Monday, August 18, 2008

Wanna Pick Up CHIC?

Eric Fox reports here that Charlotte Russe (NASDAQ: CHIC) has no debt. While it's true that this is what the balance sheet says, in reality almost 70% of this company's assets are financed by debt. How do I figure?

We discussed the importance of considering the effect of operating leases here. In essence, rather than buying its locations, CHIC has financed them, by agreeing to non-cancelable operating leases on them. If instead CHIC had bought their locations and used debt to finance them, you wouldn't ignore the debt would you? Essentially, this is the same thing, with CHIC having "current ownership" of these locations in return for lease payments.

The effect of debt going from 0% of capital (as reported by Fox) to 70% makes this company far more risky than it appears. Debt is always senior to equity, meaning its payment requirements have to be serviced completely before anything left over can trickle down to equity holders. If a company can't service its debt requirements (in this case, operating lease payments), these assets can be taken away, further eroding the company's ability to earn money. With a debt to capital of 70%, this means the company has a lot of debt to service, leaving it not a lot of room to maneuver should this downturn cause a shortfall in operating profits.

Fox recommended the company in May at $18, but it has since fallen to $12. So far, the company has managed to stay profitable, but this company should be viewed as one with a lot of debt, or investors could be in for a nasty surprise. Investors can find information on a company's operating leases in the annual report.

1 comment:

Eric J. Fox said...

I revised my opinion on this stock in November 2008 here:

Clearly I misjudged how bad the recession would get, and a good investor always has to reassess his investment thesis.

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