September Quarter Earnings Previews Expect Resilient 3Q Results; Cautious 4Q Outlook
Our September quarter earnings season officially begins Monday, October 24th with VF Corp. This earnings preview covers seven companies (ATX, BDE, ELY, HBI, JAH, SKUL, VFC) reporting September quarter results in the coming weeks. Overall we expect 3Q results will be relatively unharmed by the recent torrent of negative news flow on the global economy. However, we expect this negative sentiment will seep into 4Q guidance and potentially mute 4Q earnings upside potential.
In this report, we outline our view on five industry topics which will influence sector performance including the U.S. consumer, international exposure, currency, cotton and inventories. Overall, data points remained mixed, but not indicative of any material weakness in our space. On the contrary, reports from high-quality companies such as Nike and Wolverine World Wide support our view that well positioned companies can still deliver impressive results.
As evidenced by solid September sales trends, consumer spending remains on track in the U.S. supporting healthy sell-through for many of our brand vendors. Active lifestyle inventories continue to be a source of concern, having materially outpaced revenue growth in 2Q (up 35% versus revenue up 16%). Cotton prices have held around $1.00/lb since July, meaning we should begin to see product cost pressures abate by 2H12. Dollar appreciation in September due to European debt fears means that currency will be a headwind in 4Q (based on current rates).
The Active Lifestyle universe continues to outperform the S&P 500 year-to-date; however, the difference between the haves and have-nots continues to widen. Our thesis remains stick with high-quality names that have company specific growth drivers, defensible margin structures and a track record of creating shareholder value. Out top picks remain HBI, VFC and ZUMZ.
INDUSTRY HEADWINDS/TAILWINDS
U.S. Consumer is Holding Up
Stock market tumbles, European concerns grow, but U.S. retail sales trends appear unfazed for now. Over the last three months stagnate job market news, weak housing and stock markets, and Europe’s debt woes have plagued the news. While there have been pockets of weakness, same store sales trends have largely demonstrated that consumer spending patterns are relatively unchanged. September same store sales were up 5.8%, as measured by Retail Metrics, with 63% of companies beating estimates, suggesting that consumers are willing to spend on compelling product. We continue to believe this choppy economic picture will drive sharp differences between the winners and losers as we move into 3Q earnings season and the holiday outlook.
International Exposure: Risk or Opportunity?
With growing concerns around a European recession and a Chinese slowdown, revenue exposure by region will prove important to 2012 growth prospects. For most active lifestyle companies, Asia is a small percent of total sales, but an outsized portion of future growth prospects. Europe is, on average, the second largest market for our coverage universe (behind the U.S.) in terms of revenues and in many cases carries higher margins than domestic sales. With both of these regions at risk of slowing, we believe regional sales exposure will be an important factor to consider as companies begin to outline initial 2012 expectations.
Dollar Appreciation is a Headwind in 4Q
Steep dollar appreciation in September shifts currency to a year-over-year headwind in 4Q. Driven by European debt fears, the dollar materially appreciated versus most currencies in September, quickly erasing the currency tailwind most companies in our coverage universe have been experiencing.
Current guidance likely has aggressive currency assumptions relative to current exchange rates. The U.S. dollar has strengthened against key currencies with the exception of the Japanese Yen. Given the appreciation in the dollar occurred after the 2Q earnings conference call season, many currency assumptions baked into existing guidance could prove slightly aggressive. For example, VFC’s guidance assumes a USD/EUR exchange of $1.35 versus the current $1.34 rate.
Cotton Stabilizing Around $1.00/lb.
Global cotton production appears in balance with demand, despite Southwest drought conditions. Since peaking above $2.15/lb. in March 2011, cotton prices have fallen over 50% with the December 2011 futures trading around $1.00/lb. Improving supply coupled with weakening demand appear to be the primary contributors to this rapid price correction. According to the most recent USDA cotton report, global cotton inventories are expected to rise for the first time in two years, helping to restore supply/demand equilibrium to the cotton market.
While current cotton prices will bring product cost relief in the 2H12, it is important to remember that cotton costs will continue to be a headwind for the next four quarters (3Q11 to 2Q12). The early response from consumers to modestly higher price points has been encouraging, with minimal impact to unit volumes. However, it remains to be seen how consumers will react to steeper price increases currently being implemented in the context of an anemic economic environment.
Inventory Levels Remain Elevated
For this section, we define the Active Lifestyle apparel and footwear universe as 14 companies including: Quiksilver, Columbia Sportswear, V.F. Corporation, Under Armour, Wolverine World Wide, Deckers Outdoor, Crocs, Nike, Rocky Brands, Skechers USA, K-Swiss, LaCrosse Footwear, adidas AG, and Puma AG.
Active lifestyle inventory continues to look bloated, especially in light of a slowing economy. Exiting 2Q, Active lifestyle inventories were up 35% year-over-year, compared to 16% revenue growth in the quarter. Inventory growth has outpaced revenue growth since 4Q10.
Reasons for higher inventory levels include: 1) unusually light inventory levels in 2Q10 affecting comparisons, 2) higher product costs, 3) early receipt of products given manufacturing capacity constraints earlier in the year, and 4) order books suggesting continued positive momentum. While many of these reasons are legitimate, we believe current inventory levels could prove problematic if consumer spending materially slows from current levels. This problem would be exacerbated by the fact that it would coincide with peak cotton cost inventory flowing through the P&L (excess inventory of high cost product). If U.S. consumer spending slows, we believe excess inventory would drive increased promotional activity and pressure 4Q margins.
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