Given today’s mini blow-up (down over 20%) from J. Crew
Group (NYSE: JCG), I thought it was appropriate to share my short thesis on
Guess? Inc. (NYSE: GES) since the company reports earnings after the close on
Tuesday, June 3, 2008. Please see my prior write-up on the XRT for my macro
views on the consumer as well as the overall retail landscape. However, I
believe GES is a very good stand-alone short regardless of one’s view of the
economy/consumer. GES’ short interest is not horrible at 12% and as a result
one should receive a full rebate. Also, GES trades about $50mm per day so it
should be fairly easy to execute a position for most investors.
Business: Guess?, Inc. designs, markets, distributes,
and licenses lifestyle collections of apparel and accessories for men, women,
and children. It also grants licenses to manufacture and distribute a range of
products. As of February 2, 2008, the company operated 373 stores in the United States and Canada, which include 187
full-price retail stores, 97 factory outlet stores, 34 G by GUESS stores, 38
MARCIANO stores, and 17 Guess Accessories stores. It also operated 40 stores in
Europe, 76 stores in Asia, and 7 stores in Mexico.
Short Thesis: I believe GES’ earnings are overstated
by about 25% due to various balance sheet issues. These balance sheet issues
include: 1) ballooning accounts receivable; 2) a dramatic reduction in its
allowance for accounts receivable; 3) ballooning prepaid expenses; 4) rising inventory
As a result, there are some very basic questions one should
ask to see if GES’ current reported operating margins make much sense. For the
TTM, GES reported operating margins of 17.7%. If you back out the royalty
business (85.9% operating margins), GES’ remaining business (~200 retail stores
as well as a U.S. and European Wholesale business) is enjoying a 13.9% EBIT
margin. Thus it makes sense to look at similar sized comparable companies to
see how profitable these types of businesses (wholesale and retail) are.
Valuation: GES trades at 2.1x TTM net revenues, 20.4x TTM EPS and 10.3x TTM EBITDA. I believe the stock trades at 27.4x Normal EPS adjusting for the various balance sheet issues. The average analyst estimate puts the stock at 16.6x 2008E EPS and 13.9x 2009E EPS. I believe these estimates are very aggressive and ultimately won't be met.
Business: The best comps for GES' wholesales business are LIZ (4.0% EBIT
margins), JNY (4.4% EBIT margins) and RL (13.6% EBIT margins). Off the cuff I
wouldn't think GES' business is as strong as RL's, but its operating margins
put the company in the same league as Ralph Lauren. My view is that normal
wholesale margins for GES could be higher than LIZ and JNY, but should be much lower
than RL given less sales (~$800mm for GES v. $6.0 billion for RL) and inferior
asked the company how GES could have the same operating margins as RL, which
has 7.5x the amount of sales. Their response was that it could be due to RL
spending more on marketing and advertising the brand in order to get that sales
volume. This might explain some of the margin differential, but I think a
larger piece of it has to do with the balance sheet issues present, which could
be inflating margins.
Business: On the retail side, I think the best comp for GES is J. Crew
Group (JCG). Both companies have approximately the same sized base of about 200
stores. However, JCG's stores average $573 sales per square foot, which
combined with its direct business (catalog and retail) results in an EBIT
margin of 12.9% in 2007. GES' stores averaged $504 in sales per square foot in
Thus if RL's EBIT margins (with 7.5x more sales) are 13.6% and JCG's EBIT
margins (with 13.7% higher sales/sq. ft. on a similar sized store base) are
12.9%, then it is unlikely that GES' EBIT margins for its retail and wholesales
businesses are sustainable at 13.9%. In fact, JCG just gave the market doubts
about the sustainability of its 12.9% operating margins over the long-run.
Price: GES' operating margins have a good chance of being overstated by
about 3-4% (on a base of 17.7% in 2007) due to the balance sheet issues. If I
assume a normal EBIT margin for GES is 14.1% (v. a 16-year avg. of 13.4%, when
its royalty business, which has 80%+ margins represented half of profits on
avg. compared to ¼ today), I get normalized EPS of $1.49 (v. $2.00 for 2007).
