The unemployment numbers may not show it and the TV media may very well deny it on certain days, but the retail shopper is back.
At least, that is what top management at Guess, Inc (NYSE:GES) illustrated in November 2010 when it last reported great earnings that beat Wall Street expectations and raised full year guidance. Guess even increased its quarterly dividend by 25% to $0.20 and provided a one-time dividend of $2/share. In our opinion, that is some strong conviction meaning that the company either is on the ball or may come up short moving forward.
Now the time is upon us again as Guess reports earnings on March 14, 2011. Investors and analysts alike are anxiously waiting to see if the consumer discretionary space is actually a “hot spot” again based on top line growth. November and December 2010 was choppy, but ended with a bang and now has the crowd somewhat divided on Guess. Looking forward, we see Guess continuing to successfully leverage strong growth opportunities, further diversify its product line, operate under favorable global macro conditions, and most importantly have the potential to add value to the shareholders' bottom line.
Diversified Domestic and International Growth
Guess continues to focus on strategically expanding into foreign markets. The target demographic internationally is the fashion conscious and youth-oriented crowd that is willing to pay a premium for its merchandise. Guess knows this crowd well domestically and has been able to replicate strong success abroad. Still, we have all seen that some parts of Europe are recovering much better than others, so it will be interesting to see country specific numbers from the European division.
The firm itself works under a unique model where it actually franchises some stores and directly operates others. When looking at the European division, Guess only directly operates 84 while it has a total of 388 Guess “branded” stores. Management prefers to have direct control over stores with the most strategic locations to ensure that the brand and the image are executed without even the opportunity for slip up. The firm has been careful though to not expand too aggressively to the point where it might lose sight of its three-year sales target of $1 billion. We know how that ended for A&F (NYSE:ANF), which ultimately had to shut down its unprofitable Ruehl No. 925 concept brand. Starbucks (NASDAQ:SBUX), even though in a different industry space, can also attest to the issues with overly aggressive expansion. Guess looks to be on target as its European division revenue increased four times over, to $747 million, even through the global recession in the last four years. Top line European growth numbers have consistently come out stronger than its North American counterpart in recent years. Guess has been on the ball on where to focus its efforts relative to growth opportunities. At this point the firm is implementing a shock and awe strategy on the European continent.
North American (U.S. specific) operations are the biggest question mark. Same store sales were weak in Q3 2010, with only a positive improvement of 1.5% that was lighter than what we would of liked to see, especially when compared to international divisions. The firm has 432 stores in operation for North America and we feel that it has plenty of room for continued growth. The real question is whether Guess feels it’s worth the time and capital relative to other growth opportunities. Hopefully, after hearing the upcoming guidance and earnings numbers this week we will have a better idea where North American operations stand in terms of priority for expansion.
Shifting across the globe to Asia, we see that there remains plenty of room for continued expansion. Asia as a whole has continued to grow aggressively with an expanding middle class that has a growing taste for the finer items that Guess offers. Top line growth specific to Asia last quarter came in at 35%. A figure like this clearly illustrates the continued opportunity in that region of the world.
Industry Leader With a Diversified Product Portfolio
Guess has become a true industry leader, not just a hot name in a crowded industry. As a firm, it has taken a different business approach to the industry by partially franchising, expanding its product line with a variety of price points, and successfully leveraging some very lucrative licensing opportunities. These licensing opportunities have allowed it to enter into new product lines that include footwear, handbags, eye-wear and even jewelry.
With 19 strategic licensing agreements and only a small amount of capital invested, these ventures have helped the firm generate a 25% average return on capital over the last four years. Further, licensing agreements for 2010 accounted for 24% of operating income last year while only accounting for 5% of revenue. This firm definitely operates with an out of the box mindset that has paid dividends to the shareholder. The big picture here with these licensing agreements is that it allows Guess to penetrate new demographic markets, test new concepts with different price points, and further diversify its product portfolio. This strong and diversified product portfolio has allowed Guess to manage the recession better than many of its peers.
The Creation of an Economic Moat
Guess has finally created a small economic moat and a strong brand name. Let there be no mistake, people recognize its products and brand. The firm has worked very diligently at achieving such a feat and is now at a crossroads. In that, Guess is no longer just a name in the competitive retailer space but now holds a true presence on a domestic and international scale.
The firm has the option to start competing more aggressively with other big names in the industry and/or leverage its global brand recognition in new ways. Given the opportunity at hand, we would like to see continued expansion into Europe but also a more aggressive push toward Asia. Guess has the opportunity to enter one of the last and largest untapped markets anywhere in the world. Any retailer who is able to successfully penetrate places such as mainland China and create a name among the local population will do very well.
