302,083 56.3

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Appendix O

Berkshire Hathaway Class A and Class B Stock72

The following section is a direct excerpt from a memo, written by Warren Buffett to Berkshire Hathaways shareholders: Berkshire Hathaway Inc. has two classes of common stock designated as Class A and Class B. A share of Class B common stock has the rights of 1/30th of a share of Class A common stock, except that a Class B share has 1/200th of the voting rights of a Class A share (rather than 1/30th of the vote). Each share of a Class A common stock is convertible at any time, at the holders option, into 30 shares of Class B common stock. This conversion privilege does not extend in the opposite direction. That is, holders of Class B shares are not able to convert their stock into Class A shares. Both Class A & B shareholders are entitled to attend the Berkshire Hathaway Annual Meeting, which is held the first Saturday in May. The Class B can never sell for anything more than a tiny fraction above 1/30th of the price of Class A. When it rises above 1/30th, arbitrage takes place in which someone perhaps the NYSE specialist buys the A and converts it into B. This pushes the prices back into a 1:30 ratio. On the other hand, the B can sell for less than 1/30th the price of the A since conversion doesnt go in the reverse direction. All of this was spelled out in the

prospectus that accompanied the issuance of the Class B. When there is more demand for the B (relative to supply) than for the A, the B will sell at roughly 1/30th of the price of A. When theres a lesser demand, it will fall to a discount. As of November 20, 2008, BKR Class A share price was $77,500 and BKR Class B share price was $2,914.

72

Warren Buffet. Comparative Rights and Relative Prices of Berkshire Class A and Class B Stock, http://www.berkshirehathaway.com/compab.html

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Appendix P

AnnTaylors Financial Ratios

AnnTaylor Stores 2007 Liquidity Ratios Current Ratio Quick Ratio Working Capital Per Share Cash Flow Per Share Activity Ratios Inventory Turnover Receivables Turnover Total Assets Turnover Average Collection Period (Days) Days to Sell Inventory Operating Cycle (Days) Profitability Ratios Operating Margin Before Depreciation (% Operating Margin After Depreciation (%) Pretax Profit Margin (%) Net Profit Margin (%) Return on Assets (%) Return on Equity (%) Return on Investments (%) Leverage Ratios Interest Coverage Before Tax Interest Coverage After Tax Long-Term Debt/Common Equity (%) Long-Term Debt/Shareholder Equity (%) Total Debt/Invested Capital (%) Total Debt/Total Assets (%) Total Assets/Common Equity 1.6 0.5 3.2 3.5 2006 2.3 1.3 5.6 3.6 2005 2.6 1.5 5.8 2.4 2004 2.4 1.1 4.9 2.0 2003 3.6 2.2 6.1 2.2 2007 2.1 0.9 2.4 1.3 2006 2.6 1.3 3.0 2.7

Industry 2005 2.9 1.8 3.4 2.4 2004 2.9 1.6 2.8 2.2 2003 3.2 2.0 2.5 1.8

9.9 143.4 1.6 3.0 37.0 39.0

10.7 139.5 1.5 3.0 34.0 37.0

9.6 139.8 1.5 3.0 38.0 41.0

9.2 148.0 1.5 2.0 40.0 42.0

8.9 139.0 1.5 3.0 41.0 44.0

9.0 45.8 1.6 10.8 48.0 59.2

10.0 68.3 1.7 10.2 44.4 54.4

10.3 76.5 1.7 11.8 43.6 55.2

10.4 87.4 1.8 16.6 42.0 58.6

10.6 95.9 1.9 22.2 40.6 62.8

12.7 7.8 6.7 4.1 7.0 11.6 11.6

14.1 9.6 10.2 6.1 9.1 13.6 13.6

11.6 7.1 6.7 4.0 5.5 7.9 7.9

9.9 5.7 5.7 3.4 4.8 6.8 6.8

14.1 10.8 10.6 6.4 8.8 12.2 10.6

7.2 2.5 0.8 0.1 0.2 4.8 4.6

12.4 8.2 8.1 5.2 8.5 13.5 12.5

14.2 10.3 10.2 6.4 10.1 15.3 14.5

14.0 10.2 10.0 6.3 10.3 15.5 14.7

14.2 10.9 10.3 6.4 11.5 15.3 14.8

75.1 45.8 0.0 0.0 0.0 0.0 1.7

108.1 65.1 0.0 0.0 0.0 0.0 1.5

67.4 40.3 0.0 0.0 0.0 0.0 1.4

30.2 18.4 0.0 0.0 0.0 0.0 1.4

26.3 16.2 15.1 15.1 13.1 10.9 1.4

-2.6 -1.7 22.4 22.4 19.0 10.8 2.1

145.0 88.3 21.3 21.3 16.9 4.8 1.9

77.0 46.7 14.2 14.2 11.0 5.4 1.7

38.3 24.9 16.7 16.7 11.4 5.8 1.7

45.6 28.5 27.2 27.2 18.7 10.2 1.7

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Appendix Q

AnnTaylors Price/Earnings Valuation and Sensitivity

Price/Earnings Model Valuation Calculation Industry Average P/E multiple as of Jan 08 FY2007 EPS EPS Growth rate 19.41 $ 1.53 2%

