CATO

Business Context and Reporting Period

Company: The Cato Corporation (CATO CORP)
Filing Type: Form 10-K (Annual Report)
Period Ended: February 2, 2008 (Fiscal Year 2007)
Business Overview: Cato operates 1,318 women's fashion specialty stores in 32 states, primarily in the southeastern United States. The company operates under banners including "Cato," "Cato Fashions," "Cato Plus," "It's Fashion," and "It's Fashion Metro." It offers apparel and accessories at everyday low prices and operates a private-label credit card division.

Key Financial Metrics

Note: Fiscal 2007 contained 52 weeks, whereas Fiscal 2006 contained 53 weeks.

Material Changes vs. Prior Period

• Revenue Decline: Retail sales decreased 3.3% to $834.3 million. Management attributes this to the loss of one week of sales (estimated at $18.7 million) and a difficult retail environment. On an equivalent 52-week basis, comparable store sales decreased 4%.
• Margin Compression: Gross margin percentage dropped from 33.6% to 31.4%. This was driven by higher occupancy costs and increased markdowns on slow-selling merchandise.
• Profitability Drop: Net income fell 37.2% to $32.3 million. Pre-tax income decreased from $79.6 million to $49.2 million, impacted by lower sales, higher costs, and the absence of a $2.4 million hurricane insurance claim settlement received in the prior year.
• Store Count: The company ended the year with 1,318 stores, an increase of 42 net stores (62 opened, 20 closed) compared to the prior year.
• Cash Flow Improvement: Despite lower net income, cash provided by operating activities increased by $15.5 million to $74.2 million, primarily due to favorable changes in accounts payable.

Guidance, Outlook, and Risks

Management Outlook

• Expansion Plans: For Fiscal 2008, the company plans to open approximately 75 new stores, relocate 15, close 32, and remodel 15. This includes 30 new "It's Fashion Metro" stores.
• Capital Expenditures: Planned CapEx for Fiscal 2008 is approximately $18.9 million.
• Dividends: The quarterly dividend was increased to $0.165 per share in May 2007.
• Tax Rate: Management expects the effective tax rate for 2008 to be approximately 34.0% to 36.0%.

Risks and Contingencies

• Auction Rate Securities (ARS): The company held $41.9 million in ARS. Subsequent to the fiscal year-end, $13.9 million of these failed their last auction. While the company believes it has sufficient liquidity and does not expect losses, the ability to liquidate these investments in the near term is limited.
• Supply Chain: A significant portion of merchandise is manufactured overseas (Far East). Disruptions in trade or import regulations could materially affect costs and operations.
• Centralized Distribution: All merchandise flows through a single distribution center in Charlotte, North Carolina. A shutdown would seriously disrupt operations.
• Consumer Demand: The company is sensitive to general economic conditions, fuel costs, and consumer confidence, which impact discretionary spending on apparel.

Investor Verification Checklist

• Comparable Store Sales: Verify the 4% decline in comparable store sales on a 52-week basis and assess the impact of the "difficult retail environment" cited by management.
• Markdown Exposure: Review inventory levels and the trend in markdowns, which contributed to the gross margin decline from 33.6% to 31.4%.
• ARS Liquidity: Monitor the status of the $13.9 million in failed auction rate securities and the company's ability to meet liquidity needs without selling them at a discount.
• Store Performance: Evaluate the profitability of the 62 new stores opened in Fiscal 2007 and the performance of the planned 75 new openings for Fiscal 2008.
• Bad Debt Expense: Note the increase in bad debt expense to 4.9% of credit sales (up from 4.1% in the prior year) and its impact on the credit segment's profitability.