Valuation and Modeling Method
We are rating Guess as a Buy. We feel that the firm has the ability to reach new heights relative to an expanding product line, diversified growth, and a moderately positive global economic outlook. In our opinion, it holds a value of $59 in our proprietary DCF model, while only trading at $45.80 (01/13/2011). In addition, with a forward P/E ratio of 13.1, we find this to be moderate and acceptable. Our price target is for the next 12 months but could easily change depending on what Guess reports this week for earnings and guidance. As a whole, we feel that consumer discretionary spending is likely to continue to climb, but that Guess is one of the best opportunities in the industry relative to our valuation and its current trading price.
We assumed a long-term growth rate of 3% for terminal value and a discount rate (WACC) of 8% for the Gordon Growth Method of terminal value.
|Profit Margin (ttm)||11.50%|
|Operating Margin (ttm)||16.5%|
|Return on Assets (ttm)||15.42%|
|Return on Equity (ttm)||25.76%|
|Quarterly Rev. Growth (ttm)||17.4%|
|Quarerterly Earnings Growth (ttm)||7.8%|
Currently, 8.8% of shares are short as of January 14, 2011. This is an elevated short level in our opinion.
1. Guess continues to trade at a moderate valuation relative to peers and the S&P 500. The firm holds a P/E ratio of 15.5 while the industry average is 24.3 and the S&P 500 P/E is 15.7. In addition, the forward P/E for Guess is 13.1 while the S&P forward P/E stands at 13.7.
2. The world at large remains psychologically bearish on U.S. employment hopes. This is priced into Guess but should the situation improve this would propel the stock higher.
3. Guess has broken out among peers relative to its business model in three distinct ways. It has successfully incorporated some level of franchising as part of its international growth strategy, created strategic licensing agreements that allow it to easily expand its product portfolio, and built a narrow economic moat with a strong focus on branding.
Risks and Headwinds
Guess faces certain industry specific risks that deal with the nature of the beast. The long-term viability of the firm continues to depend on its ability to successfully spot fashion trends and bring relevant product lines to market in a timely manner. More recently, we noticed some level of increased markdowns. This could have been due to over ordering, a miss on certain fashion trends, and/or the consumer becoming more expense conscious than anticipated.
Guess operations in Europe must deal with the real and or perceived economic plight of Spain. We feel that sales numbers out of Spain could lag and potentially slow down the European division in terms of growth. We decline to speculate much on what numbers Spain will bring for the firm beyond believing they will be restrained.
The departure of a Carlos Alberini, former COO, in June of 2010 illustrates a strategic loss with top management, as he was a key player in the successful growth of the firm. We feel not enough time has passed yet to judge how well the firm is doing without him, even though last quarter the company performed well.
Financial Health and Analysis
Guess is in great financial health. The company holds no long-term debt. In particular, we are pleased to see the firm holds a Quick Ratio (AKA: Acid-Test Ratio) of 2.05. This is positive for the company because sometimes retail firms have a large portion of their current assets tied up in inventory. With a liquidity level like this and combined with the lack of long-term debt, the company should have no issue paying any upcoming debt. It could, theoretically, pay off total outstanding debt with cash/cash equivalents and by selling off its receivables, although we see no reason to do this or any indication that the firm has this intention. When looking at the cash flow statements, we see that the firm is generating a good chunk of positive free cash flow.
Paul Marciano, the current CEO and vice chairman, has served in this position since January 7, 2007, and joined the firm in 1981. As it stands now, Paul Marciano holds 13.9% of all outstanding stock. His brother Maurice Marciano, chairman of the board, holds a large portion of the firm at 16.9% of all shares outstanding. On the other hand, board members as a whole only own .5% of all shares. To say the least, it’s clear that the number is extremely low and that this firm is truly held and managed by the Marciano brothers. Few minority investors and/or corporate governance analysts view this as positive, but one must remember these two are the co-founders of the firm. They have built the firm from the ground floor up, taken the firm public, and navigated it through three different recessions in that time. These guys understand their firm and they know the industry space they operate in.
When looking at compensation, Paul Marciano received $9.7 million in total compensation for 2010. Maurice Marciano took in a smaller amount at $5.6 million for 2009 in total compensation. Both brothers have additional perks ranging from chartered jet services to home security. This may sound extravagant but compared to when the auto industry executives jumped in their gulf-stream jets to ask Congress for a bail out for their respective firms during the recession, it sounds “normal." We must realize that whether shareholders approve and or disapprove of such action by any executive at any firm, it happens and is likely to continue happening. In turn, we prefer to see how well top management is growing the firm, where they are cultivating new opportunity, and how profitable they are making the firm for all common shareholders. We feel that the management at Guess is fair.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.