Share price = Expected EPS * P/E Multiple = $ 30.29

Sensitivity Calculations Sensitivity to P/E and Growth rate Assumption P/E ratio -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% $ $ $ $ $ $ $ $ $ $ $ $ 7 10.3 10.4 10.5 10.6 10.7 10.8 10.9 11.0 11.1 11.2 11.4 11.5 $ $ $ $ $ $ $ $ $ $ $ $ 9 13.2 13.4 13.5 13.6 13.8 13.9 14.0 14.2 14.3 14.5 14.6 14.7 $ $ $ $ $ $ $ $ $ $ $ $ 11 16.2 16.3 16.5 16.7 16.8 17.0 17.2 17.3 17.5 17.7 17.8 18.0 $ $ $ $ $ $ $ $ $ $ $ $ 13 19.1 19.3 19.5 19.7 19.9 20.1 20.3 20.5 20.7 20.9 21.1 21.3 $ $ $ $ $ $ $ $ $ $ $ $ 15 22.0 22.3 22.5 22.7 23.0 23.2 23.4 23.6 23.9 24.1 24.3 24.6 $ $ $ $ $ $ $ $ $ $ $ $ 17 25.0 25.2 25.5 25.7 26.0 26.3 26.5 26.8 27.1 27.3 27.6 27.8 $ $ $ $ $ $ $ $ $ $ $ $ 19 27.9 28.2 28.5 28.8 29.1 29.4 29.7 29.9 30.2 30.5 30.8 31.1 $ $ $ $ $ $ $ $ $ $ $ $ 21 30.8 31.2 31.5 31.8 32.1 32.5 32.8 33.1 33.4 33.7 34.1 34.4

EPS Growth Rate

AnnTaylor historical EPS EPS Growth rate Avg Growth 2007 1.53 -26% 1.9% 2006 1.98 56% 2005 1.13 25% 2004 0.88 -48% 2003 1.42

Expected 2008 EPS

$ 1.56

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Appendix R

AnnTaylors DCF Valuation and Sensitivity Analysis

Historical Free Cash Flow

WACC CALCULATION Beta* 1.53 Rf** 3.78% U.S. Market Return (10/25/08)*** 11.98% Risk Premium 8.19% Return on Equity^ 16.32% *Google Finance **Average of 10yr Oct T-Bill Yields *** AnnTaylor 10-Q Report as of Aug 02 2008 ^ANN has no debt so WACC=Re (Bloomberg value 13%)

Year Operating Cash Flow (Thousands) Capital Expenditure FCF Average Growth

2007 257,197 139,998 117,199 -0.22%

2006 295,931 165,926 130,005 -10%

2005 311,323 187,613 123,710 5%

2004 169,259 152,483 16,776 200%

2003 189,618 71,364 118,254 -195%

Expected Future Free Cash Flow Year Free Cash Flow (thousands) Discounted Cash Flow Total 1 117,199 100,757.9 2 116,936 86,429.2 3 116,674 74,138.1 4 116,413 63,595.0 5 116,152 54,551.1 Terminal Value 700,616 282,886.0 $ 662,357

Debt**** Equity**** Total Liabilities and Stockholders' Equity Weighted Interest on all Liabilities WACC^

0 803,032 803,032 0 16.3%

Sum DCF* Total Liabilities/Equity* Sum DCF +Total Liabilities/Equity* Common Stock Outstanding* Instrinsic Value Per Share *Value in Thousands

$ 662,357 $ 803,032 $ 1,465,389 57,583 $ 25.45

W A C C

10.3% 11.3% 12.3% 13.3% 14.3% 15.3% 16.3% 17.3% 18.3% 19.3% 20.3% 21.3% 22.3%

-2.22% 29.35 28.18 27.18 26.31 25.55 24.87 24.28 23.74 23.26 22.83 22.43 22.08 21.75

Share Price Sensitivity Analysis FCF Growth Rate -1.22% -0.22% 0.78% 1.78% 30.63 32.16 34.01 36.29 29.27 30.54 32.06 33.89 28.11 29.19 30.46 31.96 27.12 28.04 29.11 30.37 26.25 27.06 27.97 29.04 25.50 26.20 27.00 27.91 24.83 25.45 26.15 26.94 24.24 24.79 25.40 26.09 23.71 24.20 24.74 25.35 23.23 23.67 24.16 24.70 22.80 23.20 23.64 24.12 22.41 22.77 23.17 23.60 22.05 22.38 22.74 23.13

2.78% 39.17 36.15 33.78 31.86 30.28 28.96 27.84 26.88 26.04 25.31 24.66 24.08 23.57

3.78% 42.92 39.01 36.02 33.66 31.76 30.20 28.89 27.78 26.82 25.99 25.26 24.62 24.04

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Appendix S

AnnTaylors IRR Calculation

IRR Calculation Initial Stock Price Common Stock Outstanding Market Cap (thousands) $5.58 (as of 11/19/2008) 57,583 $321,313

Expected Cash Flow (thousands)

Premium/Year 0% 11.21% 41.55%

0 1 $ (321,313) $ 117,199 $ (357,332) $ 117,199 $ (454,819) $ 117,199

2 $ 116,936 $ 116,936 $ 116,936

3 $ 116,674 $ 116,674 $ 116,674

4 $ 116,413 $ 116,413 $ 116,413

5 $ 116,152 $ 116,152 $ 116,152

6 $ 700,616 $ 700,616 $ 700,616

IRR 41.2% 36.9% 28.0%

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