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Subject: Wet Seal jumps the shark Date: 6/30/2004 6:53 PM
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Wet Seal on the rocks

Wet Seal started life as a tiny bikini shack in Newport Beach CA. in 1962. In 1996 they were trading around $5 per share and they have come full circle and are back to $5.22 (of course that is after two splits in 2001 and 2002).

They caught the wave in 1995 and rode it all the way to $25 in 2002, but it has been downhill ever since.

Year's end 2003 found them with 458 Wet Seal and Contempo Casual stores at approximately 4,000 square feet each and 99 Arden B. stores at 3,200 square feet each.

Zutopia, their failed kids line acquisition is undergoing closure.

www.wetseal.com
www.ardenb.com

Has Wet Seal jumped the shark, run aground on the shoals; is it terminally floundering? Quite possibly so. Who can predict the tastes of teenage girls aged 17 to 19(Wet Seals target consumer)? Arden B has done slightly better catering to older women with more to spend and more sophisticated tastes.

Wet Seal purchases merchandise from both domestic and foreign vendors. Approximately 22% of retail receipts are directly imported from foreign vendors. they select fashion themes to promote and the design and buying teams work with vendors to modify colors, materials and designs and create images consistent with the themes for both Arden B and Wet Seal consumers.

Additionally, they have increased focus on in-housedevelopment of exclusive designs to reinforce the fashion statements of their merchandise offerings.

They lease all of their stores and most are in mall locations with a few street front locations.


Some bad decisions

During fiscal 2002, they launched the Wet Seal catalog for the back-to-school season and again in the fourth quarter for the holiday season in an effort to further build the Wet Seal brand. However, due to relatively high costs and disappointing sales results, they did not produce or distribute a catalog during fiscal 2003, and do not plan on pursuing this type of marketing in the near future.

During fiscal 2003, 2002 and 2001, they spent 1.0%, 1.5% and 1.0% respectively, of sales on marketing. Wet Seal reduced advertising expenditures for fiscal 2003 in an effort to curtail costs, given the decline in sales for the year. There was further reduction in advertising costs due to the decision to not produce and distribute a catalog during the year. Color catalogs are very expensive to produce and distribute. This was a marketing strategy that failed to pay off and at least they were perceptive enough not to pursue it.

Three years after it acquired the Zutopia chain from Gymboree, Wet Seal hoped to sell the division after lackluster sales. It was unable to find a buyer and On January 6, 2004, the board of directors authorized the decision to close all Zutopia stores by the end of the first quarter or early in the second quarter of fiscal 2004, due to their poor financial results and perceived limited ability to become profitable in the future. The company determined that there was no estimated fair value to the Zutopia's divisions fixed assets. Wet Seal also noted that it would record a $5.5 million pre-tax charge in the fourth quarter to reflect the write-down of fixed assets at the Zutopia stores. The Zutopia division was responsible for a $7 million pre-tax loss during the first 10 months of fiscal 2003.

Wet Seal has had a series of fashion misses and has lost its core customer. They are working on seven consecutive quarterly losses. They keep hoping a turnaround is in the works. First it is the new fall line and then hopes are pinned on the Christmas season and then spring and early summer and now we are hearing the new fall line will turn their fortunes around.

Katharine Rice Galligan of the research firm Aperion Group, doesn't think a turnaround by back-to-school season is feasible, as the company and other analysts have projected.

"They're just buying too much of the same stuff," said Galligan.

Galligan thinks the company's biggest issue has been pinning down its core consumer. "They don't know who their target customer is. They keep redefining who that person is going to be, and they keep missing it," she said.

Some words about the make it or break it fall collection

A key strategy was the decision to hire an in-house designer for the Wet Seal division in order to have more control over fashions and to develop more unique clothing.

Wet Seal Inc. a teen-oriented retailer grappling with nearly two years of slumping sales, on Tuesday staked its immediate future on a revamped fall collection from internationally renowned designer Victor Alfaro, whose emphasis is on color, texture and wearability.

But even though a few investors and analysts hailed the new collection as an "improvement", others said the Foothill Ranch, California-based company still had more work to do to differentiate its offering from that of rivals, as well as make it more vibrant.

Wet Seal unveiled its "all or nothing" collection, including back-to-school merchandise, before a crowd of Wall Street analysts and some investors in New York City.

Its fall assortment marks the inaugural line from the company's new in-house designer Alfaro, whose clothes have dressed the likes of Demi Moore, Madonna, Mariah Carey and other celebrities.

"With this collection, we wanted to make a big push to help our core customer rediscover the Wet Seal brand," said Alfaro, hired last August in a push to stem a string of fashion missteps that have alienated many of Wet Seal's young customers.

"Some of the clothes, you can mix and match," added Alfaro, whose latest styling also makes abundant use of denim for skirts and jackets -- some with extensive detailing and stitch work.

