Description

LONG: Guess (NYSE: GES)
Price Target: $30.21 (41%)

Executive Summary:

I believe Guess it is being priced as if it is a business in structural decline, despite a promising return to profitability. Years of strategic and operational change have set this business up to succeed in the long term. If that’s too difficult to underwrite- 4.27x EV/EBIT is grossly inappropriate for a business that is not shrinking, is profitable, and has steady revenues.

My thesis is as follows:

1. Margins have sustainably improved under the tenure of the new CEO, this isn’t short-term outperformance.
2.  
3. The business has robust capital allocation and management with aligned incentives.

If this writeup is insufficient, or you simply don’t trust it and want to have a look yourself, here are the core questions I believe an investor should be asking- and things to keep in mind for this writeup:

1. Are this business’ margins sustainable, and not just temporary overearning?
2. Will revenues materially shrink?

If you are satisfied with the answers to these, you have a robust margin of safety, and any growth initiatives are a cherry on top.

History:

The company was founded in 1981 by the four Marciano brothers, and initially started as a book of styles, before selling jeans. The company also licensed its brand out to sell accessories and later expanded to tops, shoes, kids’ clothes, and women’s clothes. The brand established its position in the cultural zeitgeist through prominent models being the “face of the brand” and product placement throughout the 80s and 90s. Under CEO Paul Marciano’s leadership, the business aggressively expanded in the 2000s/early 2010s, growing EBIT at 24% and revenues at 10%, before profits evaporated in the face of a “weak consumer” but likely more to do with over-expansion. As a result, in 2015 Paul Marciano was replaced by Victor Herrero, who saw little success in improving operating margins, despite returning the business to growth by 2019. Herrero gave way to Carlos Alberini, in 2019- which is where we pick up this pitch- as he presented a new global strategy.

Thesis 1: Margins have improved sustainably under the new CEO- this is not temporary.

Mr. Alberini’s plan focused on changing marketing strategy to attract Gen Z customers (who from my understanding have less knowledge of Guess), omnichannel distribution (a requirement of a modern clothing business rather than an impressive strategy in my view), optimising store footprint, and “functional capabilities”, which I took to be a new form of corporate doublespeak advocating for operational improvements/streamlining. Let’s focus on the latter two.

Looking at store count since 2019- it’s clear that underperforming stores were shuttered, noting that the below includes new stores being opened too. This process was accelerated by Covid- but seems to be a persisting trend. Note that the below includes both wholesale and directly operated retail stores. Operated retail stores have reduced from 1,174 in 2019 to 1,002 in 2024. This may be taken as an indicator that management has been actively reviewing its store base.

Let’s look at costs. Throughout the last 5 years, COGS as a % of sales have come down, while Opex as a % of costs has been flat to up slightly. COGS include distribution costs (incl. labour), freight charges, purchasing costs, overheads related to supplying inventory to store locations, and retail store occupancy costs. Improvements in distribution, store efficiency, and removing underperforming stores, has likely expanded gross margins- suggesting that improvements may be persistent rather than transitory.  Looking at the 2022 report- expanded margins were linked to lower store occupancy costs, and higher markups.

Looking at SG&A- the line item includes store selling (incl. labour), selling and merchandising, advertising, design, corporate overheads, legal fees, and wholesale distribution costs. Looking at these over the last few years- there have been some interesting legal costs to do with activist defence (more on this later), transaction costs from the acquisition of rag & bones, and one off infrastructure improvements like installing Salesforce. The persistent pressures will be increased store labour costs due to inflation ($39m in 2024), and an increase in performance based executive pay. Advertising has been roughly flat ($49.9m, $51.5m, and $48.5m yearly), and corporate overheads have been approximately flat for the last 3 years, but up from 2017.

The corporate overhead expansion from 2022 may well be attributable to a) increased legal costs(2022), b) the end of Covid era subsidies(2024), c) increased transaction costs, d) increased corporate staff costs due to inflation e) higher performance-based compensation. I’d presume there is some fat to cut from here, but this isn’t a thesis killer in my view. Some of the margin expansion (160 bips in 2024) is due to improved product mix, which can wane if there is a broader economic downturn.

