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We were pleasantly surprised by the 1Q08 results that Shoe Carnival's (NASDAQ:SCVL) released yesterday. The company delivered sales of $162M (comparable store sales fell 4.9%) and EPS of $0.38, better than what we had anticipated in our preview post. The stock also fared much better than expected, rising almost 7% to $13.93.

With so much noise in the marketplace regarding consumer constraints (especially Shoe Carnival's moderate-income family audience), it's easy to forget that there are smart, seasoned management teams that have weathered difficult economic climates before. Though it can be argued that retailers haven't seen an environment this challenging in over fifteen years, we believe Shoe Carnival's management has done an admirable job keeping margins at somewhat respectable levels. A few areas in particular stand out from the quarter, including expense controls [SG&A on a dollar basis came in flat to 1Q07 at $39M] and inventory management (flat on a per door basis).

While 1Q08 was encouraging, are there enough compelling reasons to initiate positions of Shoe Carnival at current levels? We don't expect the climate for value-conscious consumers to improve materially anytime soon and the company faces several headwinds in the coming months, including inflationary production cost pressures from Southern China factories (management estimates an average cost increase of between 5%-15%), operating expense deleverage stemming from negative comps, and additional marketing spending intended to improve the in-store environment and customer service. Additionally, women's non-athletic category trends remain sluggish industry-wide, and there are few reasons to expect a significant reversal in the back half.

That being said, Shoe Carnival also has a few things working in its favor. We expect the back-to-school season to be a positive catalyst, as it represents a time when footwear purchases are more of a necessity purchase for families rather than a discretionary buy. Furthermore, there is mounting evidence that athletic footwear may be returning to favor. With the merchant team's recent collaboration with key vendors like Nike, New Balance, Rockport to create a more compelling product for African-American and Hispanic customers and added exposure of the Olympic games, the athletic category could drive unexpectedly strong 3Q08 results. The balance sheet remains clean, allowing the company to open 20-25 new stores this year (including 10 or so in new markets) and potentially take market share form other struggling competitors in this channel.

Assuming comps remain in the negative low-to-mid single digits and there is only a modest drop-off in new store contribution due to the cautionary consumer environment, full-year sales should come in around $660M (roughly flat to a year ago). Gross margins will likely fall somewhere between 40-60 basis points due to increased promotional activity and occupancy/distribution expense deleverage. Despite aggressive cost cutting, there should also be SG&A expense deleverage due to the opening of additional stores and additional marketing investments. Based on these assumptions, we anticipate full-year EPS to come in somewhere between $0.82-$0.87 (We have not factored in additional share buy-backs into our assumptions).

Investment recommendation: Much like our investment recommendation for Brown Shoe (NYSE:BWS), we encourage investors to at least evaluate Shoe Carnival's stock at its current valuation. We would be inclined to wait for near-term pull-back as the marketplace factors in what will likely be lackluster 2Q08 results, but build positions in the high $13 range (representing about 16x forward earnings). Given the headwinds outlined above, we do not recommend this stock for momentum investors, but investors with long-term horizons could be rewarded by taking advantage of Shoe Carnival's relatively inexpensive valuation.

Disclosure: No positions in subject company.

Source: Shoe Carnival: Not One of Retail's Clowns