9/1/2010
By Brian Sozzi, Research Analyst

The market held valid concerns about Guess' (GES) fundamentals prior to the issuance of 2Q10 results.  Not only has the company's sales and margin outperformance relative to consensus forecasts slowed, but back on the 1Q10 earnings call in May it was obvious management was tempering the potential outcomes for FY10.  Toss in retail sector trends that have lacked bravado (slowing sales, slowing mall traffic, increased discounting, elevated inventories) and it's but little wonder that Guess shares have been on the chopping block since late April.  Now trading on a forward year P/E multiple of 9.9x, the lowest dating back to the January 2009 ended quarter, and near the bottom end of our specialty retail sector average (stock also yields 2%), Guess shares are a sexy investment for a long-term minded investor.

Granted, the 2Q10 operating results from Guess did not exactly soothe the uneasiness of the bulls.  Perhaps, the 2Q10 results fueled the engine of the bear camp.  North American retail comps at +3.5%, though outpacing most peers for the quarter, slowed noticeably from 1Q10, with the segment's gross margin facing an attack by industry forces.  A slowdown in the consumer uptake of premium denim played a role as well; denim is 30% of Guess' business.  We believe, however, that Guess will post less disappointing results in North American retail as the year progresses as consumers adopt products outside of denim (different fabrics and fits) and desire to complete the look.  For Guess, non-denim offerings are priced comparable to denim and have a similar margin structure, so increase conversion won't necessarily equate to an unfavorable sales mix that deconstructs gross margin.

That said, intense scrutiny on Guess' North American business would be overlooking the fact the brand is fast becoming global; over 50% of 2Q10 revenue was derived from Asia and Europe, where Guess is operating more efficiently given a larger infrastructure.  We believe Guess' increased international penetration through the opening of owned stores, independently operated stores, and in concepts not solely Guess (accessories for example) will serve as offsetting mechanisms to a topsy turvy North American consumer environment.

Discussion: 2Q10 Operating Results

Guess shares were hammered the day following the earnings release as the market gave thumbs down in the face of problem areas.  They included (1) gross margin degradation on increased North American retail discounts; (2) operating margin degradation on slowing comp and increased retail related expenses; (3) inventory rose faster than sales growth; and (4) 3Q10 and FY10 guidance was basically in line to consensus.  Guess reported net sales of $577.1 million (consensus: $576.4 million), +10.5% y/y, with all segments contributing.  Overall sales trends moderated on a sequential basis and operating margin fell y/y in all segments, except for Asia.  In Asia, Guess' expansion into countries removed from China appears to be a positive from an operating margin driving perspective.  We were encouraged by the sequential operating margin improvement in all segments, except for Europe.  EPS came in at $0.72 (consensus: $0.68), two times higher than the rate of growth in EBIT, as Guess repurchased 1.5 million shares of stock totaling $49.3 million.

Conference Does Not Disappoint

Being the clothes horse that I am, and frequent Guess shopper over my 28 years on Earth, enthusiasm for the Guess analyst/investor day at the NYSE was off the charts yesterday.  Yes, I maintain a sense of objectivity before I conduct my analysis on Guess, or any stock.  Fan of a company's products or not, if the numbers don't add up or the investment thesis become suspect, out comes the axe on my rating and price target oftentimes.  Back to the event, which featured most of the Guess exuective team and co-founder Maurice Marciano.  I always knew Maurice and his brother Paul were visionaries in the industry, but perhaps never fully appreciated it until yesterday.  Almost 30 years into running Guess, Maurice still glows when talking about denim, non-denim, new store concepts, or international opportunities.  From Guess' start in a tiny NY apartment and with one Los Angeles based distribution center to its impressive global standing today, no doubt Maurice and Paul may end their careers darn near Ralph Lauren as icons of industry.

I continue to believe Guess' growth story is one left to be told.  The resounding message at the conference yesterday was of "one world, one brand", and that absolutely captures Maurice's and Paul's vision for the future.  While some point to Guess creeping up on saturation in the U.S. with its namesake store concept, I say hogwash as there are only 300 some odd stores.  Moreover, in the U.S., Guess has significant opportunities with its upscale Guess by Marciano concept (store base could double in few years time) and with G By Guess, an affordable line (products are priced 30% to 40% below core Guess brand products) that is on the verge of profitability...all that is needed are more stores to leverage the completed infrastructure investment.  I would breakdown Guess's next evolution into the following categories:

Brands
* Guess by Marciano in the U.S. (potential to 150 stores)
* G by Guess in the U.S. (potential to 300 to 400 stores)
* Guess accessories stores (smaller, very productive stores that sell handbags, shoes, etc.)

International
* Europe (with different store concepts) through owned retail stores and with franchisees
* Asia (including India, Korea, Greater China) through owned retail stores and with franchisees

Other
* South America
* Japan

Productivity
* Continue to consolidate supplier vendor base (number of vendors has declined 40% in last 12-months)
* Invest in technology that allows for improved inventory allocation and markdown optimization
* Introduction of categories outside of denim that drives increased sales (non-denim bottoms for example)
* A return of the U.S. consumer that is married to new stores boasting attractive lease rates as a result of the real estate downturn

The Bottom Line

Those harnessing a short-term investment horizon may look at Guess and see a retailer that sells denim amidst an industry slowdown in the category for back to school or one that is too fashion forward.  To me, this type of view is missing the mark on Guess, and will cost investors a money making opportunity extending 5-10 years.  The company is a full lifestyle brand that has numerous growth levers at its disposal, including new store concepts and international square footage additions.  Most importantly, it has a management team that has flat out delivered on promises to the nth degree, and never sacrifices brand identity when a new fashion trend emerges.  Rather, Guess is the company setting the trends, which is an envious position to be in for the future.

Brian Sozzi
Wall Street Strategies