Concerns Lurk In Vera Bradley Earnings

About: Vera Bradley, Inc. (VRA)
by: Vince Martin

VRA is filling the gap after a 19% post-earnings plunge - and the rally does make some sense.

Retail has caught a bid of late, the Pura Vida acquisition is off to a good start, and VRA looks downright cheap at $10+.

That said, Q2 earnings had some underlying concerns ahead of a crucial second half.

I've become increasingly positive toward VRA shares, but Q2 still looks like enough to stay on the sidelines.

The story at handbag retailer Vera Bradley (VRA) unquestionably has improved over the past six quarters. That hasn't really been the case for VRA stock, however. Shares have rallied from late 2017 lows below $8, and have gained 14% so far this year. In both cases, however, the starting point matters: late 2017 levels represented all-time lows (and an 80%+ haircut from 2011 levels), while VRA stock collapsed in last year's fourth quarter along with many other stocks in the market. Vera Bradley shares actually are about where they 18 months ago, before it set out to execute its 'Vision 20/20' plan.

Heading into Q2, that execution had been on point. And the combination of better results and a ~flat stock price made VRA incrementally more attractive. This is a stock I've repeatedly called a slam-dunk short, but a fiscal 2019 (ending January) that cleared the proverbial decks has been followed by positive comps in the first half of FY20. Meanwhile, a post-earnings plunge following last week's Q2 release sent VRA back below $9 - a point at which I could potentially, finally, turn bullish on the stock.

But even setting aside a recent rally, the report looks concerning. And that rally has recouped over three-quarters of the post-earnings decline. Back above $10, VRA is cheap, and the bull case that has slowly strengthened over the past year and a half still holds. Still, there are enough concerns here, both in the results and in the industry, to suggest that much of the upside might already have been captured.

Q2 Earnings Disappoint

The initial reaction to the Q2 report - a 19% sell-off - seems reasonably on point. Relative to consensus expectations, the release admittedly doesn't look that bad, with a $0.02 miss on the bottom line and a 2-point beat in terms of sales.

But consensus likely didn't incorporate contribution from the acquisition of bracelet maker Pura Vida, as that purchase closed near the end of the quarter. Indeed, that deal aside, Vera Bradley missed the low end of its guidance for both revenue ($114.4M vs $115-$120M) and adjusted EPS ($0.24 vs $0.25-$0.28).

To be sure, neither necessarily is a huge miss. But Vera Bradley is in a spot (or at least so it seemed heading into the release) where it simply can't miss. The company sharply pulled back on clearance activity last year, adding to the exceedingly easy comparisons created by years of underperformance. As I've noted before, the six-year comp stack, almost amazingly, is -39%. And the company, prior to last year, developed a worrisome habit of overpromising and underdelivering. Fundamentally and qualitatively, Vera Bradley needs to hit its marks this year. It didn't in the second quarter.

In that context, same-store sales growth of 2.1% looks concerning. Admittedly, the performance was better than the number suggests. The company took an extra $3 million in clearance reduction this year, a ~3 point impact to the top-line. And last year's Q2 benefited from a ~$6 million shift into the quarter (a 6 point-plus benefit to comps) owing to the timing of promotional events.

In that context, 2.1% isn't bad: in fact, the two-year stack is roughly in line with that of the first quarter despite the lower clearance activity. But a guidance miss still hurts, and 2.1% still isn't good enough. Meanwhile, the Indirect (wholesale) segment posted an even weaker quarter. CFO John Enwright guided on the Q1 call for segment revenue to be flat to up low single-digits; instead, sales dropped 11.4%, and appear to have accounted for most of the top-line miss relative to guidance. (With flat performance, total sales would have been right near the middle of the guidance range.)

The top line weakness seems to have driven the EPS miss. Tariffs and shipping costs pressured gross margin, though Vera Bradley did hold the line on SG&A. Still, given that other retailers have seen big declines after weak quarters, the quick snapback in VRA shares is a bit of surprise. From a headline perspective, this looks like a concerning quarter.

Three Key Problems Looking Close

That's still the case looking closer, for three key reasons. First, the weakness in Indirect is a reasonably big problem. That business still accounted for one-third of profit in fiscal 2019. And, as I've noted before, it's the channel that has driven much of the decline in Vera Bradley earnings and shares in recent years:

VRA stock quote source: author from VRA filings; FY20 author estimate based on company guidance

Commentary on the Q2 call doesn't suggest much optimism in getting it fixed, either. Both orders and the number of accounts declined. CEO Robert Wallstrom said in the Q&A that both specialty stores and, unsurprisingly, department stores were "under pressure".