Peter Whitford, the Wet Seal chief executive officer, said the collection would help Wet Seal "reconnect" with its core customers, who comprise mainly of young women.

"We are on plan to drive momentum through July and August," said Whitford in outlining the importance of the latest collection to his company's three-year turnaround plan.

But not everyone was so sure that the collection would translate into an instant hit.

Joseph Teklits, an analyst at Wachovia Securities, said a few items in the collection were indeed unique and wearable, but much of it seemed "cheap, sleazy or out of date."

"We have no reason to believe Wet Seal's business will improve meaningfully any time soon," he said in a research note. He added that a lot of color and fashion may be too much for fall, raising the risk of looking over-assorted.


Good decision or bad decision? We'll know more in July and August. Cheap sleazy and out of date does not sound promising!

There have been shakeups in management--also signs of trouble. The CFO, William Langsdorf left in January and the CEO Kathy Bronstein was fired February 2003. If they are unable to attract gifted management that can execute a recovery, Wet Seal may perish. CEO Peter Whitford (hired July 2003) has yet to prove he has such gifts after a year in office.

Due to poor performance they closed 11 Wet Seal stores and 7 Arden B. stores when leases expired during the fourth quarter of fiscal year 2003. They have scaled back on expansion plans and remodels. During 2004, due to commitments made early in the year, they anticipate opening approximately 10 new stores and closing approximately 20 to 25 stores. Of the approximately 10 new stores, four will be Arden B. stores and the remainder will be Wet Seal stores. Wet Seal will renovate approximately 11 stores. Of these, approximately seven will be Wet Seal stores in which completely new store frontage, flooring, wall and light fixtures and video displays will be installed. The remaining renovations will be for Arden B. stores, which will upgrade the interiors to mirror new stores in appearance.

Openings and closings:

Fiscal Years
--------------------------------
2003 2002 2001 2000 1999
---- ---- ---- ---- ----
Stores open at beginning 606 571 552 548 454
of year
Stores acquired during - - 18 - 78
period(1)
Stores opened during 31 69 51 36 31
period
Stores closed during 33 34 50 32 15
period
---- ---- ---- ---- ----


Stores open at end of 604 606 571 552 548
period

Some dismal financial figures

Income statement and per store square footage figures


2003 2002 2001 2000 1999

Number of stores 604 606 571 552 548
open at year end
Number of stores -- -- 18 -- 78
acquired during
the year
Number of stores 31 69 51 36 31
opened during the
year
Number of stores 33 34 50 32 15
closed during the
year

2003 2002 2001 2000 1999

Square footage of 2,273,349 2,279,517 2,212,146 2,191,522 2,182,606
leased store
space at year end
Percentage (0.3)% 3.0% 0.9% 0.4% 18.1%
increase
(decrease) in
leased square
footage
Average sales per $ 228 $ 267 $ 269 $ 256 $ 247
square foot of
leased space(3)
Average sales per $ 861 $ 1,027 $ 1,043 $ 1,020 $ 988
store(3)

Comparable store (16.4)% (5.5)% 4.7% 3.9% (9.8)%
sales continuing
operations
increase
(decrease)

*sales per square foot going down
*sales per store going down
*comps decreasing





2003 2002 2001 2000 1999
gross margins 19% 30% 33% 28% 28%
operating margins -12% 2% 8% 5% 4%
net margins -9% 1% 5% 3% 3%
growth revenue -12% 0% 2% 11%
growth gross -45% -8% 20% 11%
growth operating -735% -79% 73% 37%
growth net -1226% -86% 59% 37%
growth COGS 2% 4% -5% 10%
growth SGA -5% 14% 9% 7%
growth EPS diluted -1036% -86% 50% 39%
growth EPS -568% -74% 57% 35%
inventory/COGS 7% 7% 8% 7% 9%
growth depreciation 10% 12% -9% 19%
tax rate 36% 35% 38% 38% 41%

**margins are suffering as they try to boost sales with aggressive markdowns--it didn't work and just caused really poor margins.

**The comparable store sales decrease in the fourth quarter 2003 was due to declining transaction counts, primarily in the Wet Seal division.

**December product was too holiday-specific, and did not provide enough transitional styles to lead into the pre-spring months. In January continued cold weather in some parts of the country caught them short of sweaters and jackets and unable to adequately resupply the stores. In addition, in January, the average dollar sales in the stores were depressed downward by the many promotions in place to move the goods remaining from the holiday season.

**Arden B. division gained momentum during 2003 with sequential improvement in comparable store sales each quarter resulting in comparable stores sales increases in the third and fourth quarters with corresponding increases in transaction counts and average unit retails.

