PSS: Math

Here’s a great example of why estimates ≠ expectations. Let’s step back, YouTube ourselves, re-evaluate, and decide where to go from here. Math is math… Bottom line is to up our exposure.

 

 

 

Don’t you love when a company grows earnings by over 40%, beats estimates by 13%, and yet the stock still goes down meaningfully on the print? Unfortunately, there’s a difference between estimates and expectations, and as we often say here at Hedgeye, “Expectations are the root of all heartache” (borrowed from Shakespeare).

 

Make no mistake; the company missed both my estimates and expectations this quarter. I was at $0.88 cents (17% above the Street) and thought they could print something starting with a 9. The key variable was sales comps vs. Inventory.  Simply put, PSS missed the comp – printing -1.2% -- in an environment where people are scared spitless about anything surrounding the consumer. They smoked expectations on their wholesale business, which is not only higher margin but also less asset intensive and higher ROIC, but that does not have quite the offsetting dramatic flair in the headline that a comp miss does.

 

Ok McGough, you’ve liked this name for a while. Solid story last year, it’s been a dog since the start of 2010, and now they miss the comp. Have you overstayed your welcome? Are you succumbing to ‘thesis morph’?  Time to bail on this name and move on to greener pastures?

 

After going through the model ad nauseum last night and this morning, the answer is ‘No.’ I liked it 2 days ago, and I like it today – but at a better price. Yes, there are question marks that exist today that did not exist for me last week. But I am comfortable with the answers I’ve come up with.

 

Let’s dig…

 

1)      Why’d they miss the comp?  Am I happy about this? No, and there’s no excuses here for missing. A real company in this space needs to grow comp – especially one with no square footage growth. But I’m not as miffed as to why they missed. Simply put, the biggest driver was not having enough product to fill consumer demand.  Mind you, that’s one of the primary reason that gross margins were up 241bps. Ideally, they’d have managed the business to drive a few points of comp and around 100bps+ of GM% improvement. That’d look prettier, but would ultimately leave us with a similar result on the P&L.  This ability to manage the business better is something that PSS will need to show more of.

 

2)      What’s coming down the pike? PSS is going heavy on the toning category – with nearly 3x the inventory in 2H than 1H. The price point is nearly 2x the average price of the base Payless shoe, and let’s face it…regardless of how ridiculous this product is in my humble opinion (get fit while wearing them to do round trips from couch to fridge and back to score bon bons and beer) it is a hot trend. Competing product is selling around $80 (Reebok Easy Tones), $100 (Skechers Shape Ups) and $200+ (MBT).  A Payless offering under $30 will probably get noticed, as will several wholesale initiatives. 

 

3)      P&L Trends in 2010. At the same time they have this push; they’ll have a corresponding marketing push and will be going up against their easiest comp of the year. In fact, there’s no reason why we should not see avg ticket grow sequentially over the course of this year. This highlights the biggest binary risk/opportunity. We know the product is coming in. We know the trend is hot. We know the price point is meaningfully below anything else on the market. We know they’ll promote accordingly. But if this falls flat on its face, then there’s top line, GM and Inventory risk all rolled into one. If it works, then we get the opposite. The current stock price and consensus estimates discount something closer to the bear-case.

 

4)      That brings me to our estimates. Without making heroic assumptions, we’re coming out at $0.58, $2.00, and $2.50 for the upcoming quarter, this year, and next year, respectively. Over those time periods it represents 100%, 52% and 26% earnings growth, and 26%, 15%, and 25% above consensus, respectively.

 

5)      Don’t forget the long term story. This is a business that I like on a multi-year basis. It is at the center of a multitude of Macro cross currents, and just happens to have a CEO who I think has one of the best Macro processes in retail. The company owns both content and distribution – which will increasingly be important – and is the low cost/price provider of footwear with large scale distribution at a time when its main competitor – Wal-Mart – is downsizing its shoe business. Multiyear investment that have come to a head and structural changes in business alignment at PSS will allow the company to grind its average price higher over the next several years, which should unlock incremental margin dollars on what has been a perennially low-margin, highly-levered, no growth concept. As the fundamental story plays out, so will the earnings, the perception, the valuation, and ultimately the stock.

 

6)      Cash flow??? It’s rare to hear the words ‘Cash Flow’ in conjunction with PSS, but the reality is that the company has its’ net debt down to $417mm, or 33% of total capital. That’s the best position since the closure of the (horrifically ill-timed) Stride-Rite acquisition. But this is a company that should completely fund its working capital and capex needs, and still generate close to $360mm in free cash over the next 2 years. In effect, it should be nearly debt-free by the end of 2011.  I’ll have a tough time justifying that it should hang onto its ‘junky levered retail’ discount as that plays out.

 

7)      That brings me to valuation. Those who know me can count on one hand the number times I’ve dedicated any of my typing capacity to anything valuation-related unless it is break-up or M&A-related. That’s not because it does not matter, but because of our view that fundamentals will almost always trump valuation. Some cheap stocks should be cheaper, and some expensive stocks should be more expensive. But in the context of everything outlined above, consider the following valuation stats on FY10/11 using today’s stock price:

  1. PE: 9.8x/7.8x
  2. EV/EBITDA: 4.6x/3.8x
  3. FCF Yield: 14%/16.5%

 


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