Don’t Let Europe’s Woes Cause You to Second Guess This Cheap Retailer

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For the most part I like to follow Peter Lynch’s philosophy of buying what I know.  It doesn’t work on every occasion but it’s served me well over the years.  One sector that I’ve found I have difficulty investing in is retail, especially anything involving fashion.  Clothes just don’t interest me and I’m about the farthest thing from a fashonista as you’ll find.   

What I do know is that a lot of money is spent on fashion and I need to be on the other end of that process.  Seeing that I’m not likely to pick a fashion winner, I’m better off trying my luck scrounging around the bargain bin.  That’s exactly where I’ve found shares of Guess (NYSE: GES) and their discounted stock which sells at just ten times earnings and under seven times cash flow.  That bargain basement price is a great starting point and enough to entice me to add the company to my virtual “No Drip, No Mess” Portfolio.  Take a look at how they compare to some of their peers:

<table> <tbody> <tr> <td> </td> <td>Market Cap</td> <td>Dividend Yield</td> <td>P/E Ratio</td> <td>Cash (last quarter)</td> <td>Debt</td> <td>Stores</td> <td>Price to Cash Flow</td> <td>5-yr sales growth</td> <td>Sales Last Year</td> </tr> <tr> <td><strong>Buckle</strong> <span class="ticker" data-id="202961">(NYSE: <a href="">BKE</a>)</span></td> <td>$2.2 Bil</td> <td>1.80%</td> <td>13.5</td> <td>$166 Mil</td> <td>$0</td> <td>400</td> <td>10.9</td> <td>12.60%</td> <td>$1.06 Bil</td> </tr> <tr> <td>Guess</td> <td>$2.2 Bil</td> <td>3.10%</td> <td>10</td> <td>$271.9 Mil</td> <td>$0</td> <td>1595</td> <td>6.9</td> <td>9.04%</td> <td>$2.69 Bil</td> </tr> <tr> <td><strong>Ascena</strong> <span class="ticker" data-id="224874">(NASDAQ: <a href="">ASNA</a>)</span></td> <td>$3.3 Bil</td> <td>0.00%</td> <td>19.4</td> <td>$164.3 Mil</td> <td>$332.4 Mil</td> <td>2487</td> <td>12.1</td> <td>21.59%</td> <td>$3.35 Bil</td> </tr> <tr> <td><strong>Aeropostale</strong> <span class="ticker" data-id="202847">(NYSE: <a href="">ARO</a>)</span></td> <td>$1.1 Bil</td> <td>0.00%</td> <td>17.8</td> <td>$169.6 Mil</td> <td>$0</td> <td>2011</td> <td>9.2</td> <td>9.55%</td> <td>$2.34 Bil</td> </tr> <tr> <td><strong>Abercrombie & Fitch</strong> <span class="ticker" data-id="202820">(NYSE: <a href="">ANF</a>)</span></td> <td>$2.8 Bil</td> <td>2.10%</td> <td>30.5</td> <td>$312.2 Mil</td> <td>$0</td> <td>1050</td> <td>10.2</td> <td>2.48%</td> <td>$4.16 Bil</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td>18.24</td> <td> </td> <td> </td> <td>1508.6</td> <td>9.86</td> <td> </td> <td> </td> </tr> </tbody> </table>

 So Why is Guess Cheap?

The company designs, markets, distributes and licenses both apparel and accessories which combine European fashion with American lifestyle.  They do this through their three main brands: Guess, Guess by Marciano and G by Guess.  Each brand has a slightly different target market and price point.  Together they generate excellent cash flow as you can see from this chart found in their latest investor slide deck:

<img src="/media/images/user_12784/guess_large.jpg" />

What you’ll also notice from that chart is that income and cash flow grew quickly from 2005 to 2008 and has leveled off the past three years.  That leveling off is explained by their margins which grew until 2008 and have now begun to contract:


<img src="/media/images/user_12784/guess2_large.jpg" />

As you can see over the past decade they’ve grown their revenue from around $600 million in 2003 to $2.6 billion this year.  This leveling off of earnings and contraction in margins has caused shares to halt their ascent.  Combine their European exposure (at 37% of sales) with the overall malaise of the global economy and there is no surprise that shares have dropped more than 50% since their peak in 2008. 

Despite stagnating profits the company is getting cheaper by the day and the plunge in their shares is only part of the bargain.  Guess is retuning a bulk of their free cash back to shareholders by buying back their bargain priced shares.  They recently announced a new $500 million dollar repurchase authorization as they’ve expanded their buying binge after spending their previous $250 million authorization from a year ago.  When you consider that the company as a whole is debt free and has a market cap of just over $2 billion that’s a lot of shares that they have they have the potential to take out.  They complement the buyback by paying a very fashionable 3.14% dividend yield.

The company is selling cheaply, but is there value or am I just falling for a value trap?  They have a strong global brand, diversified revenue stream and a plan to grow store count by 45% over the next five years.  While margins are contracting, part of that is due to their increased marketing spend to further strengthen their brand.  Like I said before, I know nothing about fashion, but their management team does and you're getting that experience for a fire sale price. 

The Trade:

While I think Guess is cheap, as I’ve learned over the time I’ve personally owned their shares, they can get even cheaper.  That’s why I’m going to start with a 2.5% allocation for the “No Drip, No Mess” Portfolio and write slightly out of the money puts.  In this case I’m write one December $25 put which recently could be written for $175.  That is an option yield of seven percent to go with their more than three percent dividend.  I'll take that income any day and will likely continue to write options on the name if I can keep that income stream going. 

Risks and Why Sell?

Guess continues to invest more than $100 million each year in capex with some of that devoted to building new stores.  Currently they have 1,600 stores and plan in increase that count to about 2,300 in the next five years.  If new stores are not adding to earnings it would be a waste of shareholder capital. 

Finally, if Europe plunges the rest of the world into another deep recession it could put further pressure on the shares.  However, the company is debt free and cash flow positive while their shares are cheap and they pay a dividend that can be sustained and grown over time.   I think that now’s not the time to let European worries cause you to second guess this cheap retailer.

latimerburned owns shares of Guess?. The Motley Fool owns shares of Aeropostale, The Buckle, and Guess?. Motley Fool newsletter services recommend Guess? and The Buckle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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