** comparable store sales declined 16.4% in 2003 compared to a comparable store sales decrease of 5.5% in fiscal 2002. The overall decline in comps was due to a reduction in the number of transactions per store, a lower average dollar sale, and a reduction in the average unit retail price compared to the prior year. The average dollar sale in the stores was driven downward by promotions put in place in reaction to slow-selling merchandise.

The average unit retail declined as a result of the aggressive markdowns taken during the year as well as deterioration in the initial markup after allowances, primarily in the Wet Seal
division.

**Comparable store sales increased 4.7% for fiscal 2001. The comparable store sales decrease in 2002 reflected the negative sales trends in the second half of fiscal 2002. They did not have a dominant fashion trend to drive sales as compared to fiscal 2001.

**The increased cost of sales in fiscal 2003 compared to fiscal 2002 was the result of merchandise cost. This increase was primarily the result of a significant increase in the amount of goods sold at markdown prices, and also includes a substantial markdown reserve at year-end to reduce the value of remaining inventory. In addition, the initial markup of selected merchandise was lower, contributing to a lower merchandise margin, which translated into more merchandise cost as a percentage of sales compared to the prior year.

**selling, general and administrative (SG&A) expenses declined in 2003. Total advertising expenses related primarily to retail operations in fiscal 2003, 2002, and 2001 were $5,537,000, $9,116,000, and $6,039,000, respectively showing an increase in 2002 mainly due to the ill-conceived catalog. They declined in 2003.

** payroll per store for fiscal 2003 was almost flat compared to fiscal 2002, due to the tightening of store payroll hours in concert with lower sales per store, but was higher as a percentage of sales due to same store sales decline.

**SG&A expenses in 2003 declined compared to the prior year since 2002 included a one-time $4 million reserve established for a settlement with the previous chief executive officer. However, in fiscal 2003, there was a one-time $1.7 million net charge for the settlement of and the legal fees associated with previously employed store managers


Balance sheet

2003 2002 2001 2000 1999
current ratio 1.69 2.10 2.02 1.66 1.76
quick ratio 0.24 0.37 0.45 0.44 0.71
AR growth -19% 223% 100% -38%
DSO 8.88 9.58 2.96 1.50 2.71
inventory days 25.24 27.17 29.42 26.20 31.97
growth in payables -16% -33% 19% 11%
growth in inventory -6% -4% 6% -10%
CCC 8.88 6.23 -15.33 -10.3 -3.14
ROE -28% 2% 15% 12% 10%
ROA -20% 1% 10% 8% 7%
ROIC -24% 3% 14% 10% 8%
debt/equity 0.0% 0.0% 0.0% 0.0% 1.3%
debt/capital 0% 0% 0% 0% 1%
book value 5.6 6.7 6.8 5.7 4.7
cash/share $0.45 $0.71 $1.12 $1.06 $1.56
NC WC 25 42.5 42.9 14.2 4.6
change in NC WC -17.5 -0.4 28.7 9.6 4.6
payable days
outstanding 25.24 30.52 47.72 38.04 37.83

**cash and investments were $63.5 million at January 31, 2004. Sales did not improve, and they were forced to raise additional capital

**2003 working capital was $38.6 million, including cash, cash equivalents, and short term investments of $44.3 million. This compares with working capital of $64.5 million, including cash, cash equivalents and short-term investments of $61.2 million at the end of fiscal 2002. The primary reason for these decreases is the loss from continuing operations of $39.0 million for fiscal 2003.

**AR is decreasing in 2003 but is higher than 2000. There was a troubling trend for big increases in 2001 and 2002. Since this is retail I can't see any reason for AR to increase. They do not explain it.
**no debt and recent capital was raised through sale of shares\
**even though they have no debt, they have noncancellable leases and their debt from lease obligations has a current value of $347M
**terrible returns to the shareholder in ROE,ROIC and ROA
**cash per share is decreasing--burning cash
**DSO also up from 2000--would seem that the DSO should be 0
**book value decreasing

Cash flow statement

2003 2002 2001 2000 1999

growth operating cash flow -344% -88% 24% 61%
operating cash/revenue -3% 1% 10% 8% 5%
growth capex -65% 212% 293% -57%
capex/operating cash -78% 542% 61% 39% 148%
free cash flow -31.3 -31.8 92.5 28.3 -13.7

free cash flow/share $(1.05) $(1.02) $3.03 $0.99 $(0.48)

**burned up operating cash in 2002 and then hit negative numbers. A trend that was troubling and now comes home to roost
**operating cash flow negative 2003
**negative free cash flow 2003,2002
**Total capital expenditures anticipated for Fiscal 2004 are expected to be less than $12.0 million. This capital expenditure estimate includes the anticipated costs of renovating 11 stores, the leases for which will be renewed this year.

**They will record a reserve in the first and second quarters of 2004 for all applicable charges associated with the closure of the Zutopia stores which primarily includes the buyout of leases.



