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What's In These Stocks?

Over the past month, we've seen the greatest disconnect between softline EPS revisions and stock price performance in almost 10 years. The market is suggesting that EPS has bottomed for the group at large (except for J Crew, which just blew up). You know my take -- margins are still coming down by at least another 3 points for this industry over 3 years. The 'trend' is awful. But we also need to at least respect the 'trade', which (selectively) is not half bad.
  • The earnings revision model in the first exhibit has historically been super tight as it relates to synching revisions with the stocks. But in April it started to break down, and now we're starting to see an inverse relationship. There's a million ways to attempt to explain this, but I think one clear point is that there is a growing contingent looking at easy compares in 2H08 and the prospect that revisions have finally bottomed.
  • After looking at the rate of change, let's simply take a look at the next 12-month consensus EPS growth rate for the Softlines group. A year ago we were looking at consensus growth expectations of about 20% -- that since dropped like a stone. We're now looking at forward growth expectations of about 4%. The only time in over 10 years we saw numbers this low was for about a month circa Sept 2001.
  • Even more bullish is that we've got a troughy 13.4x P/E on trough growth expectations. More important is that the 2-year forward growth outlook is only 6%. Usually we see sell side estimates ramp up materially (i.e. 20% plus) after a bad year. But at least directionally, the sell side is starting to get it.

Some good news!

A House bill approved recently includes provisions to extend tax breaks for retail/restaurant companies looking to remodel. The Energy and Tax Extenders Act of 2008 allows retailers who lease their stores to write off remodeling costs over 15 years.

The bill extends the 15-year depreciation period first approved in 2004, which was set to expire at the end of the year (previous tax laws required retailers to write off remodeling costs over 39 years). Part of the reasoning for the extension, was to help boost the economy by encouraging more companies to re-invest in their businesses.

Unfortunately, for most retailers remodeling is not an option, but in a difficult economic environment remodeling can help improve sales trends.

Athletic is Better than SCVL and DSW Suggest

I was initially surprised by the headlines out of Shoe Carnival and DSW this morning. While both hit lowered guidance, the triangulation between sales/inventories and margins were both disproportionately weak relative to what I think is happening out there as it relates to the positive Foot Locker comment yesterday.

DSW: Sales up 2.6% (on a -5.4% comp) with 3.6% inventory growth. Not terrible, until you consider that gross margins were down 4 points vs. last year. It's no wonder the CEO resigned to go to Limited.

Shoe Carnival : Sales down 2% (on a -4.9% comp) with 5% growth in inventory. Gross margin decline is less severe here - only a point vs. last year.

By my math, trading off the inventory build vs. margin puts both these guys on about the same trendline. Any way you cut it, the trendline is still bad.

Read-through considerations. SCVL's athletic business appears healthy, as the excess inventory position is driven by seasonal product like Sandals and Dress Shoes. That's good news. Similarly, the overwhelming majority of DSW's business is dress/casual shoes (i.e. non-athletic). Also, I happen to be of the view that DSW's model is structurally flawed. Big box footwear retail simply does not work. The low asset turns and weak margins associated with the underlying business have bankrupted most of DSW's predecessors. It's no surprise to me that everyone on Wall Street loves this concept and yet margins continue to fall faster than the company can lower its own standards. When doing the deep dive into DSW's lease structure - it looks spot on with Dick's (i.e., that's bad).

My point here is that despite the headlines, I'm sticking with my view on the incremental positive change in the athletic space.

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CBRL - Not losing sleep over rising gas prices?

CBRL today reported its 6th consecutive quarter of negative traffic, with 3Q08 posting the biggest decline of -3.3%. And the trends are not improving as the company enters its most critical summer months as May (only 3 days remaining) same-store restaurant sales are expected to be flat to slightly positive, which implies another month of 3%-plus traffic declines since menu prices are currently running up about 3.6%. This less than encouraging monthly data point might be one reason why the company reported today that it will no longer be providing sales results on a monthly basis beginning in FY09, but to be fair, CBRL is just joining the many other restaurant companies that have already stopped doing so.
  • CBRL's CEO Michael Woodhouse started today's conference call, saying: With that let me begin by acknowledging that we are in a very challenging consumer environment. We are often asked; how the higher gas prices will affect summer travel. First, about 60% of our customers are local and our focus is to drive traffic from the local market as well as the traveler. But to answer the question directly a Triple A study released a couple of weeks ago said that 1% fewer people were expected to travel by car over the holiday week end. Our studies show that 70% of the Cracker Barrel guests are planning to travel as much or more than usual.
  • My first question is can you share those studies? Although he points out the challenging environment, his other comments (particularly his last one) imply that he is not too worried about the impact higher gas prices will have on summer travel, which is a little hard to believe. The company's most recent 10-K highlights the importance of the upcoming summer months on the company's bottom line: Historically, our profits have been lower in the first three fiscal quarters and highest in the fourth fiscal quarter, which includes much of the summer vacation and travel season. We attribute these variations primarily to the increase in interstate tourist traffic and propensity to dine out during the summer months, whereas after the school year begins and as the winter months approach, there is a decrease in interstate tourist traffic and less of a tendency to dine out due to inclement weather.
  • According to the U.S. Department of Transportation, travel on all roads and streets in the nation declined 4.3% in March (down 2.3% year-to-date through March), and this is before the more recent upticks in gas prices. Making matters worse for CBRL is the fact that about 88% of its restaurant store base is located in regions of the country that are experiencing year-over-year travel declines that are worse than the already bad national average. As of September 28, 2007, 71 of the companies 565 stores (about 13%) were off-interstate stores, which leaves the rest located primarily along interstate highways. Although the company is switching its development mix to include more off-interstate stores going forward (plans to open approximately 45% of its new stores along interstate highways as compared to 68% in 2007), based on the company's current mix, gas prices could impact travel (and traffic) during CBRL's critical summer months.

