We are upgrading Guess? Inc. (GES) to Outperform from Neutral. Although the recession is impacting consumer spending, the company’s operating cost-control mechanisms, potential growth opportunities and smart inventory management are providing optimism.

The investment case for Guess is based on the company’s cost-control efforts, balance sheet management and growth opportunities. To more effectively navigate through the difficult economic conditions, Guess has been working diligently to cut costs.

In the first quarter, the company reduced selling, general and administrative expenses (SG&A) 11% year-over-year, with its SG&A ration declining 40 basis points. The company’s cost savings were spread across all of its business segments. Guess believes it will be able to maintain its lower operating cost structure even after economic conditions improve.

Additionally, Guess has been shoring up its balance sheet. Total inventories were up just 0.3% to stock new store openings. North American inventories decreased 4% year-over-year. Management continues to keep inventories at conservative levels in order to run its business with fewer promotions and discounts.

Also, the company ended the first quarter with cash and equivalents of $313 million and $45 million in total debt and capital leases.

Lastly, the company has solid growth potential. As of May 2, 2009, the company operated 429 retail stores in the United States and Canada and 706 retail stores outside of North America, up from 425 North American stores and 690 outside North America in the fourth quarter. While Guess still has room for expansion in North America, it has more store growth opportunities in Europe and Asia. Its international operations will continue to be the main driver of its growth.

However, the difficult macro environment is beginning to take its toll on the company’s results. While first quarter results were better than expected, sales were down 10% year-over-year and EPS fell 30%. For fiscal year 2010, we estimate that Guess’ sales will drop 9%, and its EPS will drop 21%.

The declines in sales and earnings are due to macroeconomic headwinds that are reducing consumer spending. These headwinds include wealth destruction, following huge declines in the housing and equity markets, a reduction of credit availability in the financial system and rising unemployment. These headwinds are causing consumers to increase savings to make up for a portion of their lost wealth. Consumers can no longer easily borrow or refinance their debts, so they are trying to pay down debts.

Nonetheless, we believe the changes being made now by Guess will improve margins over the long-term, which makes the stock attractive at current prices.

Guess? Inc. designs, markets, distributes and licenses casual apparel and accessories for men, women and children.

Zacks Investment Research
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