Liz Claiborne's business is so bad in more ways than we can count. The portfolio is flux, customer traction is weak, and the Direct vs Partner brands strategy has yet to yield any positive benefits. The kicker is that LIZ is in the bulls eye of an industry-wide margin squeeze that could last for another five years. At face value, it's tough to make a long-term bull case on this one. But a deeper look reveals a different story emerging.
Consider the following near-term factors...
1) Say what you want about McComb (CEO) and his ill-timed decision to take the helm of one of the faster sinking ships this industry has seen in years. But one area Wall Street has consistently overlooked is the fact that the guy 'gets it' as it relates to building brands. With sales down by 2% over 3 years, SG&A is actually UP by over 10%. This cost LIZ about 8 points of EBIT margin. By no means was this a pure offensive move, and it was certainly not all well spent (the return on retail stores continues to be nearly nonexistent). But we'd rather see a margin hit come from SG&A up than GM down.
2) Now LIZ is sitting there with an SG&A ratio of better than 40%. That's nearly unheard of in this industry. Even Nike, Under Armour, and Ralph Lauren (perennial high-spenders) are in the high 30s. Either we're going to see some sales associated with the spend of the past two years, or a good CEO will pull the plug on the SG&A. We think McComb will do just that.
3) That brings me to the next point. The structure of McComb's incentive compensation should not be ignored. He has 341,370 options struck at $36.65, 63,150 at $50.13, 63,150 at $41.78 and has 138,855 restricted shares that are worth about $2.5m -- about 60% less than when they were granted. The options vest by the end of 2009 based on an even split of EPS and ROIC hurdles. To the extent that the business simply fails to grow and gross margins are unable to recover, then there's a whole lotta margin that can be found to improve profitability for all shareholders (both external and internal).
4) It's probably worth mentioning that in the latest proxy, LIZ adopted a cliff-vest for 2008 performance after 1-year. Yes, this pegs 2009 as the breakout year for margins.
5) A glimpse of it beginning? I don't think there's a single fundamental analysis better for understanding the margin trajectory for a company in this space than measuring the sales/inventory spread versus margins. The quadrant analysis in our chart shows that LIZ has just entered the 'sweet spot' where sales outpace inventory growth, and gross margins turn positive. The market shrugged it off. In fairness, the top line numbers are still extremely weak. But inventories are looking solid. This is setting the company up for a potential SG&A pull-back and margin pop. $3 in EPS power might not be a pipe dream after all...