There was an odd disconnect in leaving the PSS meeting late last week. The analyst side of us was quite content. “Ok, story on track. Check the box. Now let’s move on.” But unfortunately, there’s also the part of us that has to answer those ‘freak out’ questions around “what are we missing? Why’s the stock down? What are they comping this month? What did Matt say?”. After letting the dust settle for a few days, we’re still squarely in the ‘check the box’ Camp.
We have a complete review of the event below, but there were two standouts that put the Street in ‘freakout’ mode.
Freakout #1: For the first time, PSS articulated a clear long term earnings growth model, showing how it will deliver 3-5% top line and leverage that to 12-16% EPS growth. Like any portfolio, some areas will outperform, and others will underperform. But the net should be mid-teens. But the ‘freakout factor’ was due to domestic Payless coming in at flat-lsd in the long-term model. That, of course, triggers the question as to why it is acceptable for their core business to be flat. We’d answer that 3 ways.
1) If a flat core equals a zero-growth cash flow model, then we agree. But we’re talking about using the cash cow to fuel the PLG business (Sperry and Saucony, in particular) as well as Payless International – which have far better growth characteristics.
2) Do you think that just MAYBE this management team is tired of having egg on its face and wants to set long term goals that are achievable, and even beatable? The answer there is yes.
3) Lastly, as it relates to mid-teens EPS growth, though not the intent, our sense is that management would have softened up that meaningfully if current trends did not support those kind of numbers.
Freakout #2: The ‘A’ Word. [We’re going to get heavier into vetting acquisition candidates – some could be sizeable.]
Ok, now THIS is a concern I agree with. Last time around, when PSS bought Stride Rite, it inadvertently topped the credit market, housing market, and consumer spending cycle. Yes, it was totally overpriced, and the timing was aweful. The one thing that bugged me was a reminder by management that ‘we only had two weeks to vet the deal before making a decision.’ Based on our conversations with the team, they’ve got a real process this time around to vet any potential deals. If push comes to shove, they’ll bow out in a heartbeat.
But are acquisitions necessary? We’ll never justify paying for the hope of landing a good deal. But facts are facts, and Saucony and Sperry combined generate ~$450mm in revs up from ~$270mm in 2007 and now account for approximately 35% of the company’s EBIT. Also, with the percent of directly sourced product at domestic stores hovering at 73% (up from 30% 5-years ago) we think that PSS has simply become too slow. Our sense is that the company will downshift that percentage by at least 10 points over the next year. But in addition, a smaller acquisition of product exclusively sold at Payless might be a good traffic driver.
I hate to give a statement that is so cliché, but one thing that is clear is the depth of the bench at this company. Find me another company – in any space – that literally has its 20-top managers available in one room at the same time to a group of 20 sell side analysts and 40 investors. One smart young lad and I were talked after the meeting and he said something like “when I listen to these guys present, it makes me think I’m listening to a management team of a $5bn Enterprise Value company. Not one that is struggling to keep its head above a billion.”
So let’s take this full circle. We walked away thinking that the story is on track.
OTHER DETAILS OF THE MEETING
Despite consolidated growth expectations of 3%-5%, we believe some investors were expecting more robust growth from the domestic business, or even a major “we have it all figured out” announcement. But put into context, even if we assume flat domestic sales over the next 3-years, the PLG segment has substantial upside from low-to-mid teens growth in our view. With Sperry and Saucony combined accounting for just over 50% of PLG sales (~$450mm), Saucony has been a consistent 20%+ grower with sales recently trending north of 30% (see chart below). Moreover, in addition to the build out of retail stores, Sperry is continuing to aggressively ramp its women’s business. With roughly 7 stores by year end and approximately 15/yr going forward, we estimate retail growth alone will account for ~5% annual growth in PLG. Women’s represents an even greater opportunity. According to NPD data, women currently represent ~20%-25% of Sperry sales, which may be slightly understated but is 4x-5x year ago levels on an apples to apples basis. Based on discussions with management, expectations are to have womens at 50% of sales by year end implying over $50mm in incremental sales over the next year – another 6%-8% growth in PLG. While calling fashion is certainly not our specialty, what we saw in KC in initial product from Sperry’s new head designer was a drastic improvement from what customers have been accustomed to from the brand. Lastly, the brand is also benefiting now from a materially improved tiering strategy that was simply not in place 6-months ago with more product being flowed through the higher priced department store channel.
One additional comment on the flat domestic outlook – the company’s expectation for accessories (including apparel) to grow from 10% in 2010E to 12% by 2012 implies a ~$330-$340mm business growing 10%-15%/yr to $420-$440mm in 2012 adding another 1%-2% growth to consolidated top-line.
Sperry Top-Sider Store Walk:
- Opened first store opened in Feb 2010 (at 5 in total) with another 2 before year end (Burlington, MA & Westchester Mall, NY in mid Nov.)
