Despite a steady drumbeat of doom and gloom (it's an election year after all), investors haven't needed much coaxing to buy up retail and apparel stocks this year. PVH (NYSE:PVH) has a lot going for it, including two well-known brands that seem capable of defying gravity in Europe, but the stock's performance has already more than doubled that of the S&P 500 over the trailing year. While the company does seem to have operating momentum on its side, valuation already presumes a lot of things go right for this company.
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Q2 Results All Dressed Up
PVH did pretty much all it was asked to do in the second quarter, and a little more. Likewise, the company married solid performance with good guidance, and pre-open trading suggests that the market likes what it heard.

Revenue barely rose at all this quarter, and PVH did very slightly miss the average sell-side guess, but Wall Street is not likely to care too much. Calvin Klein sales were up nearly 5% this quarter, and Tommy Hilfiger was surprisingly strong as sales rose nearly 10% in constant currency, with very strong European growth (including double-digit retail comps). Heritage brands were the disappointment, as sales fell almost 10%, but the Street is likely to forgive the fact that a lot of this underperformance stems from businesses that the company is exiting.

Sales may have been a little light, but PVH more than made up for it in margins. Gross margin improved more than a full point from last year, whereas most analysts expected flat performance. Operating income likewise outperformed, rising 2%, even if the company spent a bit more on SG&A than assumed.

SEE: Understanding The Income Statement

Plenty of Noise from Retailers
I can appreciate why investors may reward PVH for its relatively reliable performance in an otherwise unstable retail world. Although VF Corp (NYSE:VFC) has been logging solid numbers, growth has been a little more erratic for designers and manufacturers like Columbia Sportswear (Nasdaq:COLM) and Warnaco (NYSE:WRC).

Likewise, the end market data is unsettled. Comps at J.C. Penney (NYSE:JCP) haven't looked great, nor have those at Kohl's (NYSE:KSS), but Macy's (NYSE:M) is doing a little better. With over half of its sales still going to department stores, that's not trivial for PVH. At the same time, looking only at headline comps can be quite misleading - a negative number at Kohl's (to use just one example) does not mean that the sales were down uniformly across the board; apparel might be strong while footwear is weak, or likewise a certain collection of brands can be strong even if the overall numbers aren't strong.

What's the Long-Term Steady State?
PVH isn't an especially easy stock to evaluate right now, in large part because I don't think recently-reported numbers give the true long-term picture. For example, trailing return on assets and invested capital doesn't look all that special (and doesn't seem to show much real brand value), but the company has done much better in the past. Likewise, while the trailing sales and free cash flow growth over the past decade looks great (in the high teens), the underlying growth isn't at that level.

SEE: 5 Must-Have Metrics For Value Investors

The company's large acquisition of Tommy Hilfiger back in 2010 has a lot to do with this. A lot changed almost overnight in terms of margins, cash flow and returns on capital. Management is digesting that deal, though, and numbers are already heading back in the right direction. The question, then, is whether another year or two will see the company reclaim past levels of performance in areas like free cash flow conversion.

The Bottom Line
At this point, I don't really doubt that PVH will reattain past levels of performance. To that end, I'm not uncomfortable predicting high single-digit free cash flow conversion rates, even though that represents a pretty significant improvement from current levels. Likewise, I'm not all that troubled giving the company the benefit of the doubt and awarding a better discount rate "on spec" on the basis that returns on capital should improve.

All of that said, favorable assumptions still don't make these shares cheap. Assuming mid-single-digit revenue growth and solid high single-digit free cash flow margin isn't enough to produce an attractive fair value, largely because of the sizable debt position of the company. Likewise, that debt is likely to constrain the company's options when it comes to share buybacks, dividends and additional deals. So while I do think PVH is a strong, quality company in a tough business, I think these shares need to go on sale before I step up to buy.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

Tickers in this Article: PVH, VFC, KSS, JCP

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