Guess? (GES) – An undervalued global brand

July 29, 2011
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guess modelGuess (GES) is an undervalued global brand. The stock performance has decoupled relative to many other global apparel stocks based on a number of factors such as: fashion, US comparable store sales, exposure to Europe, and management team changes. Negativity looks overblown for investors who have patience and perspective, especially relative to valuations of other apparel brands with global aspirations such as Abercrombie & Fitch, Ralph Lauren, PVH, Coach, and True Religion. The following research will explore why Guess is an investment opportunity now:

Here are the reasons why Guess (GES) shares are a buy right now with almost 100% upside to $74 in two years:

1)  Organic growth rate is high

2)  Fears related to exposure to Italy are overblown

3)  China will be a growth driver for many years to come

4)  Guess has a best-in-class business model

5)  Valuation is too low with potential for an acquisition.

We will address each of the above themes point-by-point and conclude with both the investment return targets and risks.

1)  ORGANIC GROWTH

The Guess business model has changed over the past decade. In the 1990’s, the company was a wholesale only apparel vendor (focused mainly on denim) which had less control over the brand as they only sold through department stores such as Macy’s. The Marciano brothers (Maurice & Paul) founded Guess back in the 1980’s and are still involved in the company management today. Guess has been an American success story as the brothers moved from France to California and launched the brand and the company. Michael J Fox wore Guess jeans in “Back to The Future”.

About a decade ago, the Marciano’s took a step backwards in order to move forward by limiting wholesale distribution and embarking on a retail strategy, which was very controversial at the time. Let’s review the past ten years of accomplishment and the organic growth.

Guess has broadened the store base by geography, sub-brand, and store ownership model, all of which help to diversify risks on a quarter-to-quarter basis.

Guess has developed the following diversity to the store portfolio:

  • Geographic store development:
    • US
    • Canada
    • Italy
    • France
    • Spain
    • UK
    • Korea
    • China
    • Many others
  • Guess Operates 5 sub-brands:
    • Guess?  (141 stores)
    • Guess Factory Outlet   (118 stores)
    • Marciano by Guess  (57 stores)
    • G by Guess  (54 stores)
    • Guess Accessories Stores  (60 stores)
  • Guess has different store models:
    • Company operated (lower margin but more profit dollars)
    • Licensee stores (high margin)
    • Concessions (store-within-stores – mainly in Asia)

The ability for Guess to simply continue rolling-out the store base around the world, with a flexible store format is a key differentiator relative to many other specialty apparel retailers here in the US. What creates the opportunity is the past stewardship of the Guess brand which the Marciano brothers nurtured for over 20-years.

2)  ITALIAN SUCCESS STORY

Guess provides segment information for Italy directly in 10k filings since this is the first major market which Guess has launched in – within Europe.

Guess no longer updates the specific store base by country but as of Q3 2010, there were 138 stores in Italy which was approximately 28% of the European store base. Guess stores in Italy are very productive (each store does high volumes) and the management team has demonstrated that the brand has cachet in one of Europe’s toughest fashion markets (Italy or France?). The multi-year success in Italy bodes very well for the visibility behind Guess’ organic growth strategy in Europe which is simply to open additional stores in a number of countries where there is much less store penetration and high brand equity. Focus markets for Guess are: France, Spain, Germany, Northern Europe, Russia, and Turkey.

Important to note – Guess earns higher profit margins in Europe than they do in North America. So the organic growth opportunity in Europe is also margin accretive.

3)  CHINA, CHINA, & MORE CHINA + THE REST OF ASIA

Management has been very excited about the vast growth potential in China with good reason. A number of competitors are achieving success in China and selling products at premium price points and higher gross margins as Chinese Consumers are increasingly aware of strong global brands, and desirous of these products. With Chinese GDP growth of over 9%, and a fast growth organic store rollout, China can lead the way for Guess’ Asian growth for a number of years. Also there is a very strong business in Korea so management has some history of success in this part of the world. As China works, there are a host of additional Asian countries where Guess has little to no presence but plenty of opportunity including: Vietnam, Thailand, Malaysia, Indonesia, and the Philippines.

4)  BUSINESS MODEL

Focusing on the financials, Guess has a tremendous business model. Guess is not a fashion-only, one-trick pony. The company has very strong margins and profitability metrics to go along with the strong growth.

