LPP: another drastic 2005 forecast downgrade

LPP’s management announced another forecast downgrade, according to which 2005 net income should come in at PLN 40-44m, substantially below previous forecast of PLN 53m and the original forecast of above PLN 60m. The new estimate implies almost no earnings growth versus the previous year, which was PLN 42.7m. It also implies that 4Q05 net income should come in at between PLN 16.7 – 20.7m, i.e. a 35% - 20% y/y fall. Taking into account some 20% y/y growth in sales in 4Q05, the implied net income indicates very weak margins of between 7.7% - 9.5% vs. 14.2% in 4Q04.

According to the management the reasons behind such poor quarterly and annual figures were the following:
i) mismatch between customers' expectations and Reserved collection, especially concerning the Fall/Winter collection,
ii) substantial rise in network management costs that were not compensated for by revenues due to lower than expected sales (consequence of high operating leverage), and
iii) lower than anticipated margins.

In our opinion, the management’s explanation is insufficient as it does not provide underlying reasons for the company’s poor performance. We believe the reasons for poor domestic performance relate to the mismatch between the style and prices of LPP merchandise. In 2005 LPP initiated its new strategy of designing and selling more fashionable clothes. However, the shift from offering basic to fashionable clothes was drastic and was likely ill-received by LPP's traditional customer base. Additionally, the perceived poor quality of LPP's clothes relative to price does not stack up in an increasingly competitive market. Furthermore, LPP’s consolidated results were lowered, in our view, due to negative performance of foreign subsidiaries. Initially planned as the company's future growth engine, the foreign network branches are increasingly eating into the parent company's earnings. Due to requirements of the Polish tax office, LPP has to charge an additional mark-up on clothes sold via its foreign branches, which results in prices being some 10% higher abroad. This, coupled with sales per square meter lower by some 50%, lack of efficient marketing policies, and strong competition offering better quality for similar prices result in foreign subsidiaries generating losses. As far as LPP’s future operations are concerned, we maintain our scepticism. Management has started hinting at a possible partial withdrawal from its fashion strategy, with the new Spring/Summer collection being less fashionable. The first signs whether the new approach is working should be visible in sales for March 2006.