Raising capital

On Wednesday Wet Seal completed a private placement of equity securities to institutional and other investors for gross proceeds of $27.2 million. The $25.9 million net proceeds from the offering will be used for working capital and general corporate purposes.
The company issued six million shares of its class A common stock at $4.51 per share and warrants to acquire 2.1 million additional shares of class A common stock at an exercise price of $5.41 per share, subject to adjustments. The warrants may be exercised beginning on Dec. 30 and expire on December 29, 2009. Somebody is willing to buy it--granted it was at $1 discount.

First quarter discussion of results

net loss from continuing operations, excluding the discontinued Zutopia division, was $0.53 per share for the first quarter ended May 1, 2004, $0.01 better than the low end of guidance. This compares to a net loss from adjusted continuing operations of $0.25 per diluted share for the first quarter last year. They are losing more in the first quarter of 2004 than 2003 and one must question the capabilities of management.

The discontinued Zutopia division reported a net loss of $0.15 per share in the first quarter. This makes total losses of $0.65 per share. The Zutopia results covered the loss from operations and lease termination costs for 27 Zutopia locations closed during the first quarter. The remaining four Zutopia locations were closed in the first few weeks of the second quarter.

Comps are down less than last year and sales are well down from a year ago. Again, the new CEO who has had close to a year to work things out is not making a dent in the company's troubles.

Sales from continuing operations for the first quarter totaled $99.8 million, compared to net sales of $120.2 million for the first quarter a year ago. Comparable store sales for the first quarter this year declined 17.2 percent, compared to a decline of 25.6 percent for the first quarter last year.

"The first quarter represented a transition period for the Company as we continued to implement our turnaround initiatives and focus our efforts on returning to positive sales and profitability," said chief executive officer, Peter D. Whitford. "Arden B. performed above our expectations throughout the quarter, while Wet Seal delivered mixed results."

Whitford keeps saying the next quarter will be better; Christmas will be better; spring will be better--it never is. Will fall be better? If it isn't I would fire him.

Mr. Whitford : "Consistent with our turnaround plan, we are not anticipating a significant change in momentum in our business until the third quarter, when we expect to see the full benefits of our new merchandise assortment and all of our planned marketing initiatives. As a result, we currently expect comparable store sales for the second quarter to be in the mid negative teens and anticipate a net loss from continuing operations of between $0.47 and $0.51 per share."

Gross margins as a percentage of sales from continuing operations of 14.1 percent for the first quarter compared with 20.9 percent in the prior year. The deterioration of the gross margin was largely due to the loss of leverage for sales-driven occupancy and buying costs. Merchandise costs decreased from the prior year as a result of a more effective markdown strategy, an improvement in the initial markup and a reduction in the company's shrink.

Selling, general and administrative expenses were $39.0 million for the first quarter, compared with $36.8 million for the first quarter last year. The increase can be attributed to an increased investment in marketing, increased costs for insurance and legal, and higher store bonuses related to the continued success in the Arden B. division.

Capital expenditures for the first quarter were $4.0 million, associated with the opening of six stores and remodeling five stores. The Company still expects total capital expenditures for fiscal 2004 to be less than $12 million. During the quarter, they opened five Wet Seal stores and one Arden B. store, remodeled five Wet Seal stores and three Arden B. stores and closed seven Wet Seal stores and one Arden B. store. The total number of stores in operation at quarter's end was 571, versus 590 a year ago.

May 1, 2004, they had cash and investments totaling $50 million and no debt. At quarter's end, inventory at cost totaled $42.0 million compared to $33.9 million for the first quarter of last year. This represents approximately a 28.4 percent increase in inventory per square foot over the prior year period, reflecting early receipts at the Wet Seal division and the improved performance of Arden B.

Options

There are $3.5 million shares outstanding.Only 572,573 were exercised in 2003. They bought shares back at low prices, but the price has continued to drop. Total dilution is low at 8%. They are not big options abusers, but the price is unattractive for exercise over the last two years.

Valuation

Right now, I wouldn't pay any price for Wet Seal and with the negative earnings and future growth very much in doubt, the company has little intrinsic value and no free cash flow. The new management looks mostly clueless and ineffective. If the fall turnaround promised does not materialize, I would wait to see if the CEO is replaced with someone who knows how to manage a teen retailer. So far, Whitford is doing a poor job. Unless he pulls the fall back-to-school-miracle out of his hat, I would not invest in him or Wet Seal.

They have a two year history of declining sales per square foot; declining comps; decreasing cash and no apparent feel for their market. They have a lease debt obligation of $347 M. With no net income, this makes their financial footing a little tenuous.

They are definitely not a growing retailer or an asset play or even a turnaround story at this point. they are a dying marine mammal. Investment until they prove themselves is best withheld. Perhaps they should rethink that bikini shack on the beach and return to their roots.

>^..^<
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