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VLCM: Elevated Risk Profile, Investment Year - Move to UNDERWEIGHT from Hold

By Press Releases
May 21, 2010 5:43 AM

Source: Investment note published this morning from Edward Yruma, KeyBanc Capital Markets

ACTION STATEMENT (click here to see full KeyBanc report with charts, etc.)

Volcom (VLCM-NASDAQ) is a high-quality brand with a strong management team, but European exposure (26% of 2009 gross profit), heightened investment (SG&A planned up 13% year-over-year), and volatile sales trends at key customers [Zumiez Inc. (ZUMZ-NASDAQ)/Pacific Sunwear of California, Inc. (PSUN-NASDAQ)] raise the near-term risk profile.

We downgrade the stock to UNDERWEIGHT from HOLD, accordingly.

Again, we think that the Company is taking the right steps to drive its longer-term growth via key staff additions, distribution investments and marketing investments.

However, we prefer to use the stock as a source of funds over the near term, as we think earnings could come under pressure from the aforementioned macroeconomic issues and reinvestment. We are also lowering our 2010 EPS estimate from $1.21 to $1.10.

On our newly revised EPS estimate, we find the 17.8x 2010 P/E multiple full and establish a $15 downside price target.

KEY INVESTMENT POINTS

Europe contributes 25% of revenue, which could be a source of top-line weakness in the near term. In the 4Q, the Company had relatively upbeat commentary on its European sales prospects for 2010.

However, in the 1Q (reported April 29), the Company cited weakness in Greece and Portugal. We think that this weakness has only intensified. This is most likely to manifest itself in the 3Q, as the 2Q is generally a low-revenue ($54 million in 2Q09, guidance of $59 million-$62 million in 2Q10) quarter.

This, coupled with still weak results in Japan, makes the Company dependent on U.S. growth in 2010.

... Which may be difficult given continued volatility at key customers PSUN (11% of revenue) and ZUMZ (under 10% of revenue).

Both PSUN (down 9-14% in the 2Q) and ZUMZ (up mid to high single digits in the 2Q, but a deceleration on a two-year basis) posted disappointing 2Q top-line guidance. Over time, a reorientation toward core brands at PSUN should benefit VLCM long term.

However, with retail trends showing signs of near-term strain ("needs" remain more important than "wants," as exhibited by March/April comps, we see diminished opportunities for near-term upside.

We are downwardly revising our 2010 EPS estimate.

The two primary drivers of 1Q upside relative to plan were the U.S. segment ($2.2 million of upside) and Europe (up 30% in constant dollars). As mentioned heretofore, we think both are unlikely to present as much near-term upside opportunity.

Moreover, we think that a projected 13% year-over-year increase in SGA will place continued operating margin pressure. We are lowering our 2010 EPS estimate from $1.21 to $1.10.


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