Ok, first let me acknowledge the bull case. Yes, the brand is hot, the organic growth is good, and the diversity of both the customer mix and geographic base offers some nice safety. Also, returns are high, and management's track record is tough to argue with. I get all that. But I think people are ignoring the potential for this model to inflect across the board. Consider this...
- 1) GES has been a remarkable turnaround story since 2003 under new leadership. But this also happened right alongside a 28% depreciation in the US$ vs the Euro. Something to consider given that nearly a third of sales and 40% of cash flow comes from Europe. Look back to when companies like Nike and Ralph Lauren managed through their first FX cycles as global companies. Not pretty at all. GES has never had to deal with an inflection in FX. The extent to which there is a reversal in currency scares the heck out of me here. Check out the chart to the right. Margins up by 17 points when the USD is off by 28%. Ouch!
- 2) It's also important to at least acknowledge that the GES turnaround happened in an extremely 'easy money' period for the industry as the influx of sourcing savings for this industry was in its sweet spot. This trend injected 3-5 points of margin into this industry by my math. GES definitely saw some of that. 3) A low expense structure is becoming more apparent. With a sub-28% SG&A ratio, GES is about as low as any quality higher-end brand I've seen (RL is close to 40%) - particularly one with such high international exposure. There are many companies out there that grossly under invest in their content. I do not think that GES is one of them. But I do think that GES printed a disproportionate piece of its excess earnings at the top of the cycle rather than reinvest into the SG&A line in the model. There are a few companies I can point to that can pull back expenses to the extent that times get tough. I think that GES has already pulled the goalie.
- 4) I've gotta say that the Sales/Inventory/Gross Margin triangulation mildly concerns me. Over the past 6 quarters, inventories have outgrown sales by an average of 5%, and yet gross margins have been UP. There are certainly examples of others where the disconnect is more severe, but some of the most violent price corrections in retail have come when companies shift out of quadrant 2 in the chart to the right into Q3 or Q4 (clear inventories by way of taking down margins). This is especially the case with higher-multiple retailers like GES. So what scares me about this? Sales are slowing on the margin, and at an unfavorable delta relative to inventories. In that context, Gross Margin trends have been fair at best - and this is at the same time industry tailwinds become headwinds, and SG&A is starting to de-lever - even with relative strength on the top line. With even a moderate incremental deceleration in top line trends from here, this model could churn out significantly lower EBIT growth numbers. I certainly wouldn't want to be long this stock if the dollar turns. Things could get real ugly real fast.