Castro Model Investment Idea Write-up

Date: Bloomberg Ticker: Stock price: Target price: 03/08/2006 CAST IT 87.54 ILS = $19 128 ILS Recommendation: Market Cap: 2005 P/E: Currency conversion: Long (Strong buy) 497M ILS = $108M 12.8 $1 USD = 4.6 ILS Ori Eyal 312-363-8599 MBA Class of 2006 The University of Chicago - GSB oeyal@chicagogsb.edu

Investment Thesis:
Castro Model, the leading clothing retailer and clothing brand in Israel, is rapidly opening stores in Europe and Asia. Store openings are done through franchising/ JV deals with top notch global retailers. Based on deals already signed, Castros store count will grow 20% per year over the next five years. Almost all this growth will be financed by the franchisee partners, so Castro bears little of the risk. A conservative valuation model (see below) shows a 22.7% annualized return to investors buying today.

Executive Summary:
Castro Model is the leading clothing retailer and clothing brand in Israel. Its network has 112 stores (87 in Israel) based on 2 very successful retail concepts (Castro and Castro Men). Castro Models competitive advantages include a strong brand image, innovative clothing design, low cost sourcing, and efficient distribution. Manufacturing is done through low cost producers in the Far East. Well over 1000 Castro styles are designed every season and 5-8 new styles (over 100 new SKUs) arrive in each Castro store every day. In Israel, Castro Model has successfully competed with Zara and Mango (two global heavyweights). The Castro brand has been shown to have strong appeal and staying power despite changing fashion trends over the years. Castro Model is rapidly opening new stores in Europe and Asia through multiple franchise agreements and JVs. Recently, Castro signed franchise/JV agreements with top notch global partners including Heine-OTTO Group in Germany (owner of Crate & barrel, Freemans, Grattan, Zara Deutschland, etc) and Bollag Guggenheim Group in Switzerland (represents French Connection, Aldo, and Marc Opolo). Getting such leading partners to work with Castro is a strong seal of approval and testifies to Castros excellent operations and global potential. Expansion deals that have already been signed call for opening over 194 stores (97 store pairs) over the next 5 years in Germany, Russia, Switzerland, Latvia, Ukraine, Romania and Thailand. Additional franchising and JV deals will almost certainly be announced over the next few years. Almost all this growth will be financed by the franchisee partner, so Castro bears little of the risk. Signed expansion deals give a store count CAGR of 20% (from 112 stores today to 281 stores in 5 years). A conservative earnings and valuation model (see below) shows net income almost tripling by 2010 and an expected annualized return to investors of 22% over the next 5 years. In addition, Castro singed a JV agreement with DCK Concessions (one of the leading fashion jewelry retailers in the world) to open 30-40 Diva Accessories stores in Israel (and possibly in Switzerland) over the next 5 years. Castro has already opened 11 Diva Accessories stores and plans to open 25 more in 2006. To be conservative, I have not included this third retail concept in my earnings or valuation models. So it is a free option for investors. Castro Model is well managed by the shareholder friendly Castro and Rotter families. It earns high returns on equity, has zero net debt, has re-purchased stock (only when the stock was cheap), has been generous with dividends, and has chosen to incentivise employees with profit based bonuses instead of granting employee stock options.

Websites (info about Castro Model):

http://www.castro.co.il/Site/default.aspx http://www.castro.co.il/corporate/default_en.asp http://www.tase.co.il/buildpage.cgi?sn=quotes&type=companydetails&sec=000280 http://www.castro.co.il/corporate/financialReports/financialReports_en.asp

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About Castro Model:

Castro Model was founded in Israel in 1950 and went public in 1992 on the Tel-Aviv stock exchange. Today it is the leading clothing retailer and clothing brand in Israel. The company network has 112 stores (87 in Israel) based on 2 very successful retail concepts (Castro and Castro Men). The Castro brand is very well know and loved in Israel and represents high quality, fashionable clothes for a good price. Castros operations (design, sourcing, distribution, merchandising, etc) are all world class. They employ 16 fashion designers in 3 in house studios. Clothing designs made by Castros in house design teams are manufactured by low cost producers in the Far East. Distribution is done through an efficient logistics center in Israel. A new advanced logistics and distribution center is being set-up in Europe and will be operating by 2007. Well over 1000 Castro styles are designed every season and 5-8 new styles (over 100 new SKUs) arrive in each store every day. Operations (design, manufacturing, sourcing, and distribution) are kept in motion by Castros advanced IT systems that are connected in real-time to all of Castros stores around the world. These IT systems aggregate real-time sales and inventory information that is used by Castro Model to quickly identify and react to changing fashion trends. In Israel, Castro Model has successfully competed with Zara and Mango (two global heavyweights). Castro Model says that having to compete with such efficient global companies (Zara and Mango) as well as numerous other competitors in Israel (Fox, Golf, Renuar, H&O, Honigman, etc) has forced them to improve all aspects of their operations to world class level.

