Summary

Q1 operating results, negatively received, had decent underlying trends.

Q2 sales growth has accelerated, EPS upside likely.

Valuation at 3.5x TTM EV/EBITDA is cheap relative to peers and history.

The decline in retail apparel stocks this year has been widespread, with valuation multiple contractions hurting even the better-operating retailers. I believe unseasonable weather has played a part, but that the crux of the sell-off has been the turmoil being created by the continued shift by consumers to online purchasing and the resulting reduced traffic at majority of shopping malls and centers. The pressure on retail stocks has been exacerbated by large retail store closures (i.e., Gymboree) that contribute to the fearful environment, recent acquisitions in retail that create a greater competitive urgency (i.e., Amazon (NASDAQ:AMZN) to acquire Whole Foods (NYSE: WFM), Wal-Mart (NYSE:WMT) buying several online apparel retailers including its most recent, Bonobos) and new ventures in apparel retailing by Amazon (i.e., Prime Wardrobe, Echo Look).

This article will not argue what the ultimate outcome of the current upheaval will be. However, I do believe some of these changes are actually healthy for the industry, such as the closing of stores in this overcrowded marketplace and improved lease terms, both rate and length, that retailers are getting. I believe there will ultimately be some clear winners across the retail landscape when the dust settles.

Meanwhile, some indiscriminate selling of apparel retailers has created relative values for a long-term investor or for pair trading. One stock I think has become particularly attractive is the action sports retailer Zumiez (NYSE: ZUMZ). Q1 financial results, which got a negative reaction from the market, had some solid underlying trends and sales reported since then (May and June) have improved. I believe the company could exceed the current consensus 2017 earnings forecasts, particularly in Q4’17. Trading at $12.50, the stock is cheap at only 3.5x trailing twelve month (TTM) Enterprise Value (EV) to earnings before interest taxes and amortization (EBITDA).

Q1 EPS Was Negatively Impacted By Several Non-Operating Or Fixable Issues. Zumiez reported Q1 financial results last month (June 1) that included GAAP EPS of ($0.18), $0.01 better than the consensus forecast and towards the high end of guidance of ($0.17)-($0.21). While this compared negatively to a loss of ($0.08) the year before (Q1’16), a closer look at the factors driving the earnings decline shows some temporary factors that are fixable or should dissipate as the year progresses.

  • Taxes – The implementation of new tax accounting rules related to equity compensation reduced Q1 EPS by $0.02. This is a non-cash charge and one that most retailers have been highlighting or excluding completely from pro forma EPS.
  • Shrink – Higher shrink was a 50-bp drag on gross margins in Q1 (approximately a $900,000 increase in COGS) and an estimated $0.02 drag on EPS. Per a National Retail Federation (NRF) survey, shrink increased to 1.44% of total retail sales in 2016, up from 1.38% in 2015. Having said that, in my experience it’s unusual for an apparel retailer to call out shrink as a major (50 bp) issue for any given quarter. The good news is that shrink is controllable and, according to the company, the problem causing the shrink has been identified and corrective actions have been taken. Shrink will be less of a drag on margins in Q3 and Q4 and should be mostly, if not fully, recovered in 2018, providing up to a $0.08 boost to EPS (9% of 2016 consensus EPS forecast).
  • Currency – In Q1’17, I estimate changes in foreign currency exchange rates were roughly a 50-bp drag on sales Y/Y and an approximate $0.01 drag on EPS. However, based on the current exchange rate average for the quarter (the 1.12 USD/euro in particular), foreign currency should be a relatively neutral factor for Zumiez’s revenue and earnings in Q2 and Q3 and could add 50 bps to Q4’s revenues and $0.02 to EPS.
  • Incentive compensation – Despite a decline in operating profits and EPS, Zumiez accrued higher incentive compensation in Q1’17 vs. Q1’16. The result was an additional 30-bp drag to operating margins and an approximate $0.01 drag on EPS. While the company has not disclosed what metrics it uses in determining incentive comp, I believe it’s reasonable to assume the plan takes into account at a minimum its public 2017 financial guidance for an increase in same…