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What have recent earnings releases from Coach (COH – $38.07) and Volcom (VLCM – $16.33) told investors regarding what to expect for the back half of the year?

We’re of the belief that it’s going to get ugly for the retail sector in the back half of the year. Simply, many top-line and bottom-line tailwinds that have mitigated downside or boosted profitability are now beginning to be anniversaried.

Let’s take a look at the laundry list of top-line and bottom-line benefits over the past 12-18 months that will now expire and/or become headwinds for retailers over the next 12 months:

  • The economy is not improving.

The short-lived top-line success that the retail sector experienced in February/March 2010 was a mirage. In the early part of 2009, the top-line was especially contracted due to “depression” level spending as even folks with a job thought they were going to lose it. Also, the large-scale liquidation sales sapped revenue away from the survivors a year ago.

  • Product sourcing costs have increased and will only move higher over the next year. This, before we even begin to discuss the Chinese government’s willingness to ease the Chinese Yuan’s peg to the U.S. Dollar and the newly emboldened factory workers in China.
  • Ocean freight rates have dramatically increased versus LY.
  • DC-to-Store shipping costs have dramatically increased versus LY (i.e. higher gas prices).
  • Materially lower inventory levels over the past year have led to record low levels of shrink. As inventory begins to build so will inventory shrinkage.
  • Retailers are lapping record merchandise margin levels. Price wars are breaking-out in the mall (again, at a time when sourcing costs are under pressure). Retailers will be forced to “give-back” much of the merchandise margin improvement over the past year.
  • Inventory purchase decisions for Holiday 2010 were made at a time when the economy at least ‘appeared’ to be heading in a positive direction (early-2010). Will retailers be stuck with too much inventory that will need to be heavily marked-down this year?
  • Big picture, most retailers have materially increased their level of marketing spend. Since most retailers are doing the same, the incremental marketing investment is not achieving a reasonable level of ROI.
  • Record low levels of employee turnover for the retail sector (i.e. the lack of job openings have ‘forced’ employees to stay put) has materially improved sales productivity (i.e. more seasoned sales associates are more productive).
  • Retailers with stores overseas have benefited recently from a relatively weaker U.S. Dollar. No longer.
  • There are no longer profitability-challenged stores to close or expenses to wring-out of the system.

With the above as a backdrop, let’s take a look at two recent earnings releases (COH and VLCM). Both companies were up against relatively easy 2-year EBIT margin comparisons in the most recently reported quarter. Yet, both COH and VLCM reported EBIT margins that were weaker on a 3-year basis than the prior quarter (see tables below).

The problem is that profitability comparisons for 2H 2010 are much tougher to anniversary beginning in Q3 2010 (Q1 for COH as they have a June fiscal year end).

Were the earnings reports over the last week for COH and VLCM the proverbial canary in the coal mine?

We’re of the belief that the retail sector is setting up for material downside earnings in 2H 2010 and FY 2011 versus the current consensus sell-side expectations.

The relatively disappointing profitability improvement (or, lack thereof at VLCM) in the latest quarter and the modest forward earnings expectations from COH and VLCM may be telling investors something about the back half of the year. Expect more disappointment beginning next week when large retailers begin discussing their top-line and bottom-line expectations for the second half of the fiscal year.

While you have to take a look at this on a company-by-company basis, look for many more disappointing outlooks in the next few weeks as retail earnings kicks into high gear.

COH Quarterly EBIT Margin Run Rates

COH Quarterly EBIT

*Gross Margin / SG&A Ratio / Operating Margin each are adjusted for non-recurring items.

VLCM Quarterly EBIT Margin Run Rates

VLCM Quarterly EBIT

*Gross Margin / SG&A Ratio / Operating Margin each are adjusted for non-recurring items.

Disclosure: No positions

Source: Recent Coach, Volcom Earnings Reports: Clues for 2H 2010