This gives me the conviction to say that there have likely been improvements in the business’ efficiency due to the CEO’s focus on improving margins. The net effect can be seen in this graph:

If you believe this is persistent- you have a bargain business on your hands. Just a note on further improvements from the business- management has guided to improving working capital efficiency over the next financial year- viewing this as an area for improvement. This means we could see improving cash conversion on top of continued operational performance.

Thesis 2:  Future growth opportunities

This section of the writeup is a bit more hand-waving, I can’t give numerical guidance as to how each growth initiative will contribute to the bottom line and am more trying to show that the revenues are unlikely to shrink over the long term.

Firstly, there was a recent acquisition of rag & bone for $57.1m. It’s an interesting deal where Guess acquired all the operating assets and 50% of the IP, with the other 50% acquired by WHP Global- who are a licensor of brands including Toys R Us and Anne Klein. I know incredibly little about the brand (I suspect I’m not the target audience), but the strategy seems to be to run the brand in as decentralised a manner as possible- with Guess licensing designs to distribute through their channels, but with creative agency left to the team at rag & bone. WHP Global seems to make intelligent use of brand partnerships to expand their businesses, (e.g. partnering with Kohls to sell Babies “R” Us products, and Partnerships with WH Smith for Toys R Us). There seems little reason to think that the brand’s reach won’t be developed further by WHP executing further on this strategy and can be seen as another source of potential topline growth. However, I couldn’t find revenue figures for rag & bone, so I can’t comment on the impact.

This is Guess’ first major acquisition, and if successful, could provide a road to future sources of growth.

On an organic front, the company is launching Guess Jeans this year to grow further with Gen Z consumers. Guess commands a shockingly low share of the Gen Z market, for which I am using its measly 334,000 Tik Tok followers as a proxy- putting it behind H&M at 441k, and Uniqlo at 1m.  I’m not suggesting that Guess is going to rapidly capture share among these consumers- but highlighting that there are organic growth pursuits the business can undertake that should prevent structural decline. Revenues have been stable to growing over the last 5 years, suggesting that the business is not in structural decline and heading for obsolescence, with management guiding for their first year exceeding $3bn in revenues.

I hope the revenue chart above, and the potential levers for growth highlighted, can give you some conviction to understand this business isn’t in structural decline.

Thesis 3: Robust capital allocation and aligned incentives.

Improving margins and growth is meaningless without intelligent capital allocation. I believe Guess has demonstrated they will be responsible with your capital.

Returning Capital

The company’s shares outstanding have reduced by 36% since 2017 (basic, not diluted. Much of the dilution is from the issuance of convertibles- which are hedged through buybacks and warrants).  In 2019 and 2022 the company bought back 20% and 14% of their shares outstanding through “accelerated share repurchases”, and the company issued a $2.25 special dividend in May. The business sits at a well covered 5.68% dividend yield, and has demonstrated its habit of returning capital to shareholders.  A further $200m share buyback was launched this year- representing just under 20% of the float. While most businesses approve these repurchase programs, execute incredibly slowly, Guess has a track record of cannibalising its share count.

 Improving ROIC

Before 2019- there was no mention of ROIC in any annual report, before shifting to making this a major focus for the way the business allocates capital- “we will focus on strategic significance and return on invested capital.”  This has culminated in a rising return on invested capital as seen below. Reports are including more shareholder friendly language, with 2023 including “High margin, profitable businesses” and “free cash flow generation”. While anyone can say it- it’s clear that Guess has been doing it.

Why it will continue:

Directors and executives own a whopping 30.3 % of diluted shares outstanding. Importantly, the CEO  owns 2,433,251 shares, or 4.5% of all shares outstanding- while cofounder Paul Marciano (also the Chief Creative Officer owns 13,465,180 shares (25%). Clearly, the CEO is heavily aligned and is an owner alongside us. He is also on the board (and formerly CEO) of Restoration Hardware. From what I can tell, his holdings in Guess and restoration hardware are the majority of his net worth (with more invested in Guess). Their performance based compensation is tied to total shareholder return- vesting based on which percentile of stock returns the company sits in. I don’t think (in this case) this causes issues of a TSR expecations treadmill as as the stock has frankly performed pretty poorly. 

