Wednesday, October 17, 2012

Can PVH Continue to Outperform?

Earnings reports come and go and with this season it’s largely been the same story from global retailers, with the US doing ok, emerging markets strong and Europe weaker. Customers are being cautious, orders are taking longer, etc. And then along comes PVH $PVH telling us that it generated same store sales growth of 15% in its strongest brand (Tommy Hilfiger) in Europe and guidance was raised. However revenues were flat overall but non-GAAP EPS was up 17%. So what is going on here and what can investors expect in the future from PVH?

Q2 Results

The key to these results is to recognize that earnings are largely dictated by Calvin Klein (CK) and Tommy Hilfiger (TH). In fact, they made up over 87% of earnings before interest and taxation.

TH earnings were up a whopping 29% as the company continues to generate operational efficiencies from the 2010 acquisition. Hilfiger revenues rose 4.1% overall and on a constant currency basis they were up 10%. As noted above, retail comparable same store sales grew 15% in Europe. However, I wouldn’t get too excited. Let’s recall that 70-75% of its business is in Northern Europe and the TH brand is very strong in Germany.

It was a more conventional story at Calvin Klein. Total revenues were up 4.7% but the strength was in North American retail. Asian sales grew 6% but Europe declined 10%. Management pointed to the weak performance at European apparel and underwear, which is run by Warnaco $WRC and licensing did well everywhere bar Europe. It’s easy to criticize Warnaco but remember that, for example, 70% of the CK jeans business in Europe is in Spain and Italy.

It’s not just Warnaco/PVH because VF Corp $VFC has also reported weaker results with its Wrangler and Lee brands in Europe. Similarly anecdotal evidence is suggesting that the Italian retail environment is following Spain over the cliff. That said, it’s a relatively small part of the business and management assured investors that trading in August for CK and TH was running at 8-9% versus the planned mid single digits.

The problem area is with the heritage brands. Overall sales were down 9.5% and EBIT margins are currently running at a paltry 6.4%. A major turnaround plan is in process here and PVH has exited some businesses (IZOD women’s and Timberland licensing) but it is going to take some time. Nor was the cause much helped by J.C. Penney $JCP reporting weak performance in the second quarter. J.C. Penney, Kohl’s and Macy’s $M are all key outlets for Heritage sales and investors should watch their numbers for a clue as to where PVH’s Heritage business is headed.

Going forward J.C. Penney is opening a substantial number of IZOD stores in order to turnaround disappointing performance and this augers well for PVH. Similarly, Macy’s is a key license partner and gives PVH good shop exposure as well as raising the brands cache. The idea is to get margins back up to the historical 10%, but this may take some time.

It's nice when your channel partners are pulling in the same direction.

Where Next For PVH?

Aside from the turnaround planned at Heritage, PVH is also undergoing some major changes in 2013. It is bringing its TH European men’s tailored apparel and CK European apparel and accessories in house in 2013. Naturally, the management is feeling bullish about this but I would suggest a note of caution here. I’ve previously seen fashion licensees try to extract the last mile out of a relationship by taking a ‘by any means necessary’ approach to driving sales growth. This does not always work out for the best for the license holder because some near term damage can be done to the brand in this process. It’s hard to say if Warnaco will do this or not but its something worth keeping an eye out for especially as the company is possibly a takeover target of PVH.

On that note, I would also expect some acquisition activity going forward. PVH is not shy about talking about its acquisitive nature and the TH purchase now seems to have been integrated. Moreover, debt has been repaid quicker than hoped after the TH deal and management is taking a ‘hard look’ at the acquisition landscape. Whether that means Warnaco or not is another story but many expect some activity from Q4 onwards.

PVH Worth Buying?

The stock has had a great run and it’s hard to argue that it is cheap right now. Its operating margins are lower than its peers but they could improve with a turnaround at Heritage. However, this is far from a done deal. Moreover fashion is fickle and the increasing reliance on TH is a concern. It is a brand that has had its issues in the past. For now the ‘affordable premium’ proposition that it offers is working well in the new age of austerity but, as Coach found out recently, when a competitor steps into your niche (in this case Michael Kors) things can get tougher. TH may aspire to be a brand like Hugo Boss but there is nothing to stop companies like the latter introducing cheaper product lines in order to react.

In a sense, I’m arguing that you need a margin of safety in an industry like this and I think there are cheaper options (VFC & Nordstrom) out there. I’m not sure that a forward PE of 15 or a low single digit free cash flow yield is enough to argue that the stock is cheap.