Call for details on the different chains!
Call for details on the different chains!
Anyone watching Belmont on Saturday hoping for horse racing's first Triple Crown in 30 years walked away sorely disappointed. Hardly any sportscasters' post-mortem can point to a single factor as to why such an incredible horse could place dead last. Maybe it was the quarter crack in his left front hoof that cost three days of training, maybe it was the 9,000 RPM regimen over the preceding four weeks that caught up with him. The bottom line is the Brown lost big time - like so many companies are today.
Pardon my little missive, but there actually is an important overlapping investment theme. The best brands in Softlines invest in content on a very steady basis, and understand that when times get tough they need to double down on investment spend to gain share as opposed to printing too much margin. Metaphorically speaking, Big Brown 'printed too much margin' at the Preakness and the Derby by pushing the envelope and winning by a combined 10 lengths. By the time the Belmont came, there was no more gas. I think that Ralph Lauren is the antithesis of Big Brown.
RL is coming off a year where it invested in geographic infrastructure as well as in new product initiatives. It's about 3-4 quarters ahead of margin weakness experienced by other retailers. Why? Because RL played offense then, and others are playing defense now. RL took it on the chin with an SG&A hit when it saw the need to jump-start its global growth profile (Japan, handbags, dresses, Russia, leather goods, footwear, to name a few). Better than 80% of other brands tweaked SG&A down over the past 2 years, and now are subsequently paying the price in sales and gross margin. RL is at a point where its investments are paying off on the P&L, and as such growth in its cost structure is ebbing at the same time revenue starts to flow. I'll let you do the math as to what this means to operating profit growth. (Ok, I'll do it for you... 0% goes to 25%+ for 3+ years).
Returns are Accelerating. Over the past 6 years, RL has been right-sizing the ship. It has either been in asset acquisition mode (mostly licenses), or organic investment mode. Either way, there was a constant trade-off between operating asset turns and operating margins - the two key levers to driving returns in this business. Now RL is at a point where 95% of licenses are already repurchased, and the major infrastructure to facilitate the next 3-5 years of growth are already in place. This means that asset turns and margins both head up simultaneously, which has a magnifying impact on return on net operating assets. By my math, RL just hit an inflection point which will take it on a run of a 1,000bp boost in returns to somewhere around 27%-28%. The components are in the exhibit below.
Numbers look Very Doable. I simply cannot get the company's recent guidance for the upcoming quarter and year to synch. The Street is looking at a 3% top line growth rate, which represents a 600bp 2-year erosion in growth. I think that the Street is at least 400bp low, and in fact more often than not the sales rate should accelerate - not decelerate. The only factor that might prevent that is the fact that inventory ended the last quarter -2% with sales +20%. The books are very very clean. Any sales erosion (that is already in estimates) is likely to be offset by GM strength. Bottom line is that the Street is looking for a down quarter to the tune of 10%. I think we'll see +10-15%. I'm still of the view that RL will print $4.50 or better this year vs. the Street's $4.00. Similarly, the Street looks at least a buck low in '09 and '10. Tough to find names out there that look like this.
So we've got positive revision momentum, improving returns on a multi-year basis, an added $2bn+ in sales and $2+ in EPS over 2-3 years, and troughy valuations. Not bad at all...
- PVH identified about $1.55bn in forward obligations in its 10K. But this excludes another $575mm in payments (based on my assumptions) required to be distributed to Mr. Klein under the original terms of the purchase agreement. The kicker is that this lasts until 2017, and is at a rate of 1.15% of worldwide net sales of products bearing the Calvin Klein name. When I add it all up, the CK payments are actually greater than the operating lease liabilities - which is the greatest off balance sheet liability for most other companies in this space.
- When I net it all out, PVH has forward obligations that are going up over the next 10 years, while the industry's is naturally going down. The gap is pretty startling, in fact. This is not bad by any means, but it simply means that the company's bullish CK growth strategy NEEDS to work.
- The bottom line is that I don't think that this is a short based on ugly accounting practices. That's not the case at all. PVH is a stand-up company. But if I'm going to give PVH credit for CK's growth, I've got to give credit for the liabilities as well. At 8x EBITDA, valuation is not in the ballpark of where I'm interested in owning the stock.
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- CORNCorn actually moved up 5% yesterday alone, which is not surprising after seeing the USDA's weekly crop report released earlier in the week, which showed that only 74% of the corn crop had emerged relative to the 5-year average of 89%. These big moves in corn prices will impact just about all of the restaurant operators as these higher corn costs will eventually translate into higher protein prices. That being said, the biggest movers to the downside in the past week were cattle and pork (-1.5% and -5.6%, respectively). Judging from Tyson's investor presentation this week (on which I commented on June 5), I would not be surprised to see these prices move higher.
- SOYBEANSRising soybean prices will impact most companies as well as it relates to cooking oil, but P.F. Chang's stands out in my mind as the company highlights wok oil as an important component of its cost of sales.
- WHEATAlthough wheat was up for the week, year-to-date, it has actually declined 11% and is down nearly 39% from the highs seen back in March. Wheat's current price of $7.86 per bushel still represents a 23% premium over the average 2007 price and a 94% premium over 2006. The companies most impacted by these huge year-over-year increases will continue to be Panera Bread and California Pizza Kitchen. Panera is locked in for FY08 at $14 per bushel (versus an average of $5.80 per bushel in FY07). California Pizza Kitchen is only locked in for the next few months on its pizza dough needs (at a 12% YOY increase), but is contracted for the entire year for its pasta needs. Neither company has locked in FY09 prices, but Panera stated on its last conference call that it will make a decision whether or not to do so in the June/July timeframe.
It's rare that I will give a personal opinion on a company's web site or product marketing strategy -- particularly given the lack of impactful investment significance derived from one man's opinion. But Gap's '4 for 1' strategy, whereby a consumer can shop all of its sites at once, seems ridiculous to me.
I went to the Banana site and was bowled over by the picture below. Yes, convenient that I could buy shorts from Banana and match up shoes from Piperlime, and graphic Ts from Old Navy. But management is missing the big picture.
I go directly to Banana - Gap's highest end brand - and see cross-selling with Old Navy and Gap Stores? It's bad enough that Father's Day is approaching and the only pictures on the page are women. But GPS is violating the cardinal rule of muti-brand retail. It is letting the consumer know that a corporate umbrella even exists. Does the Club Monaco customer know that it is owned by Polo Ralph Lauren? Same for Converse/Nike. Arrow shirts/Calvin Klein (PVH). The North Face and Wrangler/VF Corp. No, No, No, and No. There is ZERO benefit to a Banana customer knowing that the brand shares the same parent as Old Navy. Why? Because such affiliations do not change the allure of the lower end brand, but they (sometimes permanently) cheapen the allure of the high-end brand.
I still think that Gap's biggest problem is that it has done a tremendous job on the cost side in recent years. But that was when there was meaningful sourcing optimization opportunity in an extremely 'easy money' environment for this industry. Also, SG&A stories in this business DO NOT WORK. It takes investment in talent and best-in-class capital allocation to grow consistently. Now SG&A structure remains quite low, but GPS can't rely on industry tailwinds to soften the impact of its past missteps. Getting efficient with web-selling is not the answer. The only answer is for GPS to rely on brand strength. Guess what -- -strengthening a brand takes capital, and we're not seeing that commitment at GPS yet. The bottom line is that I think that margins need to go down before they can go up again.
PS: Thanks to my colleague Andrew Barber for his role in this post. He showed up today in jeans and Chuck Taylors. I went to Banana to find an image to forward him to gently remind him of our dress code at Research Edge. I guess I need to go to Polo.com....