‘The Question’, and a Scary Answer

We’re kicking off a new product at Research Edge called “The Question,” whereby our analysts pick one key issue each week and take industry leaders to task. We won’t take company tag-lines at face value.

I think there are few issues more important to this industry right now than the impact of FX on the P&L – not only because the multi-year slide in the dollar has been glossed over by many in this business, but also because of the violent reversal in the US$/Euro over the past 2 weeks.

I am 100% convinced that within 2 quarters, we are going to see a meaningful bifurcation between the winners and losers in a different FX climate. The winners have invested capital in their respective models while the dollar slid – companies like Ralph Lauren, Timberland, Liz Claiborne and Nike. Others printed way too much margin – such as Warnaco, Guess, Skechers, and Adidas.

‘The Question’: We asked 13 branded apparel/footwear companies the following question. “Philosophically, please walk me through your approach to managing FX. How do you alter levels of investment to take advantage of (or offset) fluctuations in the FX environment.” We were extremely consistent with our questioning, and did not lead the witness in any situation.

‘The Answer’: Weak -- all around. I expected this from the weaker players. But what surprised me most is that most of the better companies that I think have appropriately reinvested FX benefit (instead of passing it all through in the form higher margins) were unable to articulate any real strategy around the issue.

The purpose of “The Question” is to get to the bottom of key issues of investment significance, and to call out those companies that are particular standouts (+ and -). You remember back in high school when occasionally the whole class would get a detention slip instead of just the class clown? That’s what we’ve got here. No one is getting out of detention on this one.

Plan B – Math: When the results of our discussions appeared to be coming in rather grim, we started to crank through some good ol’ fashioned math. (Note, we’d have done the math anyway). We took all 13 companies and looked at company-reported FX impact to revenue, and compared to the incremental change in EBIT. In effect, we looked at what percent of the change in FX passed through to aggregate company results. The results were startling, and are shown in aggregate for the group below.

a) From early 2006 through 3Q07, the incremental FX margin averaged 100% while the Euro went from 1.26 to 1.44. No joke.
b) Starting 4Q07, the incremental margin dropped to about 15% despite another 0.14 boost in the Euro. This is the level we SHOULD see. In a perfect world, the companies would reinvest excess FX benefit in a way that keeps margins relatively steady. When FX helps, reinvest the benefit. When FX reverses, there’s a bigger base in place to help grow, and worst case to trim costs out of.
c) Unfortunately, it is not a perfect world for these companies. The fact that incremental margins came down so much when FX dictated otherwise tells me that real margins on the base business were down far more than most people realize.
d) If currency stays where it is today, we’ll be looking at negative 5-10% FX comps one quarter out. I maintain my view that margins are still coming down 2-3 points in this business over 2-3 years. FX might make this happen sooner than later. Clear the decks!