The Great Balance Sheet Disconnect

What's great about lousy retail climates is that it's pretty easy to tell whether a management team is more focused on driving an income statement strategy, a balance sheet strategy, or better yet - no apparent strategy at all. When business is bad, do they let inventories climb to hold margin, or slash inventories to mitigate margin risk. With most companies in apparel/footwear retail having already reported, there's much to glean. In order to do so, I synched the trajectory of sales/inventory growth with the direction in gross margins in the Exhibit below. Here are some takeaways.

Group One: These are companies that are growing sales at a greater rate than inventories (or, sadly, are shrinking inventories at a greater rate than sales). I cut this group off at those with a positive spread of better than 10%, which in my experience is a fairly safe zone as it relates to margins in the upcoming quarter or two. What's most surprising is that most of this group is not exactly a 'who's who' in the world of quality retail. These companies include WRC, LIZ, LTD, JNY, GPS. This makes me incrementally more upbeat on LIZ (see my posting from 2 weeks ago). Also, I've got to admit that the simple fact that Warnaco remains at the top of the list perplexes me. Despite the solid 1Q, it's time to dust off the file on that one.

Group 2: These companies are neither here nor there. Most have inventories growing plus or minus 5% the rate of sales growth, and have less potential for blow out margins on the positive or negative side in the next 1-2 quarters due to balance sheet risk. It's worth pointing out Hanesbrands, that had a pretty monstrous GM boost on just a slight downtick in inventories. I still like that model into 2H.

Group 3. I've gotta admit, this is my favorite group. Inventories high across the board. It's easy to point out companies like JC Penney and Hibbett Sports that have been down and out for a year (still have inventories high AND weak margins). But the more important ones to point out here are Dick's, Columbia and VF Corp. DKS and VFC have been viewed as the quality (I agree on VFC) and immune to a bad retail climate. But now both of those are starting to roll relative to where they've been. I'd watch out being too cautious on COLM, as it 2H headcount cuts could soften the blow to more margin weakness. Dick's still has more margin pressure to come.

Exhibit Key: The columns represent the latest quarter yy change in GM and the trailing 12-month yy change in GM. The red line connects the dots for each company's sales/inventory growth spread. I realize that there's a lot going on there. Any questions or clarifications needed, just shoot me an email.