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Claire's Baubles, Bangles, and Profits

By Michael Souers There's a good chance Claire's Stores (CLE

; recent price $22) is in your local mall -- but should it be in your portfolio? We at Standard & Poor's Equity Research believe that shares of this niche provider of value-priced fashion accessories are attractive for a number of reasons. Why? We think the company is well entrenched as the leader in its industry. Moreover, it is poised to grow sales and earnings per share at a fairly strong clip over the next several years, as it continues its international expansion.

Also, Claire's has no long-term debt and a rather large (and growing) cash position, suggesting, in our view, further dividend increases or share repurchases over the next 12 months. Finally, with the stock trading at just 13 times our fiscal 2006 earnings-per-share estimate, and offering a 1.6% dividend yield, we believe the current share price discounts many of the positives and largely reflects an October-quarter earnings miss and the company's subsequent downward guidance for upcoming periods.

To sum up, we think the risk/reward profile looks enticing. We expect significant share appreciation over the next 12 months, and Claire's stock carries Standard and Poor's highest investment recommendation of 5 STARS, or strong buy.

EYES ON EUROPE. Claire's believes it operates the world's largest chain of specialty-retail stores specializing in value-priced fashion accessories and jewelry targeting preteens, teenagers, and young adults. The company has two main store concepts: Claire's Accessories, which caters to fashion-conscious girls and teens age 7 to 17; and Icing by Claire's, which caters to teens and young women age 17 to 27. Jewelry, including costume jewelry, earrings, and ear-piercing services, accounted for 53% of total sales in fiscal 2004 (ended Jan. 31, 2004, the latest available full-year figures), while accessories, including hair ornaments, totebags, and novelty items contributed 47%.

Claire's North America segment (72% of revenues) is currently focused on increasing revenues and profitability in existing stores, while the International segment (28%) is focused on expanding its store base, primarily in Europe. The company opened a net 23 new stores in fiscal 2004, and we believe it opened more than 70 net new stores in fiscal 2005.

Claire's currently operates nearly 3,000 stores worldwide, including more than 700 in Europe and nearly 150 in Japan through a 50-50 joint venture with AEON Co. While the U.S. market appears somewhat saturated, we believe Europe offers ample opportunities for growth.

PROTECTIVE MOAT. The retailer believes it will increase its store base to 1,400 over the next five years in European countries where it currently has a presence (Britain, Ireland, France, Switzerland, Austria, and Germany). In addition, we see new store opportunities for Claire's in many other European countries, including Spain and Italy. We believe that Claire's Japan has the opportunity to expand to at least 500 stores in the long term, providing it with another growth avenue.

Franchising has been another profitable way Claire's expand global reach without spending capital. It has franchised nearly 60 stores to date in countries such as Saudi Arabia, the United Arab Emirates, Kuwait, and South Africa, and views franchising as an excellent means of extending its reach while mitigating risk.

In our opinion, Claire's has developed a formidable brand, plus there are strong barriers to entry in the value-priced fashion accessory market. We would argue that Claire's is somewhat insulated from the retail sector's significant competition. The accessories business, in our opinion, requires substantial buying power and strong relationships with vendors. Its 3,000-store base gives Claire's significant buying power, and we believe its size affords it the ability to negotiate strong licensing deals for popular characters such as SpongeBob and Hello Kitty.

HEALTHY DIVIDENDS. Plus, Claire's average price point is about $4, with items typically selling in the $2 to $20 range. The only way to attain solid operating results with such low pricing points: Buy in bulk and sell a large number of units (we project the company will sell approximately 300 million units in fiscal 2005). In addition, a recent Harris Interactive survey commissioned by Claire's indicated that its brand awareness was 98% among its targeted demographic, further entrenching its competitive position, in our opinion.

Claire's balance sheet is very solid, in our view, with no long-term debt and a rather large cash position, representing over 25% of assets. We estimate that it will generate at least $100 million in annual free cash flow in fiscal 2005 and beyond, which should bolster cash balances further.

While Claire's has increased its yearly common stock dividend payout from $0.08 per share in fiscal 2003 to the current $0.36, we expect it to raise its dividend again in fiscal 2006. We also anticipate that Claire's will announce a share-buyback program at some point in fiscal 2006, further enhancing prospective shareholder returns. However, the timing of such an action is uncertain, and we have yet to incorporate it into our earnings model.

MARKET REACTION. Operating margins have improved substantially over the past few years, rising from 12.3% in fiscal 2003 to 15.3% in fiscal 2004; we estimate further improvement, to 17.3%, in fiscal 2005. We expect operating margins to continue to improve, albeit at a significantly slower rate, as a continued shift towards a more favorable product mix, with greater sales of higher-margin jewelry, combines with improvements in operating efficiency and operating leverage. We see fiscal 2006 operating margins approaching 18%.

Ahead of January-quarter 2005 results (scheduled for release in mid-March), we see quarterly EPS of $0.60 and full-year fiscal 2005 EPS of $1.48. Based on our view of high-single-digit sales growth and slightly improved operating margins, without including any prospective EPS accretion from a possible share buyback, we see fiscal 2006 EPS increasing 13%, to $1.67.

We believe the quality of Claire's earnings is high. Based on Standard & Poor's Core Earnings methodology, we estimate S&P Core EPS of $1.45 in fiscal 2005 and $1.64 in fiscal 2006, 2% lower than our operating EPS estimates of $1.48 and $1.67, respectively. In fiscal 2005, our S&P Core EPS estimate includes estimated stock-based compensation expense of approximately $2.5 million ($0.03 per share). Claire's does not have any pension or post-retirement benefit costs.

Claire's shares have fallen more than 20% from their November, 2004, high. In our view, the weakness was precipitated by an earnings miss in the October quarter and lowered guidance for the January quarter. We think that the sell-off was overdone, and that Claire's business remains fundamentally intact.

A FEW HAZARDS. Indeed, on Feb. 3, Claire's reported January same-store sales growth of 7%, well above our projection of 5%. The strong sales results indicate that while Claire's sales momentum may be slowing from last year's torrid pace, it's still robust -- and business remains strong.

The shares are trading at 13 times our fiscal 2006 EPS estimate, well below the average for Claire's specialty-retail peers (17 times), the S&P MidCap 400-stock Index (17 times), and near historic low levels for forward earnings (slightly below 12 times). Its p-e-to-growth ratio is 1.0, compared with 1.2 for the S&P Midcap 400. In addition, the shares' current yield of 1.6% provides a small boost to total returns.

Our 12-month target price of $26, which is based on

discounted cash-flow analysis, implies potential appreciation of about 20% from current levels.

Several risks to our recommendation and target price exist, in our opinion. Same-store sales comparisons are challenging. Claire's is facing double-digit comps in the April quarter (same-store sales growth of 11% in the prior-year period) and July quarter (10%). Our estimates are for 4% to 5% same-store sales growth in each of those periods. The shares may endure downward pricing pressure, should the company fall short of expectations.

HAPPY HOLIDAYS? Merchandising trends can be very fickle. As is the case with apparel retailers, accessories retailers face the risk that their inventory will not sell because it's not in style. Companies like Claire's, which purchase from their vendors in bulk, would be particularly affected if they miss the latest fashion trends.

In particular, an unfavorable response to Claire's holiday assortment would likely have an adverse effect on the share price, as the January quarter represents over 30% of yearly sales.

More general risks include a slowdown in U.S. consumer spending, continued economic weakness in Europe, and unfavorable currency fluctuations (international sales accounted for 28% of Claire's total revenues in fiscal 2004). Analyst Souers follows shares of specialty retailers for Standard & Poor's Equity Research Services

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