Expansion deals:
Castro Model is rapidly opening new stores in Europe and Asia through multiple franchise agreements and joint ventures. All of Castros partners (see list below) are top notch global retailers. Getting such leading partners to work with Castro and commit their own capital is a strong seal of approval and testifies to Castros excellent operations and global potential. Most stores opened outside of Israel will be store pairs which consist of a Castro store and a Castro Men store adjacent to each other. Current franchise and JV deals include: 2003 - JV with Heine (OTTO Group) in Germany (owner of Crate & barrel, Freemans, Grattan, Zara Deutschland, etc) to open over 80 Castro stores (40 store pairs) in Germany. Castro and Heine established a JV company in Germany (49% Castro, 51% Heine) which was given an exclusive Castro franchise for Germany. To date, 5 Castro stores have been opened in Germany. In a press interview (see right), OTTO group has said that results are above plan and that they will accelerate new store openings in Germany.

2004 Castro signed a franchisee agreement with Arts Group to open Castro stores in Russia, Ukraine & the Baltic states. Arts Group represents Mango, Esprit, Benetton, Pull & Bear, Promod, Jennyfer, and Morgan in other east European countries. Plans for the next 5 years call for 54 stores (27 store pairs) in Russia, 14 Stores (7 store pairs) in the Ukraine, 16 stores (8 store pairs) in Romania, and 4 stores (2 store pairs) in Latvia. To date 10, 4, 2, and 2 Castro stores have been opened in Russia, the Ukraine, Romania, and Latvia (respectfully). 2005 Castro signed a franchisee agreement with Bollag Guggenheim Group to open 20 Castro stores (10 store pairs) in Switzerland. Bollag Guggenheim Group also represents French Connection, Aldo, & Marc Opolo in Switzerland. To date, 2 Castro stores have been opened in Switzerland.

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2005 Castro signed a franchisee agreement with JRA Fashions Group to open 6 Castro stores (3 store pairs) in Thailand. JRA Fashions Group also represents Mango and Guess in Thailand.

These and other deals, which have already been signed, call for opening 194 stores (97 store pairs) in Germany, Russia, Switzerland, Latvia, Ukraine, and Thailand. These expansion plans give a store count CAGR of 20% for the next 5 years (from 112 stores today to 281 stores in 5 years). Additional expansion deals will almost certainly be announced over the next few years. With the exception of Germany, all of Castros expansion deals are financed almost entirely by the franchisees. Therefore Castro enjoys a large upside while risking little of its own capital. In addition to these deals, Castro Model has recently signed a JV agreement with DCK Concessions (one of the leading fashion jewelry retailers in the world) to open 30-40 Diva accessories stores in Israel (and possibly in Switzerland) over the next 5 years. Castro has already opened 11 Diva accessories stores and plans to open 25 more in 2006. In order to be conservative, I have not included this third retail concept in my earnings or valuation models. So it is a free option for investors. In this write-up I have focused on Castros store expansion plans over the next 5 years. However, it is important to note that there will be significant room for further growth for a much longer period. Zara, Mango, and H&M all have much A Castro outfit larger stores than Castro stores, and Zara has over 626 stores in 46 countries, Mango has over 800 stores in 79 countries and H&M has over 1134 stores in 22 countries.

Company Management:
Castro Model is managed by the shareholder friendly Castro and Rotter families. The company does not grant stock options and instead incentivises its employees with an annual bonus equal to 15% of the difference between pre-tax profits and 1998 pre-tax profits. While Castro does not usually repurchase its own stock (due to relatively low trading volumes and a relatively low about 30% free share float), they recently made a large (about 6.8M ILS) opportunistic share repurchase when the stock price dropped sharply (see graph). This clearly shows that Castro Model believes in its own future potential and understands how to create value by repurchasing cheap stock. Castro Model earns high returns on equity, has zero net debt, and has a generous dividend policy: Dividend equal to 40% of net income, but not less than 10M ILS per year.

Store level economics:

Castro Model does not break out its store level sales and margins in its reports. I will therefore try to estimate these data points based on historical financials, company comments, and other data. All Castro stores in Israel are company owned (currently 87 stores). All stores outside Israel are franchisee owned (currently 25 stores), including the stores in Germany where Castro owns a 49% stake in its own franchisee. All store real-estate is leased. Castro stores in Israel have sales of about $1M per year on average. Store sizes in Israel are about

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2000 square feet for Castro stores and about 1100 square feet for Castro men stores. This implies annual sales per square foot in Israel of about $645 (note that for clothing retailers, smaller stores such as Castros usually have much higher sales per square foot than larger stores). Gross margins are over 55% and operating margins in Israel for company owned stores are about 13%. Stores outside of Israel are about 25% larger than stores in Israel and have higher price points. It is therefore conservative to estimate that stores outside of Israel will have annual sales of at least $1M (same as stores in Israel). This estimate is in line with Castros guidance.

