Payless ShoeSource's (NYSE:PSS) second-quarter results confirm its transition to selling more fashionable, high-priced shoes and related accessories. But just as the 18% run-up in the stock price after first-quarter earnings was perplexing (the numbers weren't that solid), I'm not sure yesterday's 11% plunge was warranted either. So what's with the volatility?
Over the last couple of years, management has been focusing on reducing costs to drive bottom-line results, and also transitioning the product offering to more upscale tastes for higher profitability. This means its current, cost-conscious clientele has begun to shop elsewhere, as management increasingly caters to a more fashion-conscious crowd. Second-quarter results confirm the trend: there was weaker top-line growth, but higher margins and lower costs led to strong earnings growth.
Specifically, sales grew an uninspiring 1.8% for the quarter, but same-store sales growth was decent, up 2.2%. Diluted earnings jumped nearly 66% for the quarter, and the gross margin increased by about 60 basis points to 34.5%. Selling, general, and admin expenses fell a nice 1.5%, but that was thanks to a couple of one-time items, including a settlement received from a Visa/MasterCard antitrust case. A final favorable development was that inventories fell from the year-earlier period and were up only about 5% since last quarter, or sequentially.
So why did the stock trip so much after the release? Well, earnings came in a nickel below what analysts were projecting. Sales were slightly ahead of expectations, but that didn't appear to matter, since companies that miss earnings these days are duly punished by the market. Investors were also concerned with the slowing rate of margin improvements. All in all, the sudden drop seemed a bit drastic to me, but Payless does have some work to do regarding sales trends.
That's because cost-saving initiatives can only go so far. Eventually, Payless will have to reinvigorate sales growth, which may not happen any time soon. Management plans on relocating 120 stores this year, while closing another 70 (it plans on opening an additional 70 as an offset). While that's only about 4% of the 4,584-store base, the company is also mixing up the merchandise and target customer at existing stores.
Payless' strategy may eventually pay off, but a company with a more stable operating strategy may be less risky in this crowded retail space. Retail investing is hard enough, since it relies on a fickle customer base with constantly changing tastes. I usually advocate going with companies with weak comparable store trends, since they usually recover at some point. That includes Urban Outfitters (NASDAQ:URBN), Pacific Sunwear (NASDAQ:PSUN), and perennial underperformer Gap (NYSE:GPS). They are all struggling, but their sales strategies are consistent.
In the shoe space, I've been recommending the companies that also own their own brands and can reap more lucrative licensing deals -- in addition to selling their own merchandise. That includes 800-pound gorilla Nike (NYSE:NKE) as well as Steve Madden (NASDAQ:SHOO) and Kenneth Cole (NYSE:KCP), though the latter two have posted more erratic cash flow generation than Nike.
For related Foolishness:
Gap is an Inside Value pick, while PacSun is a Stock Advisor recommendation.
Fool contributor Ryan Fuhrmann is long shares of PacSun and Nike, but has no financial interest in any other company mentioned. Feel free to e-mail him with feedback or to further discuss any companies mentioned. The Fool has an ironclad disclosure policy.