However- it is worth noting that I think there are governance issues in the form of Mr. Paul Marciano’s place as Chief Creative Officer, and the benefits he is granted. The table below paints a pretty stark image of compensation between a CEO and CCO. The CCO has been granted ~3% of the company’s market capitalisation in compensation, as the stock has languished for 5 years.

The proxy materials contain eyesores such as $3.8m in private jet travel for the Marcianos, and the company hiring Paul Marciano’s son for $355,000 last year. This gets even more nauseating when you see Guess is a co-investor in a footwear company with the Marcianos that it also extends a $5m line of credit. I believe this dodgy element of governance is part of the reason for persistent mispricing in the stock. While awful- Mr. Alberini is well aligned and seems to be the leadership the business has sorely needed.

Valuation:

Please find my base case valuation below.

I Believe this section alone demonstrates just how cheap the business is. Trading at 4.3x EBIT suggests that a business would have to rapidly deteriorate in short order to prevent you from recuperating your capital.

I believe the above valuation is conservative for several reasons. Firstly- while management and the sell-side have suggested potentially weaker margins over the next year due to US consumer weakness, I have suggested that margins are going to structurally reduce over time- giving little credence to the structural improvements in the business (sell-side targets LT. margins of 8.5%).  Furthermore, while management guides to $3bn in revenues this year, I suggest this takes them 3 years more to achieve, giving the business very little top-line growth, and simply suggesting the business doesn’t enter decline.  You may note that our cash flow projection is above management’s guide- the major reason is that I modelled in no growth throughout this model- and therefor the business shows no growth capex- despite growth initiatives and investment in rag & bones (it would not make sense to include this as Capex but not reflect it in the top line).  I also show no improvements in DSO, DPO, DIO, despite management targeting this for efficiency gains.

Another way to understand how cheap this stock is, is to look at distributions of capital historically.

I would suggest your downside is well protected, with the business likely to repurchase an appreciable percentage of the business.  

Risks:

Sell-side is modelling in poor US performance, thereby compressing margins, particularly since the market threw something of a fit over a “hard landing”.  I believe this could cause short term headwinds to this investment- but we can expect this to dissipate as the US consumer returns to strength. This is something management is aware of- addressing it in their Q1 earnings call, and something they’ve likely factored into their full-year guidance. Given that it isn’t a persisting issue, and it is the main warning given by sell-side, I don’t understand why the stock is priced as if it is in structural decline. The model shows declining long-term margins, little revenue growth, and is still ahead of the current price.  

Dodgy governance/founders. This is why an activist engaged with the company in 2022. Notably, the CCO has had 11 accusations of sexual misconduct made against him in 2018, which were “investigated” by external counsel before he returned to his post. Beyond this, the related party transactions and sky-high compensation post risk to this thesis as founders could use the firm as their piggy bank. I believe that the CEO’s alignment with shareholders and long-term vision for the company mitigate this to some extent, it remains a risk to monitor.

As part of these governance issues- we have seen the churn of 2 CFOs in as many years. The most recent departure is taking a new role to be “closer to his family”. This is something of a red flag and caused the stock to drop by 4% on announcement. When the replacement is announced, this is something to monitor, to ensure this isn’t a systemic issue with the company.

Conclusion:

As the CEO put it- Guess is at an inflection- returning to profitability and looking forwards towards growth. Usually when businesses experience inflections in their ROIC and have a path to grow while returning capital to shareholders, the share price appreciates handsomely, but the market is perhaps too concerned by short-term consumer appetite concerns.

Appendix:

Sensitivity Analysis:

Bull case:

• I think the bull case is not taxing on the imagination. My margins are in line with LT. sell-side assumptions, with weakness this year due to economic headwinds.
• I still project slower revenue growth than management, with the business taking 2 years to break $3bn in revenues.
• I project working capital improvements in line with management’s aims, but these are relatively minor relative to historical swings.
• I still project a 7x EBIT multiple for the multiple exit method.

Bear Case:

• The business is significantly deteriorating here. I set PGR to 0, margins all but collapse, I have the exit at the same multiple as it trades at today (it’s difficult to justify compressing past 4.32x)

Catalyst

- Continued share buybacks

- Further ordinary and special dividends

- Margin expansion due to persistent profitability