Negative Sentiment Is the Trend in Retail

by: Mellon Martin

We attended the annual consumer conference hosted by ICR last week, where we were able to sit down with management teams from the likes of VF Corp (NYSE:VFC), Guess (NYSE:GES), Crocs (NASDAQ:CROX), Waranco (WRC), Domino’s (NYSE:DPZ), Ascena Retail Group, G-III Apparel Group (NASDAQ:GIII), Children’s Place (NASDAQ:PLCE), Fossil (NASDAQ:FOSL) to smaller names such as Gordman Stores (NASDAQ:GMAN), Destination Maternity (NASDAQ:DEST), Nautilus (NYSE:NLS), and QKL Stores (NASDAQ:QKLS).

The most notable takeaway was the nervous chatter from portfolio managers and analysts we spoke with pertaining to guidance risk going into the upcoming earnings season for the broader apparel and speciality retail group. The bulk of the concern stems from a number of companies in the group facing a materially higher cost for goods in 2011 - and management's expectation that the solution is raising prices to the consumer. We noticed a few management teams get somewhat irritated with sourcing and inflationary cost questions, suggesting they would review this topic in more detail in the upcoming fourth quarter earnings call.

An interesting analyst note from Avondale published yesterday highlighted that farm products were up 20% for dairy, meat and grains and 6% on processed supplies such as butter and sugar in 2010, while consumers paid around 2% more for their groceries. So what makes one think that what we saw in 2010 with food costs will not repeat in 2011 in the moderate-to-value-priced apparel brands or retailers?

The intense focus by the street over the last 2-3 weeks on gross margin concerns for 2011 is likely pressuring names like VF Corp (VFC), Delta Apparel (NYSEMKT:DLA), Children’s Place (PLCE) and similar peers, to Collective Brands (NYSE:PSS). We noticed year-to-date the RLX is basically flat and names like VF Corp and Phillips-Van Heusen (NYSE:PVH) are down 4% or more vs. the S&P 500 up 3%. While we are attracted at some of the valuations we are seeing, the tide seems too strong to step in and we will look to find an entry point when we feel guidance has been clarified for 2011in the upcoming earnings season.

A few names that stood out at the conference last week were Ascena Retail Group (NASDAQ:ASNA), Crocs (CROX), G-III Apparel Group (GIII), Nautilus (NLS) and a speculative China play called QKL Stores (QKLS).

Ascena Retail Group, formerly known as Dress Barn, is a three legged retail play that currently runs Justice, Dressbarn and Maurices. Ascena has around 2,500 stores and is currently trading at 11x NYE. We are attracted to the $4.63 in cash per share that the company currently has with minimal debt. Prior to presenting at the ICR conference last week Ascena pre-announced fiscal 2011 EPS guidance, raising its estimate to $2.20 to $2.25.

We came from the conference with confidence that we will continue to see a healthy cash balance put to work to generate shareholder value and would not be surprised if the company has continued to buy-back more shares during the fourth quarter. We also feel that Justice continues to execute at above industry trend levels and that the sourcing headwinds that the group faces can be mitigated due to its success in seeing modest price increases being accepted and its unique position to move Dressbarn and Maurices to a lower cost model of direct sourcing via its Tween Brands division. Our experience tells us that agents at a minimum can cost 3% and would argue it is 5-7% in terms of cost of goods.

Crocs is another name that we felt was on track to continue its robust top and bottom-line growth rate for 2011and beyond. The company currently trades at 17x NYE and has $1.64 in cash per share with minimal debt.

Crocs has been selling off since it reached the mid $19 level late December. Profit taking, trading down with the group or other factors are likely causing the current pressure in the stock. Our sense is that footwear in general continues to be strong, with the exception of the toning category.

We are attracted to the strength that is being seen on the international side, unit growth for 2011 of 25% (majority outside of the U.S.), improvement in wholesale booking of 60%, which seems to validate new product acceptance, and new account opportunities at Kohl’s and Target (NYSE:TGT).

G-III Apparel (GIII) is another name that seems to be attractive considering near term challenges in the category. Management was upbeat and highlighted that business improved when the weather turned arctic during the holidays.

Its license business with Calvin Klein has expanded into handbags and luggage, which is offering incremental growth staring this year. We also are encouraged to hear that management feels it can off-set higher product costs by changing its mix, tweaking the product construction and raising prices. We feel G-III Apparel could be in a position to see minimal gross margin declines this year and has a unique operating margin recovery play with Wilson’s Leather.

The company trades at 11x NYE and note the 12% short interest. So far this name has been an outperform in the group vs. the recent sell-off.

This once left for dead sporting goods may have a pulse. Yes, Nautilus Group (NLS) could be positioned to come out of the penalty box. While it is difficult to look at bottom-line valuation metrics based on 2011 estimates, one can revisit pre-recession to see that NLS can generate $1 in EPS.

We like the fact that Ed Bramson, the current Chairman and CEO, is a managing member from Sherborne, which just happens to own over 20% of the company - and from what we gather a cost basis north of $7 a share. This alone peaked our interest when we met with the team, as we find not only a management team that has ample incentives but the fact that they paid for it. Too bad this is not a requirement for all public companies.

We see Nautilus in a position to actually show investors positive earnings in 2011 based on improving credit trends, a decrease in discounting and stronger sell-thru trends on some of its new products.

Occasionally we find some under-followed or speculative names. Asia Entertainment (AERL) and SeaCube (NYSE:BOX), which we highlighted in November, are past examples. As a side note, we met with Asia Entertainment at the ICR conference last week and management seemed upbeat. After seeing the latest gaming data points last night coming out of Macau, we can now see why the tone was positive. We also would not be surprised to see continued upward guidance and possibly further VIP room acquisitions.

QKL Stores was our last meeting at ICR and we were curious as to why a fast growing grocery store play serving small markets in China and trading at less than 10x NYE encountered a 50% hair cut in its valuation following the third quarter miss in November. There are two very distinct takeaways after sitting down with management. Mike Li, head of Investor Relations did all the speaking.

  1. The third quarter miss was either a one off based on our interpretation of how business is trending currently or there is something materially wrong with what is trying to be communicated to investors.
  2. This could be a multi-year growth expansion story that has strong store economics, ample door growth, and an interesting margin improvement component. All key factors that we screen for when looking for a longer term investment.

QKL is a regional supermarket chain in Northeast China that is basically doing what Wal-Mart (NYSE:WMT) did to most of small town America in its early stages of growth. Thus with Wal-Mart and other super-mart plays focused on Tier 1-3 markets, QKL is serving the next layer down with little organized competition and there is a chance that down the road QKL is bought out.

We are still flushing out the QKL story but for those seeking growth and China exposure this may be an under followed play that got oversold following its last earnings call.

Disclosure: I am long CROX, GIII, GMAN, NLS, DPZ, QKLS and ASNA.