7/28/2010
By Brian Sozzi, Research Analyst

More Articles by Brian Sozzi

The role of analyst has, without question, spilled over into my personal (insert "lol") so I figured I would provide you, John Doe investor, with insights into how I think when tasked with breaking down an earnings report.   I will be using footwear maker Timberland (TBL) as my guinea pig.  The word "masked" was uttered frequently by the CEO of Timberland on the earnings call, and was even acknowledged in the 8-K.  "Masked" in this case was used to draw investor attention away from a $13.2 million charge to operating earnings related to two small brands in the Timberland portfolio and instead shift gaze to the underlying fundamentals.  When fixated upon, it's apparent that the fundamental narrative at Timberland continues to improve; 2Q10 was yet another feather in a cap that began to accrue feathers in the latter stages of 2009.  The turnaround in the core areas of the business and an attractive valuation profile (relative and compared to own historical), are the primary reasons underpinning our positive weighting on Timberland shares.

Timberland's recovery has centered on the following: (1) developing products outside of the yellow boot category that are differentiated relative to the peer base and which allow for share gains within pre-existing accounts and within new customers; (2) better management of inventory in the channel, which is bringing down markdown allowances among wholesale partners and less profitable closeout sales, in addition to creating a more full-priced selling platform; and (3) staying one step ahead of the supply chain evolution that is unfolding in the shoe industry (say goodbye to cheap sourcing from Southeast China).  Timberland touched upon all of the major buzzwords in 2Q10, and it was far from smoke and mirrors.  Sometimes, sales do not flesh out the entire story...

Words from the Horse's Mouth: An Education in CEO Speak

"We had full-price sales"

What is means:
* Accounts want the product in their stores.
* Customers are responding favorably to products at full-price, a function of marketing and perceived value.
* Retailers are not sticking Timberland with high markdown allowances.

"Closeout sales were lower year over year"

What it means:
* Full-prices sales equates to fewer closeout product at outlets.
* Design team hitting homeruns.
* Inventory is in proper balance to demand, perhaps too low, and running the risk of lost sales opportunities.

"We will be taking price increases to offset raw material cost increases"

What it means:
* Consumers are not balking at already premium prices so why not recoup input costs by raising prices.
* Product momentum + higher prices=sustainable margin growth.

All of these items are critical in determining the true story beneath a company's success or failure in any one quarter.  While Timberland's sales were soft, the underlying numbers suggest that margin tailwinds are likely here to stay given compelling new product lines that customers are buying.  To me, I will gladly take a company growing revenue at a consistent pace quarter after quarter but managing to drive higher margins from those sales.

At a Glance: Timberland's Second Quarter Earnings

* Soft revenue ok, it's all about the margins: Timberland reported net sales of $189.0 million (consensus: $189.5 million) and a LPS of $0.44 (consensus LPS: $0.34) in what is typically the smallest quarter for the company.  Fewer closeout sales globally was behind the sales mediocrity, but the takeaway here is that Timberland was able to earn a greater margin on the products that drove the top line.  Gross margin surged 747 bps y/y to 49.48% (consensus: 44.10%), benefiting from lower product costs, full-priced sales, and fewer closeout sales.  Excluding a $13.2 million charge to write-down goodwill and intangible assets for IPATH and Howies, we have Timberland at an operating loss of $20.1 million, beating consensus by $10.0 million.  Per the usual, Timberland closed with a stellar balance sheet, chock full of cash and no bank debt.

* Pricing power: The Earthkeepers product line continues to be en fuego globally.  The product looks great and it tells a conservationist message; can't get any better than that.  Importantly for Timberland the products are being sold at full-price and the costs to develop them must be low as they are made from recycled materials.  In addition to Smartwool demand momentum as its transitions to an outdoor lifestyle brand, it's no small wonder Timberland's gross margin spiked over 700 bps in 2Q10 y/y, significantly above the bps change at other operators thus far in the reporting season and consensus forecasts.

* Inventory control: This was also a key contributor to Timberland's gross margin success; there is simply not an avalanche of product in the channel.  Timberland's comp sales metric for 2Q10 is actually deceiving at -3.9% for U.S. retail and -0.5% for global retail.  Asia comps increased 11%, North America rose 1% in total but were up 2% at specialty stores (outlet was lower due to fewer closeout inventory on hand), and Europe as to be expected was lower.

Brian Sozzi
Wall Street Strategies