This Apparel Retailer is in Value Territory
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The apparel retailing sector is becoming increasingly dynamic in 2012 as discretionary consumer dollars continue to return. Emerging markets including China are getting their first taste of certain prestigious foreign brands, and historically high cotton prices are putting a strain on industry margins and therefore masking the effect of generally growing top lines. Guess Inc. (NYSE: GES), with its stock price falling nearly 15% since mid-March, has recently appeared to be on the opposite end of the industry’s post-recession rebound.
Looking closer within the corporation’s past several year operating history, however, reveals a rather attractive entity within the largely fragmented and sustainable competitive advantage-lacking industry. There are several key takeaways to consider:
- Guess derives a majority of its revenues from the ailing European market (37.6% in 2011), which is largely due to the pessimism surrounding the stock. Despite the continued uncertainty regarding the sector’s mid-term growth prospects, Guess enjoyed a meaningful 8.1% revenue jump between 2010 and 2011, and has grown revenues by nearly 54% since 2007.
- The corporation is experiencing rapid growth in emerging markets. Asia-based revenues, which hit $250.7 million in 2011, have more than doubled over the past four years. Top line contribution from Asia-based operations hit 9.3% in 2011 (from 5.7% in 2008), and operating income has expanded by a factor of 5x over the same time period. Although the concern over European uncertainty is sound, it appears as though the market has totally ignored Guess’ growth potential in emerging markets.
- Guess has remained free cash flow positive despite the reduced operating margins in the core European market. Free cash flow of $241 million in 2011 was up 8% year-over-year, and represents a 300% growth over the past five years.
- Guess, which boasts a debt-free balance sheet (it does have capital lease obligations of a mere $12.2 million), has been able to use free cash to fuel its rapid expansion plans. The corporation opened 261 new stores during 2011, and operating margins are expected to return to more historic levels between 15-17% after the growth phase begins to slow in 2013.
- Following the 33% price drop over the past two months, the corporation is – most importantly – extremely cheap on a historic and peer basis. This relative undervaluation is despite the solid fundamentals over the past five years and the corporation’s super clean balance sheet. Compared with other similar apparel retailers including Gap (NYSE: GPS), Ralph Lauren (NYSE: RL), and Abercrombie and Fitch (NYSE: ANF):
5 Year Revenue Growth:
- Guess: 53.6%
- Ralph Lauren: 31.8%
- Abercrombie and Fitch: 10.9%
- Gap: -7.7%
5 Year Operating Income Growth
- Guess: 28.5%
- Ralph Lauren: 29.5%
- Abercrombie and Fitch: -74.3%
- Gap: 2.3%
5 Year EPS Growth
- Guess: 43.7%
- Ralph Lauren: 54.2%
- Abercrombie and Fitch: -72.2%
- Gap: 48.6%
A quick and rather conservative valuation of Guess shares would start with the variable that is known with certainty – the corporation’s net asset value – and would add additional value for the sustainable return that Guess earns on the book balance. Guess’ book value can be broken down into three component parts: net operating assets (the working capital that is used in its core apparel retailing operations), net financial obligations (any short and long term debt obligations minus excess cash), and minority interests.
Book Value of $12.79 per share in January 2012 = $11.75 Net Operating Assets per Share – (-$1.33) Net Financial Obligations per Share - $0.29 Minority Interest per Share. See Footnote for Details
Comparing the corporation’s operational result (post tax operating income) to its net operating assets yields the annual return on net operating assets:
A corporation’s return on core operating assets tend to diminish over the long run due to natural competitive forces and the law of big numbers – it becomes increasingly difficult to generate the same percentage return on a base of assets that is continuously growing. Although Guess’ return on net operating assets has decreased from 33.7% in 2007 to 25.0% in 2011, the excess return (defined by charging a 12% cost of capital to the return) is actually growing. The excess return (see footnote) per year is as follows:
Residual earnings per share in 2011 was affected by one time charge of $19.5 million, or 21.2 cents per share. Residual earnings per share would be $1.74 if these charges were added back.
Additional value to the $12.79 per share in the known book assets should be considered due to the corporation’s historic above-average earnings potential. What implications does the market make with its current price of $24.50?
Market Price = Net Operating Assets per Share – Net Financial Obligations per Share – Minority Interest per Share + Residual Earnings Per Share/((1 + 12%)*(12% - Growth Rate))
$24.50 = $11.75 – (-$1.33) - $0.29 + ($1.53)/((1.12)*(0.12 – G))
Implied Growth Rate = 0.3%
The market has become so pessimistic on Guess stock that the current price of $24.50/share implies no growth potential for the corporation’s excess earnings generation. This is despite the fact that not only has Guess historically generated residual earnings on core operating assets through efficient asset utilization, but it has also had a history of growing those earnings over the long run. Residual earnings per share grew nearly 20% between 2007 and 2011 fiscal years, and even with the operational inefficiencies being experienced in the European market, Guess is continually building a hedge with an increased presence in emerging markets. If a modest long-term growth rate of 5% is assumed (using calculations above), Guess is likely worth slightly north of $30 per share, or a 30% price appreciation potential.
Even at $32 per share price target, Guess would be selling for around 10.6x next year’s earnings, which is still a conservative estimate compared to the average forward P/E of 12.8x for Gap, Ralph Lauren, and Abercrombie and Fitch. Despite the corporation’s issues in its core European market, it has shown its growth ability to continually grow its top line, free cash flow, and excess earnings per share. Most importantly, the market has become so pessimistic on Guess’ European ailments, and has not placed enough positive emphasis on its growth in the Asia market, that the stock is now in value territory.
Net Operating Assets = (Total Assets – Financial Assets) – (Total Liabilities – Financial Liabilities)
Return on Net Operating Assets = Post Tax Operating Income / Average Net Operating Assets
Net Financial Obligations = Short and Long Borrowings – Excess Cash (defined as anything greater than 5% of the year’s sales)
Residual Operating Income = (Return on Net Operating Assets – 12% Cost of Capital) * (Average Net Operating Assets)
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