China Cotton Relief: Not Enough

China's Ministry of Finance today announced cuts on import duty rates for 26 products to address supply imbalances caused by the Sichuan earthquake. In addition to foodstuffs, medicines and some building supplies, the list includes a 38% cut in duties on cotton imports, which will be reduced for the four month period ending October 5. The ministry has indicated that the move is intended to make up for the cotton supply gap before new cotton came out this season.

That's very good of them, but this is absolutely immaterial for the apparel industry in the US. Yes, availability of raw materials is a big issue. But a bigger issue is getting migrant workers to the factories to actually cut, sew and assemble the materials. (Check out our past postings on this topic).

Too bad the Chinese government can't import and drop-ship workers.

FL: The Pug of Retail

I think that people generally underappreciate how bigger-picture industry trends have disproportionately beaten up Foot Locker. Some of those are turning, and while it almost pains me to say, this perennial underperformer is starting to look really interesting.

A friend of mine has one of those mini Pug dogs - the ones with the mashed-in face and bulging eyes. The kind of dog that's so ugly that it's cute. That's how I increasingly feel about Foot Locker. While the best investors divorce all emotion from investing, I've got to admit that it's extra tough with this one. The company is a perennial underperformer, with one of the worst track records in all of retail. From a GMROI perspective, the only companies I can find that historically rank below Foot Locker on such a consistent basis are Sears and the former K-Mart. Without giving away my age, let me just say that if I was gifted a share of Foot Locker on the day I was born, my cumulative return would have been close to zero. Based on all my 'margin squeeze' preachings, with all the Asian cost pressure coming down the pike, Foot Locker should be a big loser. Then why am I changing my mind on the FL's fortunes? Consider this...
  • THEN 1) For most of the past 5 years, almost every last bit of the industry's growth has come from the 'low profile category.' In fact, 5-years ago the industry run-rate was about 220mm pairs of athletic shoes annually. Now we're at about 250. But over the same period, the 'low profile' category added about 30mm pair. In other words, consumption of core athletic footwear simply did not grow. Last I checked, this is about 80% of Foot Locker's business. 2) While FL suffered through the 'low performance' drought, it relied increasingly upon Nike to drive traffic and stabilize comps. As a percent of total sales, Nike went from 40% in 2003 to just over 50% today. Nike keeps a disproportionate share of the aggregate margin in exchange for driving traffic into the retail stores. FL gave up the margin, got the traffic to some extent, but did not convert it to sales. 3) So we're talking a share-losing, zero-square footage growth retailer with a big fashion headwind and a shift in mix towards a lower-margin mix of business consolidated with one massive customer. It's no surprise that Gross Margins went from 27% to 23%, and EBIT margins tumbled from 7% down to 1%.
  • NOW 1) As I noted in prior postings, the footwear retail channels overall appear to be very clean from an inventory perspective - as evidenced by 2-5% increase in average selling prices and sharp declines in aged inventory versus last year. 2) The 'low profile' shift is absolutely, positively waning. For the past three months the category grew at a rate less than the total industry, and April marked its first down month -- ever. 3) Even the removal of a fashion headwind could give a modest sustained comp lift. A revival in performance product would be icing on the cake. Under Armour's foray into footwear could be the boost FL is looking for. This is currently a Finish Line exclusive, but will be available at Foot Locker in Fall '08. Then UA follows up with performance running product in Spring '09. What's nice about this industry is that it competes on innovation, not price. As UA and Nike duke it out, Foot Locker is likely to win. 4) Keep in mind that when the environment gets incrementally healthy, FL can shift orders on the margin to non-Nike brands. Assuming no traffic fall-off, this helps FL's margin economics. 5) Despite the margin downdraft over 2 years, Free cash flow margin has held steady at (an admittedly appalling) 2.5% as FL exited bad leases, closed down underperforming stores and converted associated inventory to cash. 6) The bottom line is that the leverage is pretty meaningful at both the operating and cash flow line, and to the extend any of these trends continue, we could be sitting here looking at a 3-4 point margin pop without making heroic assumptions - or about $1.50 in ES power (35% better than consensus).
  • BALANCE SHEET CONSIDERATIONS I'm torn on the 'this thing has a great balance sheet' argument. Ok, $2 per share in net cash and tangible book value of $12ps. Not bad at all. But 2/3 of book value is comprised of finished goods inventory. While that's a solid liquid asset, this is carried at cost, and I've seen inventory liquidated for a fraction of cost. In addition, FL has $1.9bn in lease obligations that I'd be remiss to leave off the balance sheet. What I like, however, is that FL's lease terms are about as good as they get. Its annual lease obligations rate declines meaningfully - by the tune of about 60% based on my math. Unlike some other retailers that are pushing out lease obligations to print higher margins today (DKS, DSW, to name a few). The point here is that if for whatever reason FL opted to extend terms on its leases, it can push obligations out and take margins up. I'm not recommending that FL does this by any means - but it is one of the few companies that has the option (others being PSS and HIBB). If there's one think I like in this environment, it's flexibility. This balance sheet has it.

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