Every celebrity needs a flaw. Without a defect to lend perspective, it can be difficult to judge a thing of beauty. Which is why, when found on Marilyn Monroe or Cindy Crawford, a mole isn't a mole -- it's a beauty mark.
Companies can be like celebrities in this respect. For example, in reviewing the fiscal Q3 2006 earnings release for teen clothier Deb Shops (NASDAQ:DEBS), my first impression was: "It's perfect. Enough said."
It was only after finding the flaws that I appreciated just how good the earnings results were -- when I caught myself saying: "Hey, this isn't really that bad, at least not when stacked up against the profits." But I'm getting ahead of myself. Beauty first. Beasts later.
Analysts were hoping to see Deb post $0.16 in profits per share; Deb gave them $0.21, a 62% improvement over the year-ago quarter. Analysts also expected Deb to book $83.2 million in sales. One way -- the wrong way -- to look at Deb's $83.1 million in actual sales is that the company suffered a "revenue miss." The correct way to look at it is with astonishment that the company beat profits expectations on lower-than-expected sales, and respect for how the company managed this feat.
How did Deb Shops do it? By boosting its margin by 130 basis points.
Not quite sure what a basis point is? (Don't worry. It's just a fancy way of saying 1/100th of a percent.) Not sure why a 1.3% increase in profitability is impressive? Well, when you're squeezing just 2.4 cents of profit out of every dollar of sales one quarter, and manage to increase that margin to 3.7 cents per dollar a year later, then one way to look at it is that you've increased your profitability by 1.3% (or 130 basis points.)
A better way to look at it, though, is that you've become better than 50% more profitable than you used to be. Take your enhanced profitability and add a respectable uptick in sales volume -- say, the 10.4% increase that Deb reported -- and you turbocharge your net profits.
And now for Deb's "beauty marks." I found two of these, but I had to look closely -- they're small. First, Deb diluted its outside shareholders by a full 4.1% over the course of the past year. That's not exactly Bubble-era dilution, but it's still more than we'd like to see. Deb's second flaw was that its inventories grew faster than did its sales, at a 13.4% rate.
That suggests potential issues with the company's free cash flow, and it raises the risk that Deb may need to discount merchandise in the future, sacrificing those beautiful Q3 margin gains, unless inventory and sales growth are soon brought back into balance.
More on this cash-rich waif of the retail clothing world:
- Deb's Latest Coming-Out Party
- Deb Shops: Dividend Diva
- Looking for a Wealthy Debutante?
- Is Deb Well-Dressed?
Fool contributor Rich Smith does not own shares of Deb Shops.