- Size: Kansas City store ~2,000 sq. ft. – company has determined ~1,500 sq. ft. is optimal size
- Have a few stores as small as 1,000 sq. ft. - too small
- Customers doesn't use the ‘boathouse' (the help yourself layout more typical of a Payless store in the rear) in smaller footprint stores
- Growth: looking at 10 in-line + 3 outlet locations annually depending on opportunity (analyst day suggested closer to 10-20 stores/yr)
- Distribution: The first initiative of Bill Bettencourt, SVP of Sales, Marketing, and Business Development, after joining the firm in May 2010 was to properly tier the product by channel
- Sperry developed the Compass line (more value) for the mass channel
- Tiered product more by design differentiation than price
- Select product is now released downstream on a lag (e.g. a style launched at Nordstrom hits shelves at Dillard's 3-months later)
- Apparel & Accessories: Company findings from focus groups suggest that consumers are challenged with how to match product with apparel
- Starting next month, PSS will be working with a partner showcase apparel along with the footwear in an effort to help educate the customer – the byproduct is acquiring an acute sense of what resonates with the Sperry consumer as PSS looks to pursue its own branded opportunity in the channel
- AUR has been above plan all year as well as less promotional
- Head designer Bradley started roughly 12-months ago – product just starting to flow through now (Fall 2010) and has been very well received so far
- Selling into FL well, great representation at new Run concept
- Less enthusiastic re FINL - appears to be diluting their offering on the margin
- 1 lightweight shoe currently (Kunvara), will have 5 by next year
- Sporting Goods channel one of most significant growth opportunities going forward
- JWN, M, DDS, & Belk (4 of top 5 customers)
- Have closed 2,000+ doors over the last 18-months at past customers KSS, JCP, & FINL (400 doors)
- Have entertained/discussed partnering with JCG to curate apparel in-store for the intermediate-term, another smaller brand near-term that they will use
- Expect women to represent ~50% of sales by year end
- Sperry retail stores carry ~300+ SKUs per store; Department store customers more like 30-40 SKUs per store
Highlights from Presentations:
- Contrary to the company's historical view on guidance, it provided an initial 3-year outlook with annuals goals of Sales +3%-5%; Operating profit growth of +9%-12%; and EPS growth of +12%-16%.
- Payless > flat-to-+LSD (domestic +/- flat/ Int'l +MSD); CLI > +mid teen; PLG > +low-to-mid teen
1) Appears conservative though little upside in setting the bar high when sentiment is already low
While some expected more robust growth from the domestic business, smaller segments CLI and PLG appear to have upside
- Rubel first mentioned acquisitions as in the bolt-on kind, then suggested the possibility of a larger deal later in the presentation - this is after being more focused on share repurchase and debt reduction following Q2 results
- Company hasn't made a transformative deal since Stride Rite in 2007 - this likely raised concern among investors given the length of integration
- Int'l accounts for ~$445mm and nearly 700 stores
- Int'l far more productive with EBIT margins of 10.5% vs. 4.2% at domestic Payless stores
- Payless stores have ~$575k store productivity; Canada/Puerto Rico ~$625k; and Latin America ~$750
- Latin America key growth region (Canada and Puerto Rico mature)
- Current store base of ~300 with opportunity for additional 100
- Jamaica to add 10 in 2011
- Mexico to enter Mexico via franchise model then invest as JV - expect 5-15 stores by 2012 with opportunity for 300+
- Newly announced franchise agreements for Middle East, Russia, Turkey, Israel, Singapore, Malaysia, Philippines, and Indonesia give Collective Brands access to 800mm people
- Plans for 80+ stores under franchise agreements to open in 2011 with an opportunity for 700+ stores within 5-years
- Plans to aggressively shift out of China to other countries (primarily Vietnam and Indonesia)
- % of footwear production from China from 96% in 2008, to ~85% in 2010E then down to mid-to-low 70s in 2011 and 2012
- Migrating stitching and operations to west and north China
- Continue to consolidate # of factories to increase synergistic value and quality control from ~125 in 2010E to <100 by 2012
- Distribution infrastructure in Colon, Panama adjusted for growth through 2012, then flexible to grow or potentially move depending on growth prospects in Central/South American growth
Apparel & Accessories:
- Category has grown to 10% in 2010E from 8% last year with the expectation of reaching 12% by 2012
- Implies a ~$330-$340mm business in 2010 growing 10%-15%/yr to $420-$440mm in 2012 and adding 1%-2% growth to top-line alone
- Expect inventories up in Q3 when Oprah left levels very low and again in Q4 with new product in (e.g. boots & toning) versus lower than average levels at the end of last year
Improvement in Store Metrics:
- Typically fluff, but measureable improvement out of the company's 'New Customer Engagement Model' including 90bps improvement YTD in customer conversion and 350bps improvement in units per transaction