DBI - Guess Requires More Caution

Summary

• Guess continues to face some issues in the current environment, with sales and profits weakening.
• Digging deeper, sales are actually rising if you ignore foreign currency fluctuations, but this doesn't change the fact that bottom line figures have been volatile.
• Shares look cheap, but the uncertainty when it comes to cash flows, combined with broader economic concerns, warrants caution.

As a rule of thumb, I tend to stay away from companies involved in the production and/or sale of clothing, accessories, and other fashion-oriented products. This is because the space is highly susceptible to sudden changes in consumer sentiment and competition amongst competitors can be fierce. But every so often, I will come across a firm that makes me make an exception. One example of this from last year that I would like to point to that played out well involves a company called Guess ( GES ). Although fundamental performance achieved by the company has been rather mixed, shares of the business looked to be trading on the cheap. The fact that shares were as cheap as they were ultimately led me to rate the company a ‘buy’ to reflect my view that the stock should outperform the broader market for the foreseeable future. Fast forward to today though, and while I do acknowledge that shares are still quite affordable, I am taking a more cautious approach when it comes to the enterprise. Recent financial performance, combined with uncertain market conditions, all combined with a nice increase in share price, has made me downgrade the stock to a ‘hold’ for now.

Mixed financials are a problem

Back in early June of 2022, I found myself taking a rather bullish stance in an article that I published about Guess. In that article , I talked about how the company had seen its financial performance improve over the prior few months, especially compared to the pain it experienced during the COVID-19 pandemic's worst days. I was also attracted by how cheap shares were. Even though I acknowledged that the company could be subject to volatility moving forward, I felt as though the reward well outweighed the risk. Ultimately, this led me to rate the company a ‘buy’, a decision that played out nicely. You see, since the publication of that article, shares of the company have generated a return for investors of 12.7%. This compares to the 6.8% decline experienced by the S&P 500 over the same window of time.

Interestingly, the company has held up so well despite the fact that fundamental data has been somewhat mixed. Consider the financial results from the first three quarters of its 2022 fiscal year. On the good side, sales for the company increased nicely, coming in at $1.87 billion. That's 4.4% higher than the $1.79 billion reported one year earlier. On a constant currency basis, the picture for the company would have been even better. Sales, in that case, would have increased roughly 14%. But because of foreign currency fluctuations, sales were negatively impacted to the tune of $170.1 million. Management attributed about 40% of the increase in constant currency revenue to higher wholesale revenue.

On the bottom line though, the company definitely experienced some pain. Net income, for instance, shrank from $102.9 million in the first nine months of 2021 to $53.8 million the same time of 2022. This was driven in large part by a 2.5% decline in the company's gross profit margin. This, management said, was driven by higher markdowns and the aforementioned unfavorable currency fluctuations. Other profitability metrics were also hit hard. Operating cash flow, for starters, dropped from $4.6 million to negative $21.4 million. But if we adjust for changes in working capital, it would have risen from $73.6 million to $165.4 million. Countering that to some degree, however, was the fact that EBITDA for the company declined from $224.5 million to $193.7 million.

Extreme variation in the company's financial data could also be seen in the third quarter on its own. In this case, sales did actually fall year over year, dropping from $643.7 million in 2021 to $633.4 million in 2022. This drop, according to management, was driven entirely by foreign currency fluctuations. In fact, on a constant currency basis, sales would have been up roughly 10% instead. Unfortunately, bottom line results for the company also worsened. A 3.2% decline in gross profit margin was instrumental in pushing net income for the company down from $29.9 million in the third quarter of 2021 to $21.8 million the same time of 2022. Operating cash flow surprisingly improved, climbing from negative $38.4 million to negative $22.9 million, while the adjusted figure for this went from negative $56.5 million to $58.1 million. But on the other hand, EBITDA once again moved in the opposite direction, declining from $83.4 million to $71.4 million.

When it comes to 2022 in its entirety, management is expecting continued volatility. On the whole, revenue should be up about 2% year over year. But on a constant currency basis, that number should have been 10.5%. Earnings per share, meanwhile, should be $2.35, translating to net income for the company of $157.7 million. In truth, valuing the company based on other metrics is going to be difficult given how extremely volatile they have been. But if we annualized results experienced so far in 2022, we would anticipate adjusted operating cash flow of $436.6 million and EBITDA of $299.5 million. To be very clear though, I don't have much faith in the adjusted operating cash flow multiple given the extreme volatility the company has demonstrated.

Based on these numbers, the company seems to be trading at a forward price to adjusted operating cash flow multiple of 2.7 and at a forward EV to EBITDA multiple of 5.2. These numbers compare to the 6.2 and 4.5 readings that we get, respectively, using data from 2021. As part of my analysis, I also compared the company to five similar enterprises. On a price-to-operating cash flow basis, these companies ranged from a low of 10.5 to a high of 36.1. No matter which data we use for the price to operating cash flow approach, Guess ends up being the cheapest of the group. And when it comes to the EV to EBITDA approach, the range was between 3.4 and 6.8. In this scenario, two of the five companies were cheaper than our prospect, while another one was tied with it.

Takeaway

From what I can see, foreign currency fluctuations are definitely a drag on the company. The fundamental picture would look a lot better if that weren't an issue. Having said that, bottom line results for the company seem incredibly mixed right now and economic uncertainty is growing. At the end of the day, I feel as though shares of the company are still undervalued and do offer additional upside. But given the changes we have seen since I last wrote about it, both with the firm and the economy, I believe that risk is now heightened. At the end of the day, this leads the conservative, value-oriented investor in me to rate the company a ‘hold’ instead of a ‘buy’. After all, I would prefer to underestimate a company's upside and be proven wrong than to take a rosy approach and end up being wrong in a painful way.

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