The key department store customers, per the 10-K, are Dillard's (DDS), Macy's (M), Belk, and Von Maur. That's not a group likely to improve going forward. And indeed Wallstrom said the company would reduce its distribution in the department store channel - which may further reduce revenue and profits going forward.

It's tough to see how Vera Bradley can consistently grow profits if Indirect remains a material drag on earnings. And it's tough to see how Vera Bradley can stabilize that business amid what should be continually declining traffic in the channel. VRA is cheap enough that the weakness in indirect isn't enough to recommend a short, but that weakness is a significant impediment to the path to $15+ I detailed after the first quarter. And updated guidance for flat to modestly down revenue in the channel still suggests a big uptick in the second half - and thus a risk to the full-year outlook.

The second concern is evident by unpacking a sentence from the Q2 release:

Full-price selling in the Company’s full-line stores and on increased by approximately 10% for the six months.

Compare that to a similar statement in the Q1 report:

We once again improved the quality of sales in our full-line stores and on by increasing comparable full price selling in these two channels by approximately 20%.

Q2 Direct revenue actually was up sharply sequentially (as Q1 is seasonally quiet). As such, the two statements actually suggest that full-price selling actually was negative year-over-year in Q2.

To be sure, that almost certainly is not the case. Comps were positive, and as noted the company said clearance selling (which mostly impacted e-commerce, per the Q2 call) was down ~$3M year-over-year.

But it does suggest that full-price selling, which has been the focus of the last six quarters, has decelerated significantly relative to both Q1 and to fiscal 2018. Some of that is comparisons: the figure increased 20%+ in FY19, for instance. And the shift that benefited last year's Q2 likely plays a role. Still, the core top-line thesis here was that Vera Bradley's clearance reductions and product improvements would strengthen the brand. Between 2% comps and apparently lower full-price selling, that pillar, too has taken a hit.

Finally, it's worth noting what channel was left out of the full-price selling discussion: factory outlets. That's not necessarily because those outlets are clearing product: again, clearance has been done mostly through the website. The outlet channel is almost solely (95%+, according to the 10-K) made for outlet, not clearance merchandise.

Wallstrom did say in the Q&A that the company is "very pleased" with how outlets are performing so far this year. But traffic and promotional efforts both have been challenging in recent years - while Vera Bradley continues to open stores, including five so far this year.

All told, there seem to be worries across the Vera Bradley business: in full-line stores, where comps remain light; in Indirect, where partner weakness is an ongoing issue; and in factory, where the environment still looks somewhat shaky, even with Wallstrom's optimism toward 1H results. That's not necessarily a surprise for retail, but on the whole it does feel like the optimism built by the last five quarters was undercut somewhat by second quarter results.

Good News and Valuation

All that said, VRA does look cheap at the moment. FY20 EV/EBITDA, based on my estimate pro forma for Pura Vida, is 4.7x. Pro forma P/E backing out cash (still over $2 per share) is likely in the high 8x/low 9x range.

And it's worth noting that there was some good news on Pura Vida. As an analyst noted in the call, Vera Bradley is guiding for incremental revenue this year - in a little over six months - to equal the 2018 figure. Enwright said in the Q&A that revenue was likely to grow "close to 50% this year". That suggests that Vera Bradley paid a ~1x revenue for its majority stake. Given margin discussion at the time of the deal (Enwright seemed to project some level of compression on the acquisition call) it almost certainly paid less than 7x EBITDA for 75% of that business.

At ~9x cash flow, with Pura Vida growth on the way and comps still positive, VRA does look potentially cheap. And I can see the case that the sell-off to under $9 was too far, and the rally thus makes some sense.

But that rally also is coming with strength across retail, and in handbags in particular: larger peers Capri Holdings (CPRI) and Tapestry (TPR) both have jumped in recent sessions. And it's hard to ignore the fact that most retail rallies in recent years have been dead cat bounces. Indeed, the rebounds for CPRI and TPR both came off long-term lows (seven years for CPRI, ten for TPR). Those lows also undercut the easiest path to upside for VRA: a sale to one of those majors, with Tapestry the better fit given Capri's pivot away from handbags.

Meanwhile, there's still some risk here. Missed guidance is an issue given Vera Bradley's history. Indirect weakness could undercut second-half performance and put the full-year outlook at risk. There's an easy compare coming in Q3, but the key Q4 holiday season likely will still face tariff impacts and traffic issues in both full-line and factory stores. (Vera Bradley is moving some of its sourcing, but will still have ~one-quarter of product impacted by duties.)

Q2 seems to highlight, and amplify, those risks. Yes, VRA is cheap, but it's been cheap before. So have most specialty retailers. With few exceptions, they've been value traps rather than value plays. To go against the grain requires a truly compelling bull case. After Q2, VRA doesn't seem to reach that bar.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.