Shares of Zumiez (NASDAQ:ZUMZ) have been on a huge momentum ride in recent months, creating strong returns for shareholders this year. This momentum ride exceeded the earnings growth displayed over the time period as investors have been attaching a premium valuation multiple to the shares. This followed years during which the valuation multiple attached to the shares has been contracting.
I generally do not like the increase in valuation multiples being attached to a business, a key reason why I hold off making an investment currently despite excellent sales and earnings momentum. As a result, I display caution maintaining my targeted entry point at around $30 per share.
Zumiez describes itself as a specialty and lifestyle retailer, focusing on footwear, apparel, equipment and accessories. Over 90% of its 604 stores are based in the US as the company has a limited presence in Canada and Europe as well.
To differentiate itself from the competition, Zumiez aims to create a distinctive culture with passionate employees, being trained on its own ¨university¨. Growth of staff and internal promotions as well as a changing and a unique selection of merchandise should drive development and growth of the business. This differentiated offering appears to be successful with operating growth this year, and over the past decade, having outpaced the general lagging performance of the wider retail sector at large.
Roughly a third of total sales are derived from men's apparel, a fifth from footwear, and a similar percentage from accessories. The growth of the business has been remarkable with Zumiez having tripled its store base between 2005 and the current moment.
Growth in Europe has been driven by the Blue Tomato deal in 2012 which added roughly $50 million in annual sales, as the company aims to double the current store count of 35 stores in Canada to 60-70 stores.
Strong Momentum Continues In Q3
Zumiez continued its operating momentum during the third quarter. Sales for the quarterly period were up by 11.6% to $213.3 million, aided by a 3.7% increase in comparable sales for the three-month period. It was comparable sales growth which accelerated throughout the quarter, coming in at 6.3% for the month of November, the last month of the quarter.
Gross margins for the quarter were down by 50 basis points to 36.5% of sales. This gross margin pressure was more than offset by operating costs which fell by 140 basis points to 24.8% of sales, allowing operating earnings to improve by nearly a percent to 11.7% of sales. As a result of this margin gain and a slightly lower effective tax rate, net earnings saw a big jump.
Consequently, third quarter earnings were up by 32.6% to $15.7 million, which combined with a lower outstanding share base allowed earnings to rise to $0.54 per share for the quarter. Both sales and operating cost control positively surprised CEO Rick Brooks, who cited a strong resonating of the merchandise with its customer base as the reason for the strong performance.
Holiday Quarter Guidance
For the important fourth quarter, Zumiez anticipates sales of $249 to $251 million on which it expects to report earnings of $0.69 to $0.72 per share. Including in this earnings estimate are acquisition costs which are expected to total two cents per share.
Underlying the sales growth is the forecast of a 3 to 4% increase in comparable sales which indicates that Zumiez does not anticipate that the momentum seen in November will continue throughout the entire fourth quarter. The market and myself are not worried about the ¨softer¨ comparable sales guidance in relation to recent sales numbers, as Zumiez could very easily be conservative with regards to this outlook.
Premium Valuation, Strong Balance Sheet
Zumiez operates on a solid financial footing, having access to $109 million in cash and equivalents as the regular debt load totaled just $3 million. That said, the company has some other liabilities on its balance sheet outstanding including $43 million in deferred debt.
The solid net cash holdings of little over a hundred million are welcomed given the quick developments in the business in which Zumiez operates. Fashion comes and goes, and a strong financial footing is required to survive a bad fashion season as well as finance the inventory balances. These inventory balances of $133 million are manageable and grew much less quickly compared to top-line sales growth.
Shares have gained nearly 50% so far this year, trading around $38 per share which values the business at $1.10 billion given that the company has roughly 29 million shares outstanding. Subtracting the net cash holdings results in a valuation at a billion.
Based on the fourth quarter guidance, Zumiez anticipates full-year sales around $800 million and earnings of $46-$47 million. This values operating assets at roughly 1.2 times sales and 21-22 times earnings.
Strong Growth, Poor Shareholder Returns
Zumiez has seen spectacular growth amidst the domestic increase in the store base, foreign expansion as well as online growth. Sales more than five-folded from $154 million in 2005 to an anticipated $800 million this year. Earnings growth has been even more spectacular as after-tax margins have come in between 2 and 7% of sales over the past decade, currently coming in at the high end of the range.
Despite the rapid growth in terms of the operations, Zumiez managed to limit dilution of the shareholder base over the past decade. As a matter of fact, it has actually repurchased some shares recently amidst the built up in net cash balances. The strong operational performance and rapid growth has initially been rewarded by investors. Shares rallied from their IPO level at $18 in 2005 to a peak in the $50s in 2007.
Investors with a bad sense of timing which bought into the stock at the time are still underwater with shares trading at $38 currently, despite the momentum seen in 2014. That said investors who bought into the shares at $6 in 2009 have seen great returns ever since. Timing is everything, especially in the fashion industry in which recent trends offers no guarantees for next year's fashion season, something to consider for investors in the industry.
The strong growth in recent years, and especially recently looks very favorable compared to many of Zumiez' competitors which have been struggling as of lately. That said, the company has few direct competitors given its specific targeting of certain customers, creating a differentiated offering versus more mainstream competitors.
Companies like Express (NYSE:EXPR), Aeropostale (NYSE:ARO), American Eagle Outfitters (NYSE:AEO) and Abercrombie & Fitch (NYSE:ANF) are just a handful of competitors which have seen a disappointing operating as well as share price performance in 2014. The key differentiator between Zumiez and some of its competitors is the relentless focus on special and distinctive apparel and other offerings of the company.
I like Zumiez for the strong growth displayed in recent years, the current sales momentum, the strength of the balance sheet and the solid omni-channel activities. That said shares have risen sharply already this past year, outpacing earnings growth which thereby resulted in valuation multiple inflation with shares trading at 21-22 times earnings anticipated for this year.
This yields a premium valuation versus the rest of the market, with shares trading at a roughly 20% premium versus the rest of the market. This followed the huge momentum ride seen in recent months, as shares have risen by nearly 40% already in the time frame of less than three months.
A 17-18 times earnings multiple which is in line with rest of the market translates into a $30 targeted entry point which are levels at which I could become enthusiastic again on the prospects for the shares. As a result I hold off making an investment for now, not chasing the momentum wave, and maintaining my investing discipline.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.