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Shares of Guess (GES) made a large move towards the upside on Thursday after the clothing retailer reported a solid second quarter report in a weak retail environment. Strong execution and a focus on costs resulted in strong earnings, while other competitors missed badly on earnings in recent weeks on weak store traffic.

Yet don't rush in to buy the shares following the report. I think shares are quite fairly valued at this point in time, as shares have risen despite deteriorating operating performance.

Second Quarter Results

Guess generated second quarter revenues of $639.0 million, up 0.6% on the year before. In constant currencies revenues would have fallen by 1.4%. Consensus estimates for revenues stood at $623.6 million.

Adjusted earnings rose by 3.3% to $44.3 million, while GAAP earnings came in at $39.9 million on the back of modest restructuring charges.

Adjusted earnings rose by three cents to $0.52 per share, while GAAP earnings fell two cents to $0.47 per share. Adjusted earnings far exceeded consensus estimates for earnings of $0.35 per share.

CEO Paul Marciano commented on the solid performance, "We are pleased to deliver second quarter earnings that exceeded our expectations. The earnings not only reflect the achievement of our revenue expectations for the quarter, but also the benefits of our expense management and cost control efforts."

Looking Into The Results

Guess saw moderate revenue results across all geographies. U.S. revenues rose by 0.5% to $254.3 million, impacted by a 2.0% decline in comparable store sales.

European revenues were up by 1.4% to $250.4 million. Note that this is entirely thanks to favorable foreign currency movements as revenues in local currencies fell by 3.3%. Asian revenues fell by 1.5% to $65.9 million on the back of a 3.6% fall in constant currencies.

Gross profits fell by 70 basis points to 38.9% on the lack of operating leverage. However, gross margin compression was more than offset by a 220 basis points decline in selling, general & administrative expenses which fell to 28.4% of total revenues.

Lower advertising expenses, productivity improvements and last year's bad debt provisions are behind the fall in these costs.

An offsetting factor were restructuring costs which totaled 100 basis points of revenues this quarter and were absent last year.

Outlook

For the current third quarter, Guess anticipates to report earnings between $0.34 and $0.38 per share on revenues between $610 and $620 million. Operating margins are seen between 7.5 and 8.0%.

Full year GAAP earnings per share are now seen between $1.70 and $1.84 per share. Full year revenues are seen between $2.56 and $2.59 billion, while GAAP operating margins should come in between 8.5 and 9.0%.

Guess boosted the non-GAAP full year earnings guidance from $1.70-$1.90 per share to $1.78-$1.92 per share. This came as a positive surprise to analysts which were looking for a guidance around $1.79 per share.

Valuation

Guess ended its second quarter with $348.7 million in cash, equivalents and short term investments. The firm operates with merely $10.2 million in borrowings and capital lease obligations, for a net cash position of around $340 million.

Revenues for the first six months of the fiscal year came in at $1.19 billion, down 2.2% on the year before. Net earnings fell by 28% to $49.8 million in the meantime.

Trading around $31 per share, the market values Guess around $2.65 billion, or its operating assets at $2.3 billion. Based on the company's full year outlook, operating assets are valued at 0.9 times annual revenues and roughly 16 times annual earnings.

Guess pays a quarterly dividend of $0.20 per share, for an annual dividend yield of 2.6%.

Some Historical Perspective

Shares of Guess peaked around $50 in 2007 when the U.S. consumer was still thriving. During the financial crisis shares have fallen all the way back to $10, but recovered to peaks around $50 again in 2010.

From that moment onwards shares have roughly lost half their value. After witnessing year to date returns of almost 25%, shares are now exchanging hands just above the $30 mark.

Between the calendar year of 2009 and 2012, Guess has increased its annual revenues by a cumulative 25% to $2.66 billion. Earnings have fallen by 26% to $178.7 million in the meantime. Guess retired about 7% of its shares outstanding over the past four years, limiting the impact on earnings per share.

Investment Thesis

Guess made quite some progress in halting comparable store sales declines, accompanied with very strong cost control. Despite challenging traffic numbers, operating margins were increasing on the back of tight cost control and inventory management.

The U.S. operations showed comparable sales declines of just 2% compared to a 10% drop in the previous quarter. The improvement is really good in light of the very tough quarter which other retailers saw. Abercrombie & Fitch (ANF) and Aeropostale (ARO) published disappointing numbers last week. Yet Europe, which generates higher margins have seen issues, notably in Southern Europe and emerging weakness in China.

As such Guess beat on low expectations, yet the extent of the earnings beat satisfies the market as it shows genuine strong execution by the firm in a highly-discounted and low traffic environment. Guess cannot entirely escape the tough times as August comparable sales have slowed compared to the second quarter on lower traffic.

Back in December of 2012, I last took a look at the prospects for the firm. I concluded that the valuation remains appealing at a time when shares exchanged hands around $25 per share. The strong balance sheet and solid operating performance in a structurally more difficult retail market more than justified the share price at the time.

The calendar year of 2013 turned out to be quite difficult, yet shares have seen some 20% returns ever since. At current levels I remain very cautious as shares have seen a nice run-up despite falling revenues and earnings.

I remain on the sidelines despite a reasonably attractive dividend yield.

Source: Guess - Solid Performance In A Difficult External Environment