Guess (GES) reported Q2 earnings last night after the close with results at the higher-end of the company plan coming into the quarter. The knee jerk reaction in the after-hours was a selloff in the shares. Guess is one of the consumer sector’s best positioned companies and any weakness in the shares can be bought. In other words, my “Focus List” buy recommendation at $37, is well, even a better buy here and now. Analysts often get things wrong and simply claim that timing was off etc…..I’ll go out on a limb and state that the analysis per Guess posted on 8/1/11 remains valid and investors with time horizon and perspective are presented with an opportunity.
Here is s link to the Q2 conference call which I encourage investors to listen to in order to get some perspective about the company:
The current quarter was much better than feared when you step back and reflect that the stock has sold off from $45 to $32 (down 29%). The mid-point of guidance was reduced from $3.40 to $3.30 (down 2.9%). As you compare the stock price decline to the cut in earnings guidance please be sure to note the decimal point for the size of the guidance cut. Often, a situation with the stock price sell-off being 10x the change in earnings expectations is over done.
But was the stock price way over-valued at $45 this spring? The answer there is no. At $45, the shares were only trading at 13.2x forward earnings estimates, which was below the median historical stock price valuation of the past decade of 14x.
The Q2 adjusted EPS results were $0.84, above the high-end of Q2 earnings guidance ($0.77-$0.83). The near-term hiccup for Guess is that they are choosing to cut back on distribution of select accessories products in Europe (costume jewelry and handbags) that were popular but management feel may not be in the best interest of the enhancing the longer-term brand image. Guess quantified the distribution pull-back as an $0.08 hit to earnings estimates in Q3. I attribute the $0.10 reduction in full year EPS as mostly due to this issue, with a modest impact from conservatism related to the increased macroeconomic uncertainty. The most important risk-factor was actually addressed quite positively – Italy. Guess has a substantial business in Europe which generates 40% of operating profits, while Italy alone is 40% of Europe (16% of total company) because of the long-standing business Guess has in Italy, built out of Florence. Italy was highlighted as one of the stronger countries in the European region with actual retail sales and business trends holding up much better than one would fear by reading the financial press each morning.
The Guess North American business is healthy with improved profitability as Guess has been able to increase the percentage of full-price selling (fewer markdowns). Sales have been flattish but at higher margin and North American retail profitability increased 25%. The North American wholesale business is sound with stable and high margins and Guess mentioned they are growing in line with sales trends from Macy’s and Bloomingdales. Lastly, Asia is one of the additional drivers of growth and the expansion is right on plan with both strong same store sales and high store growth potential. The largest markets in Asia are South Korea and China.
Guess has one of the best business models in the entire consumer space. Guess is in the realm of Coach, Abercrombie & Fitch, and Ralph Lauren, from a business model standpoint with a dramatically lower valuation. The reasons to remain positive are:
- The growth potential is vast as Guess expands their brand to a number of new geographies around the world. The world is desirous of strong global consumer brands and Guess has had success in enough disparate geographies to demonstrate global brand equity. Growth due to organic store and wholesale distribution roll-out is high visibility and accretive to company-wide returns on invested capital. In short Guess has the potential to monetize the past 25 years of investment in the brand in a number of new geographies without the startup costs associated with brand building from scratch.
- The margin structure is high with low 40s gross margins and 16%+ operating margins. Guess also has the potential to expand margins as the geographies they are growing fast in generate higher incremental margins (the brand is premium positioned in Europe and Asia).
- Fast growth and healthy margins lead to tremendous cash flow generation after all the growth related CAPEX is funded from operating cash flows. Free cash flow is sustainable at $250M and the market capitalization is $3B so the free cash flow yield is over 8% which is too high for a stock with so much growth potential.
- Return on invested capital (ROIC) is north of 30%. In short, Guess is a value creating machine that generates free cash each and every year that grows. There is no debt, excess cash on the balance sheet, and an increased ability for the firm to do shareholder friendly things with cash flows. The company pays an $0.80 dividend (2.5% dividend yield) which has the potential to grow at a fast rate. Moreover, the company has the potential now to buy back shares at very attractive prices and valuations.
- Valuation is as low as it has been ex-crisis, because investors are fearful there will be a recession in the US, and Armageddon in Europe. The shares are trading at 9.5x this year’s earnings and the year is half done. The shares are trading at 8.2x our initial estimate for next year. Ex-cash ($4.66 per share) the shares are trading 7.0x next year’s earnings. On an EBITA multiple, the shares are trading at about 4.5x. Too cheap. The risk/reward is favorable as a recession and very bad news is already priced in.