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Do you get those times when you analyze a company and the numbers simply don’t add up and you get that queasy feeling in your gut? That’s Warnaco.

We emerged from WRC’s 1Q with more questions than answers. Specifically, it relates to FX. This is a company that generates ~60% of its EBIT outside of the US.  When FX moves, WRC is always first on our list as it relates tweaking our model when the Dollar changes. With what we consider a ‘crash in process’ in the Dollar (-8% yy) we should have seen a blowout at WRC.  We saw the opposite.

In fact, incremental FX revenue was up $9.8mm vs. last year, marking a quarter where FX should have been a positive contributor. But at the same time, we saw incremental EBIT go the other way. This is the greatest deviation in this spread we’ve seen in at least 10 quarters.

WRC: Why? - WRC FxEbit

What does this mean?  There’s many possibilities…

  1. The company is doing the right things and investing in sales, marketing and infrastructure to support growth in its CK One launch this year. There’s probably some of this. But not enough to make up for the whole delta – or even half.
  2. WRC is building reserves for what will be heavy discounting in 2H to clear its 36% rise in inventory.
  3. WRC is feeling the operational pain of growing its store base by 80% over two years – remembering that it guided to 120k incremental square feet last year, but ended up adding closer to 200k. This year they threw out the same guidance, but have brought on the Taiwan retail stores since. We’ll likely see the accelerated growth continue. Store level SG&A is around $800k-$1mm per store. Initial productivity is around 60-70% of a more mature store – which run at about $2.5mm. That’s some pretty tough math to result in profitable growth. If we estimate a 3-year maturation curve, we’re looking at 2012 when we should start to see more meaningful leverage. Until then, we’ve got some tough expense numbers to overcome; such as more retail as a percent of the mix, disproportionately high SG&A relative to revenue due to International slant, and higher FX translation of both store-level SG&A as well as inventories needed to support the retail sales ramp.
  4. Gross margins were down 86bps – though the 2-year was a more upbeat +121bps. But what is odd is that Asia GM was up, and Europe was down – despite the FX tailwind. Product costs were only a minor part of the gross margin erosion – and were isolated to the sportswear group.
  5. New store productivity is a question mark. The imputed rate based on numbers given (stores, square footage, and comp) comes in at around 82%. This is great – but it is also a catch-all line item that includes dot.com sales, which are growing strong double digit. In the end, it does not have a huge incremental impact on profitability as it cannibalizes a degree of sales from wholesale and company-operated stores – but it can overstate the productivity of new stores.
  6. Speedo had a monster quarter and its WRC’s highest margin business in 1Q from a seasonal perspective. This alone contributed almost 100bp to consolidated margins (which ended up being down 222bp).
  7. Sportswear operating revenue was up by 10.8% -- but it certainly did not get any help from CK Jeans, which was down -3.7%. 19% growth at Chaps more than made up the difference, but there’s no way the single largest line item on the P&L should be down year/year.

All that said, WRC took up guidance for the year – both revenue and EPS. The revenue, we’ll give ‘em. The EPS, not quite. Our estimates are shaking out at $3.90 and $4.38 for this year and next, respectively. We’re ahead on revenue, and are meaningfully behind on margin.

The reality is that inventory is up 36%. They’ve got a lot of ‘stuff’ and it’s gonna sell. The question for us is the degree to which it sells at full price. We’re starting to see cracks in consumer accepting pricing increases, and we won’t be relying on the ‘trust me’ factor here. With some companies we will, but not WRC.

This thing is trading at about 7.4x EBITDA and 14.4x earnings. By no means is it expensive. But given how squirrely some of these items are on the P&L, we think it definitely deserves a risk premium relative to peers. When we can buy names like Nike, RL, GES, and other higher quality names within 1-2 multiple points, we simply think that the risk/reward here is unattractive.