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Fool On The Hill

Wednesday, June 9, 1999

FOOL ON THE HILL
An Investment Opinion
by Louis Corrigan

Gucci Gucci Yah-Yah-Yah

Shareowners of leading luxury goods designer and distributor Gucci Group N.V. (NYSE: GUC) luxuriated today in some reasonably stylish earnings results and even more fashionable projections for the current fiscal year as a whole. At the same time, more fireworks exploded in Gucci's lingering battle to fend off France's LVMH Moet Hennessy Louis Vuitton (Nasdaq: LVMHY), the world's top luxury goods company. LVMH has engaged in a kind of awkward schoolboy mating game offering bruises as well as kisses. But Gucci has said bullies don't make good lovers, and found comfort instead in the arms of French retailer Pinault-Printemps-Redoute S.A. (PPR), with whom Gucci has formed a major strategic alliance. That's left LVMH all aghast and agag. In any case, Gucci closed up $2 1/16 to $65 on all the news.

Turning to the earnings report, we see that Gucci's first quarter results were solid, though not overwhelming. Revenues rose 7.7% to $270 million thanks to a 9.6% increase in sales at its retail stores, or 11.6% on a constant currency basis. However, operating margins declined slightly, with operating profits up just 4.9% to $179.3 million. Factoring in higher interest income and a lower tax rate, net income per share jumped 14.9% to $0.77 from a restated $0.67 a year ago, beating the consensus estimate by two cents per share.

Looking closer, we see that Europe continued to be a bright spot for Gucci, with Q1 sales rising 17% to $79.8 million. While sales to Japan increased 8.4% in constant currency, the actual dollar-denominated gain was just 3.5% to $53.8 million. Meanwhile, U.S. sales rose 4.6% to $77.5 million while sales to other parts of Asia increased 7.1% to $51 million thanks to double-digit gains in Hong Kong. European sales have benefited from the decision by Gucci Chair/CEO Domenico De Sole to redesign its stores to focus on local customers rather than tourists. Like many other luxury goods companies, Gucci has traditionally derived a significant amount of its business from well-to-do Asian tourists. But the Asian financial crisis has dampened such sales over the last two years.

The results were relatively impressive because Gucci's core leather goods business came in flat at $113.9 million while its shoe sales declined 1.8% to $39.9 million. The company is seeing particular strength in its ready-to-wear apparel (up 36.9% to $36.4 million) thanks to a well-received spring collection. Having previously licensed the Gucci name for use on timepieces, the company brought watches in-house in 1997 and continues to see solid growth, with revenues up 10.3% to $55.2 million. It's also expanded its jewelry line with an eye toward distributing it to 350 to 400 jewelry stores early next year. Currently, Gucci jewelry is available only at the company's retail locations.

After taking back control of some its Asian franchisees, sales at Gucci-owned stores increased 9.6% to $170.1 million, or 11.6% on a constant currency basis. Such direct sales accounted for 63.0% of Gucci's Q1 sales mix versus 61.9% a year ago. The rest came from royalties (2.7%), distribution of timepieces to retailers (17.6%), and its traditional distribution business to its franchise stores, duty free shops, and specialty and department stores (16.7%). This historical distribution business was down slightly, reflecting orders placed amidst the Asian financial ugliness last summer. Still, the higher direct sales helped boost gross margins to 66.4% from 63.8%. Such fat gross margins are what make luxury companies so attractive to investors. In case you didn't realize it, you're paying up for the brand, not just quality.

Yet, continued store expansions and remodeling held operating profits back. And that's the important metric here because the other earnings numbers are skewed. Pre-tax income soared 24% to $73.2 million from $59 million, but $17 million of that was interest income owing to the $2.925 billion PPR handed Gucci on March 19. That money bought PPR a 40% stake, or 39 million Gucci shares at $75 a share, a 13% premium to the 10-day average closing price at the time. Also, Gucci's tax rate has dropped from 30.7% a year ago to 17.1%, possibly reflecting tax benefits from the Asian franchises it acquired.

Gucci will open a new flagship store in Tokyo in September. It's also now moved to new digs in New York City while its old location is being renovated. The additional rent and associated costs will add $7.5 million to operating expenses for the remainder of the current fiscal year, which ends next January. The outlook, though, is upbeat. CEO De Sole said the company thinks it can do $3.40 per share in earnings this year, better than the $3.31 consensus forecast produced by Wall Street's analysts and far better than the $3.00 per share figure De Sole had blessed in January.

Part of the excitement, too, is that Gucci now has a huge war chest of $3.1 billion in cash versus total liabilities of just $331 million. It plans to use this cash to acquire other properties that will "enable us to transform Gucci into the world's leading multi-brand luxury goods company," according to De Sole.

That threat is no doubt part of what's incensed LVMH and its Chair Bernard Arnault. LVMH started accumulating Gucci shares last year. In January, it acquired the 9.5% stake held by Prada, the Italian fashion house. By March, it had amassed a 34.4% stake. That was just shy of the level necessary to trigger lucrative golden parachutes for De Sole and all-important Gucci designer Tom Ford. It appeared that LVMH was determined to gain substantial influence over Gucci without ever launching a formal takeover, with the requisite premium for attaining control. To resist what De Sole dubbed a "creeping takeover" attempt, Gucci turned to PPR as a white knight.

PPR has agreed not to increase its stake in Gucci to more than 42% in the next five years barring a 100% takeover attempt by a third party. And shareholders will soon be asked to vote to increase the size of Gucci's board to 9 members, 4 of whom will be PPR nominees. While Gucci's current board has said it would look favorably on an unconditional $88 a share bid for all of Gucci's shares, the best LMVH has managed to produce is an $85 a share bid requiring top management to stay on for at least two years and dump the PPR alliance. Given the bad blood between Arnault and De Sole, that's not going to happen. Still, to keep LMVH at bay, Gucci has resorted to an employee rights plan. A Dutch court ruled that this plan wasn't proper but that the PPR alliance was. Today's actions by LMVH represent an attempt to get Dutch courts to overturn these rulings.

At $65, Gucci's stock is trading for about 19 times forward earnings. It's also 13% below what PPR paid for its stake and 26% below what Gucci's board has determined is a fair price. With Asian economies recovering and Gucci looking to expand its influence, this highly profitable business is worth a closer look, despite having already soared from its September lows.

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