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VFC reported solid results last night, ahead of the Street by $0.10 and well-ahead of our estimate.  Admittedly, the areas of risk that we had been focused on heading into the quarter were not fully realized.  However, we’re not going to try and poke holes in earnings quality or point out the inconsistencies in the results in effort to try and justify our cautionary tone.  Instead, the reality is that VFC put up a sizeable headline beat and did not lower guidance.  Did they massage the components of guidance and adjust them accordingly to maintain the $4.70-$5.00 outlook?  Absolutely they did.  But, the reality is manufactured results are exactly what they are – a reality.  In this case, with numbers coming in close to, or perhaps even above consensus for the back half, it is unrealistic to believe VFC shares are heading meaningfully lower in the near term.  Consider the following:

Including the $0.10 beat, management reaffirmed its full year guidance of $4.70-$5.00; however, it’s important to note this guidance is now predicated on a few new factors:

1)      Foreign currency: Baked into 2H earnings is a Eurodollar exchange rate of 1.37 compared to the previous assumption of 1.30 lessening the Fx impact on revenues by ~$60mm or roughly 1%. Depending on the margin at which incremental Fx related money flows through the P&L, VF would realize a $0.07 benefit assuming corporate margins, but the reality is that it is likely to be higher so let’s call it a $0.10 benefit on a 20% incremental margin in the 2H.

2)      Tax rate: While the 25% tax rate posted in Q2 was noted as “in-line,” it was outside of the expected range between 28%-30%. As a result, the full-year rate was adjusted from 29% to 27% equating to another $0.10 tailwind in the 2H.

3)      The Q2 beat: The full-year range now includes better than expected results in Q2 that take up year-end earnings by yet another $0.10.

Despite a weakening overall top-line, dismal revenues from the company’s core cash-cow (Jeanswear), and a meaningful slowdown in the North Face, the company was able to report a substantial gross margin performance. The mix shift towards owned retail driven by robust store growth will continue to benefit gross margins (especially in international markets), but we maintain that decelerating top-line trends will have to improve to sustain operating margins. Based on 80 new stores over the last twelve months and the average store contribution, we calculate that retail contributed roughly $120mm in revenues this quarter. Taking into account management’s comment that retail accounted for a 40bps improvement in gross margin, we estimate that retail stores are operating just shy of 50% compared to a low 40% core margin. As a result, the incremental 70 stores should contribute approximately 75bps to gross margins in 2009. With management committed to a 10% inventory reduction by year-end, it will be a challenge for VF to expand margins beyond recently adjusted expectations.

Additionally, while late to the expense control party vs. other apparel manufacturers, VFC seems to have found upside from their cost cutting efforts.  After all, the company spends $400m on advertising alone, which is a huge source of funds when trying to make the numbers.  

The timing here is no longer imminent as evidenced by the 2Q results, but the reality is cutting costs and opening stores can only go so far.  With jeanswear, imagewear, and sportswear all showing meaningful declines we suspect the ability to manufacture decent results will eventually come to an end.  But for now, we’ll watch the fundamentals closely and monitor key organic growth drivers to determine when the next opportunity arises to become cautious again.

VFC: Same Guidance, Different Mix - VFC S 7 09