My normal (while giving GES the benefit of the doubt) case assumes 10.1% EBIT
margins for the combined wholesale and retail business. If we apply a 13.5x P/E
multiple then we get a target price of about $20, which would result in ~50%
downside from current trading levels.
Balance Sheet Issues
1) Ballooning Accounts Receivable: Accounts
receivable, net as a % of net revenue from 1995-2003 ranged from as low as 4.4%
in 2000 to as high as 8.5% in 1996. Since 2003 they have increased from 5.1% to
14.5%. If you back out the retail business (since A/R is mainly tied to
wholesale and licensing) you can see that since 2001, A/R, net as a % of net
revenue grew from 13.6% to 28.7% in 2007.
company stated on the last conference call: "Accounts receivable increased
by $111.7mm to $254.4mm compared to the prior year. Over 80% of the increase
supported the substantial growth in Europe as well as in Asia.
Receivables also increased by about $24.3mm due to the strong EURO and Canadian
dollar. Overall DSOs from comparable businesses improved slightly with the most
significant DSO improvement coming from our existing European business."
followed up with the company about this. GES claims that the increase in
accounts receivable was due to a mix shift in that European operations now make
up 24.6% of total revenues versus 16.4% from 2005-2006. However, in 2005
European accounts receivable as a % of European revenues was 32.5% and now it's
at 54.9%. Most of its customers in Europe are
mom & pop type of accounts so maybe it has gotten its increased sales by
helping finance working capital for these types of stores. In addition,
wholesale accounts receivable as a % of wholesale operations revenue increased
from 35.0% in 2005 to 43.6% in 2007. The response to this was that it could be due
to timing and that there are normal fluctuations in accounts receivable.
Dramatic Reduction in Allowance for Accounts Receivable: Since 2002 GES’
allowance for A/R as a % of A/R has declined from 17.8% to 5.2% in 2007.
Looking at its allowance for A/R relative to its wholesale (U.S. & Europe)
revenues, it has declined from 3.9% in 2002 to 1.8% in 2007. Its allowance for
A/R as it relates to its royalties receivables declined from 4.4% in 2002 to
0.4% in 2007.
I spoke to the company about this the response as to why allowance for doubtful
accounts (for wholesale and European operations) has declined from 4.2% in 2005
to 1.8% in 2007 is that its products are selling better and thus there is less
of a need to reserve against it. This seems aggressive to me.
Ballooning Prepaid Expenses: In 2001, prepaid expenses per square foot
stood at $8.66. At the end of 2007, they stood at $17.86 or more than double
where they were just six years ago. As a % of retail sales (since prepaid
expenses are mainly tied to the opening of new stores), they are up from 2.66%
to 3.64% over the same time period.
Rising Inventory Levels: This doesn’t appear to be that great of an issue,
but it is worth mentioning that inventory levels have risen at the retail level
as well as within its European division. Retail per square foot has risen from
$42.85 per square foot in 2001 to $52.85 per square foot in 2007. Over the past
four years inventory tied to Europe has
increased from 13.9% to 16.2% as a % of European revenues.
Some of the answers from GES are not consistent. For example, if GES is selling
to more mom & pop European customers, wouldn't you think those customers
would have a greater tendency not to pay vs. larger, more established
retailers? Yet GES gives a weak response as to why the allowance for doubtful
accts has declined. Also, if GES is spending less money as % of revs on its
brand than RL, over time GES could have a more difficult time maintaining its
brand image and, therefore, operating margins.
Insider Sales: The Chairman of the Board (Maurice Marciano) and CEO (Pual Marciano) as well as various VPs have been selling quite a bit of stock over the past year from the low $50s down to the high $30s. With the stock price declining about 20-30% over the past 6-7 months, the insider sales have not let up.
A difficult consumer/retail environment coupled with its balance sheet issues ultimately impact revenues and earnings. This forces the market to finally realize that GES’ operating margins are massively inflated and the normal earnings power of the business is about 25% less than what it reports. As a result, the P/E multiple should contract to a more normal one in the 12-15x range, which would result in a ~50% stock price contraction.