Description

PERY is a well established, reasonably diversified apparel retailer with a long track record of solid earnings and free cash flow that has become severely mispriced due to a recent earnings warning and corresponding credibility issues.  I believe that these concerns will prove temporary and once management has restored any hint of credibility, PERY’s stock price will be significantly higher.

While management is guiding to FY 1/12 EPS of $2.00 or higher, no one is giving the company the benefit of the doubt.  There is also some concern about the integration of the Rafaella acquisition, which was some of the reason for the earnings warning.  I have no idea if $2.00 in EPS is achievable in FY ’12 but I do know the following:

• PERY is consistently profitable.  PERY has generated positive net income every year since it went public in 1993.

• Average EPS since 2003 has been $1.30 and back in 2003, sales were ½ the levels of 2012.  PERY is selling for < 10x long-term average earnings.

• Cash flow is solid.  Since 2003, FCF has approximated 116% of Net Income.  Annually, the FCF/NI+D&A relationship is lumpy due to inventory changes. 

• Financial strength is adequate and management has never leveraged the business too aggressively.

BACKGROUND

Perry Ellis International began operations in 1967 as Supreme International Corporation with a focus on marketing men’s apparel products targeted at the Hispanic market in Florida and Puerto Rico.  Over time the company expanded its product line and its number of brands and went public in 1993.  In 1996, the company began a series of acquisition of brands and now is one of the leading apparel companies in the U.S., managing a portfolio of 34 brands, some of which were established over 100 years ago. Over 75% of sales are derived from the U.S.

Wholesale licensing accounts for 97% of sales, with retail comprising the remaining 3%.  Roughly 85% of sales are men’s sportwear products, with women and swimming accounting for the remaining 13%.  Largest customers include Kohl’s, Macys, TJ Maxx, Marshalls, Dillard’s, Sam’s and J.C. Penney.  The company believes that its relationships with many licensees reduces brand vulnerability and provides opportunities to grow sales and earnings while minimizing capex and execution risk.

PERY maintains a staff of designers, merchandisers and artists who are supported by a staff of design professionals.  The company’s in-house design staff designs substantially all of its products using advanced computer-aided design technology.

The company’s most important brand is its namesake brand, Perry Ellis, which are sold in upscale and major department stores and cater to higher income, professional men.

Rafaella acquisition.  In January 2011, PERY acquired the Rafaella brand.  Founded in 1982 (and previously owned by Cerberus Capital, a private equity fund), Rafaella is a leading designer of women’s sportwear, for $80mm.  The rationale for the deal was to extend product offering to additional retail customers and further penetrate the women’s apparel market, which is 3.5x larger than the men’s apparel market.

Key Drivers

Continued penetration with new licensees.

Acquisition of new brands.

Successful inroads into Hispanic and/or women’s apparel market.

Stated Business Strategy (per 10-K)

Continue to strengthen the competitive position and recognition of its brands.

Continue to diversify product line.

Pursue strategic acquisitions than leverage and enhance business.

Financial strength.  PERY senior subordinated debt is rated B+ and B2 (Stable) by S&P and Moody’s, respectively.  Liquidity appears very sound à PERY has cash of $21mm and access to over $115mm on its revolver.  The company has not material debt maturities until 2019.  Also, to further bolster liquidity and reduce debt (associated with the Rafaella acquisition), in March 2011, PERY issued 2.0mm new shares of stock at $28.00 per share.  PERY’s credit rating largely reflects PERY’s relatively narrow product focus (men’s sportwear) and the competitive climate in retail generally.  Attached herein are PERY’s credit write-ups. 

Valuation.  On an absolute valuation basis, PERY is selling for around 6x EPS, implying either that $2 in EPS is unsustainable or a prohibitely high risk premium.  The latter probably applies, and once the risk premium associated with owning PERY dampens over time, I believe PERY's valuation will migrate back to more normalized levels (P/E 10-14x, EV/EBITDA 5-7x), which implies 100-150% upside over time.  On a relative basis, PERY has significant appeal as well.  Oxford Industries, a U.S. and U.K. licensor of brands including Tommy Bahama, Lilly Pulitzer, Oxford Golf, etc, is arguably the closest “peer” for PERY.  Oxford’s business risk is not significantly lower than PERY’s, yet its valuation is significantly higher (across all metrics).  If PERY received OXM’s multiples, the stock would sell for $30 per share, or 140% higher.  Note that prior to PERY guiding down 2012 earnings, analyst targets were for $30-$36 per share, 2.5x – 3.0x the current quote. 

Where could we be wrong?

1)     If earnings misses continue.  As with all retailers, earnings can fall further and longer than many expect  Why is the market wrong?  I believe that stock price is already discounting further misses (which are not guaranteed to occur).   But the fact that PERY is a retailer and just warned is ample reason to “ease in” via a smaller (2.0% - 2.5%) position.   

2)     If acquisition integration issues continue to plague the company.  Why is the market wrong?  Same as above re: easing in as Rafaella may cause integration indigestion for another couple of quarters.

3)     If apparel consumer spending falls considerably.

Other Risks

Macro risk.  The worldwide apparel market is heavily influenced by general economic conditions.  

• Commodity price risk.  If cotton spikes again, margins could suffer. 

• Acquisition integration risk.  PERY has had some integration challenges with its Rafaella acquisition thus far and claims to be making the necessary adjustments to improve operations, but this is just an example of how large acquisitions can cause disruption.

• Increased buyer power among customers.  Kohl’s and Macy’s are 19% and 11% of PERY’s sales.  Sales to PERY’s top five customers accounts for 50% of sales.  The department store channel has consolidated into a smaller number of larger retailers.  PERY does not have long-term contracts with its customers and purchases generally occur on an order-by-order basis.   

• Sourcing risk.  84% of PERY’s products are produced in Asia. 

• Fashion risk.  As PERY increasingly moves into women’s apparel, fashion risk increases.

Catalyst