<FOOLISH WORKSHOP>

Margins Wear Well      

by Louis Corrigan (TMF Seymor)

Atlanta, GA. (March 16, 1999) -- Our Rising Margins screen gives us three interesting stocks: Men's Wearhouse <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SUIT)") else Response.Write("(Nasdaq: SUIT)") end if %>, AnnTaylor <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ANN)") else Response.Write("(NYSE: ANN)") end if %>, and Oracle <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ORCL)") else Response.Write("(Nasdaq: ORCL)") end if %>. Oracle's revenue growth in key database and applications markets was lame, sending its shares nose-diving last Friday in a widely covered story. So we'll focus on the first two.

But first, an update on K-Swiss <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: KSWS)") else Response.Write("(Nasdaq: KSWS)") end if %> to remind you yet again just how much this screen can rock. On November 3, with the stock at $24 and margins a-rising, this sneaker maker looked cheap. Then on February 9, I checked back in for the latest earnings report and still saw a terrific story: "Using a multiple of 20 on even the stale $2.90 per share earnings estimate for FY99 (it's sure to be jacked up) and adding the cash gets us a target price of $64.50, or another 50% gain from here. So it's not too late to take a closer look at K-Swiss."

Sometimes I scare myself. The stock closed Friday at... $64.56! That's a 169% return in just over four months. I hope someone listened to me on this one. Imagine if the margins screen could give you just one stock like K-Swiss every four months. Well, my guess is that it can.

For what it's worth, the new FY99 estimate for K-Swiss is a stunning $3.66 per share. The high-side estimate is $4.05. Backing out the $6.50 per share in cash, it's still trading for just 15.8 times forward earnings, or just 14.3 times the high-side number. Though not the bargain it was, K-Swiss could still beat the market over the near term if it manages to hit the new consensus.

Now for this week's candidates. We'll start with Men's Wearhouse, which operates 414 specialty retail stores in 38 states where it sells brand-name suits and other apparel at 20% to 30% below department store prices. The highly fashionable Q4 numbers looked like this: sales up 19.6% to $264 million; EPS up 32.5% to $0.53, in line with estimates. For the quarter, same-store sales (SSS) increased 9.3% on top of a 11.2% jump in the year-ago period. Full FY98 results showed sales up 21.7% to $768 million on 10.4% SSS growth (versus 8.5% for FY97); EPS rose 34.5% to $1.17.

By making smart acquisitions, often of distressed assets, the Wearhouse has grown to become a leading discount chain selling brand name men's suits. In February, it acquired Moores Retail, a mainly Canadian-based chain with 115 men's stores and a large manufacturing facility. Combining the companies on a pro forma basis, earnings would have been the same, but Q4 sales would have jumped to $300 million and full year revenue to $899 million. In March, Men's Wearhouse agreed to buy K&G Men's Center <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MENS)") else Response.Write("(Nasdaq: MENS)") end if %>, operator of 33 men's apparel superstores, for $133 million in stock (about $13 a share), to expand its offering of low-priced suits.

Including the Moores deal but not K&G, the company now operates 546 stores, with plans to open another 40 regular stores and a few SuitMax stores this year. Though the Wearhouse spent two-thirds of its cash last year, ending January with $19.6 million, it did pay down debt of nearly $58 million. For Q4, gross margins improved from 39.9% to 40.5% while selling, general and administrative (SG&A) expenses fell to 28.1% of sales from 28.9%. For the year, net margins rose to 5.3% from 4.6%. Return on average equity was 15.8%.

Trading around $25, the stock goes for 17.6 times FY99 consensus earnings of $1.42 per share. With long-term growth put at 23.6%, it looks like a modest bargain. Clearly, men are buying fewer dress clothes as the casual look pervades offices. Still, I'm a happy Men's Wearhouse customer. In my experience, they offer good prices, clean stores, and attentive service.

Figuring this year's number to be bumped up to $1.50 and putting a multiple of 20 on that, $30 seems a reasonable price target. However, apparel retailers can get crushed in bad markets (the stock dipped briefly to $14 last fall). Given such risks, I'd prefer to buy this one on a panic. In the meantime, it's a good one to get to know since its management has proven to be top notch.

Next, AnnTaylor, the women's apparel retailer that's seen its stock triple in the last year. It last appeared on our screen in November.

Q4 sales rose 24% to $263 million while EPS soared to $0.42 from $0.09 a year ago. Reportedly, women love the more neutral-colored career clothes that Ann's selling this year, after turning up their noses at the tighter, brighter apparel offered last year. As a result, the retailer didn't need to mark down prices as aggressively as it did a year ago. You see that in the 14% increase in same-store sales for the period. Also, gross margins rose to 48% from 44%.

Operating profits were actually $0.49 per share, but an asset write-off cut 7 cents off that number. It's not clear to me whether the analysts had expected that, but they were looking for $0.43 per share. Since the stock held steady, I assume that means the write-off had been factored in already.

For the year, sales increased 16.8% to $912 million, pushing EPS to $1.44 from just $0.46 a year ago. On March 4, the company announced that February SSS shot up 21.4%, so Ann still appears to have terrific momentum. That reportedly represents the 11th straight month of increased SSS.

Unbelievably, though, AnnTaylor doesn't issue its earnings to the general public via a newswire. That means interested investors can't get the story directly from the company but must rely on second-hand accounts. Ann apparently doesn't even have a website where it posts the earnings reports. To which I say, "Hello, what are you people thinking? Get your head out of the rayon and join the digital age!"

At around $45, Ann shares trade at 26.3 times the consensus FY99 earnings estimate. Unfortunately, our Fool Snapshot remains stale until Ann issues its year-end filing. While the current price looks rich for a women's apparel retailer, management certainly seems to have turned the business around. When apparel retailers get on a roll, they can continue to produce surprisingly impressive results. I was too skeptical of Ann's turnaround last July.

Of course, I have too little info to even hazard a guess today. If you shop at AnnTaylor, you know if their merchandise continues to look good or not. The February numbers suggests it does.

Finally, another look back. Last month I mentioned Safeskin <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SFSK)") else Response.Write("(Nasdaq: SFSK)") end if %>, a maker of disposable hospital gloves that had delivered rising margins and higher EPS, defying the short-sellers who had been pointing to outsized inventories and accounts receivable. Then trading at $24 1/2, the stock plunged last week to a low of $8 after the company warned that Q1 results will badly miss estimates as distributors have too much inventory and new orders have been lighter than expected.

So the shorts were exactly right. Which goes to show that rising margins are only a start. In researching a stock, you should grow cautious if short-sellers have moved in, because they usually don't bet against companies on a whim. It's worth delving into their bearish thesis, because there may be something to it.

Along those lines, it's worth noting that Yahoo!'s profile of Ann indicates extraordinarily high short interest. Over half the float (5.9 million shares out of 10.3 million) has been shorted, producing a short ratio (days of trading to cover) of 14.7. Anything over 5 is considered high. Don't know the story here, but anyone interested in Ann should definitely check it out before investing.

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