  • Guess achieves a ROIC of 31%
  • Company-wide operating margins north of 16%
  • Strong operating cash flows which are consistently enough to fund all the CAPEX needs
  • Free Cash Flow generation in the range of: $220-$275M (which is 6.3% to 7.9% of the market cap).
  • Free Cash Flow is higher as a % of the market cap relative to other global consumer brands
  • With the FCF, Guess pays a dividend, buys back stock opportunistically, and builds cash.
  • The company pays a 2.1% dividend yield
  • The balance sheet is debt free with cash and investments per share of $4.63

5)  VALUATION

Guess’ stock price valuation is at all-time lows (ex financial crisis) since the company transitioned (and improved) the business model from a wholesale-only company to a global retail and branding powerhouse. The shares have traded to a low valuation of 10x forward earnings (right now) to as high as 21x forward earnings in the mid-2000s. Currently the EV/EBITDA is 6.5x trailing EBITDA and 5.0x Crackerjack’s estimate of EBITDA for 2012. This seems way too cheap (multiples for earnings and EBITDA) for a company with the brand strength and growth potential which Guess has. Private equity firms which are interested in this space will typically pay 9x EBITDA in a deal ($52 stock price).

Guess shares are essentially flat since 2007.  Demonstrating the value, since 2007:

Operating Profits: are 31% higher

EPS:  are 59% higher

Free Cash Flow has gone up 3x

Balance Sheet is stronger with net cash growing from $2.94 per share to $4.63

 

Peer Group Valuations:

WHY HAS THE VALUATION COME DOWN SO MUCH?

Public company valuations come down when market participants are either scared, frustrated, or don’t believe in the future.   There are numerous concerns and risks swirling around Guess which Crackerjack believes are more than priced into the share price:

  • Italy could have a sovereign debt crisis (remember this is 17% of total company sales)
  • The company is missing North American fashion trends and comps sales could be negative.
  • Maurice Marciano (the older brother) recently transitioned to a non-executive board member role.
  • The global expansion strategy is still in the early stages and risky.

Crackerjack believes that all of the above risks are more than reflected in the share price. With the strong cash flows the company generates, dedicated investors will be rewarded as the company buys back shares opportunistically with free cash flow. In addition there is a north of 2% dividend yield while waiting for a re-rating of the shares.

Crackerjack is estimating the following EPS stream:

2011 – $3.44 EPS

2012 – $4.02 EPS

2013 – $4.68 EPS

In less than two year’s time if the company reverts to normal valuation multiples the shares will approach 16x earnings. We believe that Guess’ multi-decade track record of success and brand stewardship warrants this valuation.

 

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4 Responses to Guess? (GES) – An undervalued global brand

  1. jared on August 1, 2011 at 11:29 pm

    Any thoughts on how recent inflation (cotton, gas) will impact Guess?

    • crackerjack on August 2, 2011 at 3:19 pm

      Hi Jared – great question – with Guess’ high gross margin they are relatively well insulated from cotton prices. They have a gross margin in the vicinity of 44%. With pricing for product in the $100+ range (sometimes as high as $150-$200 at Marciano) what is much more important is the ability to sell product at full price. Avoiding markdowns is the primary driver of gross margins not cost pressures. Moreover, Cotton prices have been cut in half since the spring. Peaked at $2.10 or so and have been trading at $1.00-$1.10 in July.

  2. The Analyst on August 26, 2011 at 4:11 pm

    What do you think about Guess (and its competitors) exposure to the wealth effect (what I think are generally inflated asset prices, especially stocks) relative to macro fundamentals (e.g. unemployment, credit, etc)?

    I hate to use the “double dip” phrase but with things in the U.S. not exactly looking as peachy as the stock market (well, at least a few weeks ago) suggested, Chinese inflation running pretty damn high (if you actually believe any of the official #’s from China), and a fair amount of macro/geo-socio-political risks, I find it hard to be so bullish on an aspirational luxury/luxury brand.

    Nice work up, far better than 98% of the crap I read!

    • crackerjack on August 26, 2011 at 4:35 pm

      This is a key risk for all discretionary consumer exposures. I have researched and modeled the wealth effect substantially, and this is a pretty complex question. If you take the view that the stock market and financial assets are over-valued i think it has to be based on the fact that the economy is still “over-producing”. Because the valuation multiples of the stock market and other asset classes aren’t high by either historical comparisons (over 100 years) nor or they high in an absolute sense. Valuation is only high if the economy is headed for a recession and corporate earnings are coming down substantially. I don’t see this at present – but am well aware that this is what is feared in the market today. If the S&P 500 were to hit 800-1,000 – i agree there would be a leg down in sales at all the mid-market to upper middle market retailers, including Guess. Don’t see it at present, but am watching this risk very closely. I was very bearish in 2008 and invested profitably on the short side. I’m not afraid to change views and think adaptation is an important skill for investing.

      CJF

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