I’m Getting Fundamentally Bullish

Improving delta on consumption + controlled inventories + slowing rate of GM % erosion + impact of job and capex cuts = long awaited visibility in cash flow. I really like the risk/reward here on key ideas.

I’m really getting fundamentally Bullish. While it’s tough to admit that when the tape does nothing but go the other way, I think that fundamentals will line up in a way that will call the earnings/cash flow bottom by 3Q. Consider the following…

1) No one is allowed to be bullish on the consumer right now. It’s pretty simple – if you make a call on the consumer and you’re right, then you’re considered ‘lucky’ and don’t get paid for it. If you’re wrong, then you’re ‘stupid’ and still don’t get paid, and perhaps lose your job. I’m not making a sentiment call here. Sentiment calls and valuation calls are ‘unmakable’ in this tape (and it’s also not my job to do so). But the cash flow trajectory in the industry should change meaningfully in 2H09.

2) We’re currently looking at about a 2% EBIT margin for the entire softline retail industry on a consolidated basis (See Ehibit 1). Yes, that’s off by about 600bp vs. last year. I won’t begin to argue for a fleeting second that this is not completely warranted. This industry has over-earned and underinvested for the better part of 8 years. Those peaky margins of ‘05/’06 are history. But I do think that we’re going to bounce back to a 5-6% rate over 12 months. Yes, that’s 2% to 6% after a near-vertical drop in each successive quarter since 1Q07. How do I model this?

3) First, consider that real consumption went negative last quarter for the first time in 64 quarters (Exhibit 2). I’m not a consumption bull by any means, but unless our model’s math is way off, we’re going to see the second derivative in consumption improve meaningfully in 2 quarters (3Q09 – which starts in 4 months). We’ve recently seen a full 3-point-slide in the real consumption rate (from +1 to -2%). In modeling the two-year trend, we’ve got real consumption declining for four sequential quarters – the first time we’ll have seen this since well… ever. Bottom line: we should finally get visibility on top line erosion slowing – and likely improving on the margin.

4) We are 2 quarters into the biggest gross margin (Exhibit 3) hit that this industry will have seen in history. The good news is that inventory levels are being worked down fairly methodically. Days inventory in the channel are hardly healthy, but order levels and production out of China and India are not churning out the quantity of product that would scare me into thinking that there’s a supply-driven Gross Margin shock on its way. I’m not modeling that margins go up, but simply that they stop going down.

5) SG&A (Exhibit 4): Anyone watching these job cuts? Well, by my math that should take down the growth rate in SG&A by 2%, not to mention other discretionary cost-containment initiatives. All in, my math has SG&A growth going from 5-6% over 3Q/4Q down to 2-3% in 1H09.

6) Oh…by the way, Capex is swinging from +10% in ’08 to -5% in 2009. It’s been a while since US retail had a year where cash flow was greater than EBIT. ’09 is shaping up to the year.

7) Names I like. Quality brand, investment base in-tact, co invested through the tough economic cycle even if at the expense of margins, share gainer.
a. Ralph Lauren (RL)
b. Under Armour (UA)
c. Lululemon (LULU)
d. Nike (NKE)
e. Bed, Bath and Beyond (BBBY)
f. Liz Claiborne (LIZ)
g. Crocs (CROX – high risk-reward)

8) Names I’d avoid. Weak brand position. Share loser. Weakening internal investment base. Might show good EPS growth, but have ‘pulled the goalie’ and driven EPS growth the wrong way.
a. VF Corp (VFC)
b. Gap Inc. (GPS)
c. Ross Stores (ROST)
d. TJX Corp (TJX)
e. Jones Apparel Group (JNY)
f. Iconix (ICON)
g. Warnaco (WRC)
h. DSW
i. Brown Shoe (BWS – beware a bounce)