Estimating Castros operating profit per franchisee store outside of Israel:

The key data point needed to forecast Castros long term earnings is Castros operating profit per store outside of Israel. The company level operating margins for Castro Model competitors Mango, H&M, and Inditex (mostly Zara) are shown in the table below. To be conservative, I will take the low end of these numbers and assume Castro stores outside of Israel will earn operating margins of about 13% (same as Castro stores in Israel). 13% of $1M in annual sales (see above) gives operating profits per store of $130K. This $130K is my conservative estimate of the combined operating profit for both the franchisee and Castro (combined) per store.
Competitor Name Data from years Data source Operating margins

Mango
2003, 2004 Mango financials, authors estimate 13% - 14%

H&M
2000 - 2004 H&M financials 12% - 19%,

Inditex (mostly Zara)

1996 - 2004 Inditex financials 15% - 16%

Since stores outside of Israel are all franchisee owned, Castro Model will participate in their earnings through franchising fees and by selling them merchandise. In most Cases, Castro sells its merchandise to the Franchisee at about 30% - 40% of the final cost to the consumer. Castro also gets an annual franchising fee equal to 3% of sales. Following is a sample P&L statement for an average franchisee store from the franchisees point of view and from Castros point of view.

While this P&L model is based on my estimates and research, Castros management has indicated that it is inline with their own forecasts and is even somewhat conservative. As my model shows, each store will earn about $130K in annual operating profits (matches my earlier estimates) of which $50K will go to Castro. This leaves $80K in annual operating profits per store for the franchisee. It costs the franchisees about $200K to open a Castro store (about $105 per square foot) so $80K annual operating profits for a store give the franchisee a 40% annual operating ROI.

Financial projections and valuation:

A conservative earnings and valuation model for the year 2010 (see below) shows an expected annual return to investors of 22.2% over the next 5 years. Israel does not have a capital gains tax for foreign investors, so this 22.2% return may even approximate the after tax return for tax exempt offshore investors. With the exception of Germany, all of Castros expansion deals are financed almost entirely by the franchisees. This means Castro enjoys a large potential upside while risking little of its own capital. Therefore, return on equity, while already high, will almost certainly increase dramatically over the next Page 4/5

few years. My price target (128 ILS/ share) is the price at which the expected 5-year annualized return shown in my model drops to 12%.
All numbers are in Millions of ILS

Year 2010
87 0.6 52.2 194 0.25 48.5 100.7 0.0 100.7 27.2 73.5 8.1 81.6 15 1224 497 19.7% 3.0% 22.7%

Comments
Conservatively assumes zero store growth. 17 stores are franchisee owned. Castro owned stores already earn 0.6M ILS and franchisee owned stores will get there by 2010.

Castro Stores in Israel

# of stores Operating profit per store Total operating profit

Castro stores outside of Israel

# of stores Operating profit per store (for Castro, not the franchisee) Total operating profit (for Castro, not the franchisee) Based only on expansion deals that have already been signed. $50K today (see above for explanation) +2% annual same-store sales growth --> $55K in 5 years = 0.25M ILS.

Castro Model (System Wide)

Total operating profit Interest expense Profit before tax Tax expense Profit after tax Castro share of JV company profits in Germany Net income P/E multiple Projected market cap in 2010 Current market cap Annualized return from capital gains Current annual dividend yield Total annualized return to investors 52.2 + 48.5 = 100.7 Very little debt. Almost all future growth will be financed by franchisee capital and reinvested earnings. Corporate income tax in Israel will be 25% by 2010. I use 27% to be conservative Assuming JV has 70 stores in Germany, $1.1M sales and $60K net profit per store (6% net margins). Castro owns 49% of JV. Conservatory assumption in light of rapid growth for foreseeable future.

497 X ( (1 + 19.7%) ^5 ) = 1121.3 Annual capital gains + Dividend yield

Why my valuation and projections are conservative (additional upside):

Ignores upside potential from new Diva accessories retail stores. Assumes zero store growth in Israel. Ignores new franchise and JV deals that will be signed and expansion of existing deals. Ignores likely P/E expansion due to increased market cap, liquidity, and visibility.

Risk factors:
The main risk factor for my investment thesis is the failure of new Castro stores outside Israel to meet target sales and profitability goals. Such a failure could lead to less store openings and lower future earnings. While it is difficult to predict consumer tastes, Castro has been thriving in Israel for many years and has shown a quick ability to detect and adopt to changing fashion trends. The willingness of multiple global retail industry leaders (see expansion deals above) to work with Castro and to finance new Castro stores in multiple countries shows that they believe the expansion is likely to be very successful. A second risk is Castros need to quickly and efficiently expand its distribution operations to stores in Europe and Asia. To this end, Castro plans to operate an advanced logistics center in Europe which should be operating by 2007. Offsetting this risk is Castros existing distribution experience and the assistance and know-how it will get from its top-notch expansion partners. Additional risk factors include potential operating problems, currency fluctuations, increases in minimum wage rates, a global recession, political or military problems, and the imposition of textile import taxes or quotas. Most of these risk factors are unlikely to materialize (and would be an industry wide problem if they did). Castros management team is very capable and should be able to overcome difficulties along their way to becoming a leading global clothing brand and retailer.

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Several Castro stores in Germany.

A Castro store in Latvia.

A Castro store in Russia.

A Castro store in Switzerland.

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