Has The Street Finally Overshot Brown Shoe?

By Stephen D. Simpson, CFA | August 27, 2013 AAA

It can take a few quarters for Wall Street to dial in its expectations when a company has started out/underperforming, and that's particularly true in cases of turnarounds. Brown Shoe (NYSE:BWS) enjoyed a good two-year run in the market as the company's turnaround/restructuring efforts paid off and as the company's outperformance reset the bar for expectations. While the company's second quarter results and guidance weren't bad as such, they would suggest that maybe the Street has finally caught up to the story and the momentum angle of outperforming expectations is no longer in play.

Solid Results, But Not As Strong As They May Appear
Brown Shoe had a pretty good fiscal second quarter, particularly relative to the carnage in the teen retailing space, but it wasn't quite as good as it may look at first.

Reported revenue rose 10%, which looks like a meaningful beat against the published average estimate. Results were boosted by an extra week in the quarter, though, and adjusted revenue growth of 6% was more or less in line with expectations. Comps at Famous Footwear were up nearly 7%, while the wholesale business saw double-digit growth in both the “Healthy” and “Contemporary” categories.

Brown Shoe also continues to make further progress with margins. Although wholesale margin improved only 20bp this quarter, overall gross margin improved about 70bp on an adjusted basis. Operating income shot up from last year (up 165%), with operating margin more than doubling.

It is worth noting, though, that core operating expenses were up about 9% this quarter and that bears watching for the next couple of quarters. On a more positive note, inventories rose only about 5% from the year-ago period (less both adjusted and reported sales growth), with about 3.4% growth at Famous Footwear.

Guidance Makes Things Complicated … Wall Street Hates Complicated
For an industry that boasts a lot of gilt-edged diplomas, Wall Street really doesn't like it when earnings or guidance get a little complicated. Unfortunately, because a week of back-to-school scales were recognized a quarter early, Brown Shoe's guidance gets a little noisy and complicated.

The bigger issue, though, would seem to be that the Street has caught up to the pace of the company's improvement. While management boosted EPS guidance for the year by about four cents at the midpoint, the top end of the new range is still below the prior average Street estimate and management used words like “realistic” and “cautious”. On the whole, Wall Street doesn't want realistic and cautious, it wants strong and ebullient.

Will A Tougher Market Suit Brown Shoe?
All things considered, I think Brown Show is doing okay. Rival DSW (NYSE:DSW) is up nicely today on its earnings report, but the company's “strong outlook” of 1% to 3% comp store growth isn't really that much different than the low-to-mid single-digit growth guidance from Brown Shoe, particularly relative to where analysts were before.

In any case, I would think Brown Shoe should be on relatively better footing in a difficult retail climate. Multiple retail earnings reports suggests shoppers are trimming back their spending, and that would seem to suit the company's market and price positioning. Along those lines, other retailers with a solid value or off-price reputation – including Ross Stores (Nasdaq:ROST) and Kohl's (NYSE:KSS) – appear to be doing relatively well in the market today.

The Bottom Line
Brown Shoe has already made quite a bit of progress in stabilizing and improving the business. Now I wonder how far management can ultimately drive those improvements. If you look at the sort of operating margin and free cash flow that comparables like DSW and Shoe Carnival (Nasdaq:SHOO), it's tempting to think Brown Shoe could have a long way yet to go. And while they certainly could, that opportunity has to be set against the reality that Brown Shoe's operating margins have always been below 4.5% over the past decade, while DSW and Shoe Carnival have had much higher levels of performance.

I'm going to start giving the company partial credit, bumping up my long-term free cash flow margin assumption to 4%. That works back to a fair value of around $21 today, and if 5% comes into range as as a credible target, the fair value could move beyond $26. That $21 target doesn't quite do the job today, but if management can lay out a stronger case for higher long-term margins and/or the pullback continues, these shares could get interesting relatively soon.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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