Is Wet Seal Beginning to Look Like J.C. Penney Did Before Its Turnaround Began?

Is Wet Seal Beginning to Look Like J.C. Penney Did Before Its Turnaround Began?

Last Wednesday, Wet Seal reported earnings for its third quarter of 2013. In response to a significant earnings miss, shares of the retailer fell nearly 16% in after-hours trading. Given such a tremendous fall in price, is it possible that some value is being left on the table or is an investment in Wet Seal doomed to failure?

Wet Seal just couldn't deliver
For the quarter, Mr. Market expected Wet Seal to report revenue of $134.49 million, a 0.8% decline from the $135.54 million the company reported for the same period a year ago. However, as business at the struggling retailer has deteriorated over the past quarter, its revenue came in at $127.7 million which was 5% lower than forecast. A decline in operations was partially offset by a 0.8% increase in comparable-store sales, which should provide a modicum of comfort to shareholders.

On top of reporting lackluster top-line results, the company also reported earnings per share of -$0.18 which was $0.06 below estimates and $0.01 worse than the same period last year. According to the company's earnings release, the decline in its bottom line came about in spite of its cost of sales declining from 80.8% of sales to 77.3%, while its selling, general, and administrative expenses fell from 32.8% of sales to 30.3%. The improvement in these metrics resulted in the company reporting an operating loss that was significantly better than what it reported last year. However, a small tax expense this quarter and a large tax benefit in the quarter a year ago resulted in a worse bottom line this year.

What does Wet Seal expect going forward?
Moving into the fourth quarter, management expects the company to continue to deteriorate. Wet Seal forecast revenue between $134 million and $137 million, a substantial decline from the $161.7 million it reported for the same quarter last year. The decline in revenue will likely be driven by a comparable-store sales decline that could be as high as the low double digits. If this forecast proves correct then Wet Seal's earnings per share will likely come in between -$0.14 and -$0.17, roughly in-line with this quarter but far better than the -$0.97 it reported last year.

A sign of more trouble to come?Lessons from J.C. Penney
With a market cap of $270.3 million, Wet Seal is smaller than the $2.94 billion J.C. Penney Company . However, by looking at J.C. Penney we might be able to see what is happening with Wet Seal. You see, business at J.C. Penney has been deteriorating at a relatively good clip over the past few years.

For instance, between 2011 and 2012 J.C. Penney's revenue fell by 24.8% from $17.26 billion to about $13 billion. Over that same time-frame, the company reported a net loss that widened from $152 million to $985 million. Both revenue and net income have continued to worsen year-to-date but the company did report a slight uptick in comparable store sales of 0.9% in the month of October and 10.1% in November. In response to this news, shareholders at J.C. Penney are cautiously optimistic about the company's future.

Looking at Wet Seal, the company may be following in J.C. Penney's footsteps. Just as revenue and net income fell off for J.C. Penney, the same appears to be true with Wet Seal. Despite the moderate news this quarter, next quarter will prove extremely challenging for the retailer. If management is correct about its prediction of significantly lower sales, this could leave Wet Seal stuck with unwanted inventory like J.C. Penney has seen. This could incite Wet Seal to offer larger sales in an attempt to rid itself of excess inventory. However, it might also result in the deterioration of Wet Seal's attractive balance sheet, which could cause solvency issues and bring into question the company's long-term viability.

In the table above, we can see how Wet Seal's cash and inventory have changed as a percentage of total assets. Looking at this data, we can already begin to see signs of a deteriorating balance sheet. From 2010 through 2013, cash stayed relatively stable, while signs of excess inventory slowly began to materialize. Now, however, cash is beginning to decline while inventory is on the rise. This suggests that some deterioration has already begun and that the situation may become far worse if management can't turn the business around.

Also noteworthy is the company's cash flow. Between 2010 and 2012, cash flow from operating activities has improved annually. However, from 2012 to 2013, cash from operating activities declined from $61.9 million to -$26.2 million. Year-to-date, the company's results have continued to disappoint.

Foolish takeaway
I am not sounding an alarm on Wet Seal at this time. Although the company's results this quarter and its forecast for next quarter are troubling and reminiscent of J.C. Penney's fall from grace, the company has a healthy balance sheet and it is trading on the cheap. These two factors likely mean that the company has a long way to go before it faces insolvency troubles but the Foolish investor should keep a watchful eye on any significant developments, especially into the New Year.

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