The Channel Is Looking Solid

I've been keeping my eye on the so called 'revival' in footwear industry sales. We started to see it in the higher price points about a month ago, and that has not cooled. Sources in the off-price channel are telling us that they're having a tough time getting their hands on inventory, as 'the channel is just so darn clean.' Some of this is a snap-back from a dreadful 1Q. But what I find so interesting is the uniformity among channels of distribution. Consider the following...
  • 1) Units sold are not knocking the cover off the ball by any means, but this is entirely offset (and then some) by higher ASPs. Athletic Specialty, Department Store, National Chain, and Shoe Chain are all up 2-5%.
  • 2) The National Chain channel is showing the greatest strength in ASP, but there's a dark side to this. My sense is that nearly all of this is driven by Target. My sources indicate that Target is planning its footwear unit sales down better than 10% for the balance of the year.
  • 3) I'm liking these trends as it relates to Payless. This company's margin potential is tremendous, but has been crushed over the past year because an ill-timed (overpriced) acquisition coincided with a meaningful downshift in industry sales. That's painful for a company with zero square footage growth and a highly levered balance sheet. If this turn in industry fundamentals is for real - even for a couple quarters, then 2H numbers could prove to be way too low. That matters at 3-4x EBITDA.

HSY - Hershey is an American icon, and the icon is tarnished!

The Hershey Trust represents everything that is wrong with the dual class stock structure. Hershey is an American icon, and the icon is tarnished! The Hershey trust, which controls the company, is a dinosaur, and has presided over a colossal collapse in profitability of the company and should be made accountable for a massive breach of fiduciary duty.

The global this time theme is making life very difficult for the board members of the Hershey Trust. From this point forward, with every passing day life becomes increasingly more difficult for the trust to sit and do nothing. It's clear that the changes in the competitive landscape, rationale for the InBev/BUD merger, the decline in the dollar and commodity trends are making the board look like they are out of touch with reality. The Hershey Co. has operated in its own little world and has remained (mismanaged) and independent through the years of corporate raiders, shareholders activists and the lure of the private equity bubble.
  • Relative Shareholder Returns have been disastrous.......Hershey's two-year decline in market share and profitability is catching up with the company. As a consequence, in July 2007, Hershey announced that it will be closing multiple plants, cutting its workforce by 11.5% and moving jobs to a new plant in Monterey, Mexico. Shortly after this announcement, the company announced 2Q07 earnings, in which the company saw a 700 basis point decline in EBIT margins. The largest decline in the company's history! With this announcement it became clear that LeRoy Zimmerman, Chairman of the Hershey Trust, is out of touch with the realities of the business and has lost control over the operational issues facing the company. As you can imagine, the response to the free fall in profitability was predictable! The company announced the retirement of the current Chairman and CEO Richard H. Lenny. Filling his shoes was a Hershey insider David West - I guess there was no thought to looking outside the company to bring in some new blood! The bloodletting continued as six independent directors resigned from the Board at the request of the Hershey Trust. I guess shareholders should take heart in the fact that LeRoy still has his job!
  • The Hershey Co. is a strong company with great brands, a strong market position and significant cash flow. Where did things go wrong? Management has underinvested in the business. Over the past five years, the company reinvested less than 40% of its operating cash flow back into the business. Second, the company has been lowering advertising expenditures as a percentage of total sales to keep margins stable, resulting in an extended period of market share declines and trying to compete in the international market. In addition, the company failed to diversify from the slow growth mainstream U.S. chocolate market into the fast growing dark and premium segment of the industry.
  • In an extremely difficult operating environment, the company is forced to right size the organization and look to the international markets for growth. Unfortunately, given the value of the dollar this could not be a worse time to be looking at trying to grow overseas. In fact, it is the primary reason why they should sell to Cadbury.

LL Cool Eddie

What do a 40-year old suburban male looking to buy a hammer, a family shopping for a washer/dryer, and a 16-year old urban hip-hop-inspired girl all have in common? Well if you ask Eddie Lampert, they'll all be shopping at Sears.

In yet another effort to push 'the softer side of Sears' and get apparel to consistently not bleed, Sears teamed up with L.L. Cool J for a line of apparel targeted at young men and women.

Those of you who know me well also know that I will very rarely comment on fashion. Analytics is my strength - fashion is not (though that's why I employ a fashion consultant here at Research Edge). But this one is tough to resist a quick comment.

Personally, I like LL Cool J --- which is probably a contra-indicator in itself. But let's face some facts. The guy is 40-years old, and went from the poster child for rap music in the 1980s, to making 1-off appearances in 30-Rock and House and taking on supporting actor roles in semi-successful movies (Deep Blue Sea, and Rollerball).

In order for a person to launch a successful brand - especially with no real pre-existing fashion persona - there needs to be a consumer connection that is nothing short of massive. Sean-John did it. But Diddy was absolutely committed to the fashion scene (and had J Lo to help). Tony Hawk did it (Quiksilver exclusive to Kohl's), and has proven that he has remarkable staying power and relevance to the skate consumer almost in a (scaled down) Jordan-esque way. But there have been no shortage of failures. Paris Hilton for starters. A shocker to me is Beyonce's lack of traction.

I don't know about you, but if I have to put my money on Beyonce or LL Cool J, Beyonce will get it every time. LL Cool J's new album (#13) due next month had better be one heck of a blockbuster.

Given that this line is at best $200mm, or about 0.5% of sales, I've probably already dedicated too much effort over the past 10 minutes typing. But the bottom line is that I can think of half a dozen apparel initiatives that make more sense for SHLD than going down this path (one of which is not selling apparel at all).

I'll be curious to hear what my consultant says about this one.

(Acting chronology courtest of IMDB)

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Buy High, Sell Low

This analysis is hysterical.

Let's aggregate every company in the apparel industry's supply chain and see how good the collective is at buying its stock.

To say that this industry has mastered the 'buy high, sell low' mantra is a severe understatement.

Instead of bowing to activist investors to plow excess cash into stock repurchase, I'm in that camp that companies should be focused on buying back stock when they SHOULD, not when they CAN.

The irony here is that if these trends hold in the future (and if my supply chain margin squeeze theme plays out) then we may be about to see the industry get into equity issuance mode again.

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.

EYE on Commodities - Soybeans

Argentina is the world's third-largest soybean producer after the U.S. and Brazil. Last month, Argentine farmers went on strike to overturn a sharply higher export tax on soybeans and other products. On Friday, Argentina's government failed to resolve the farmers' dispute over export taxes, raising concerns of more protests that could slow grain shipments. As a result, Soybean futures surged 50 cents a bushel.

If rice and soybean prices stay where they are PFCB will feel the pinch in 2009.

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