Declining margins and disappointing sales. That was Duluth’s reality when COVID-19 hit, breeding the perfect storm for a dwindling retailer.
But things aren’t as bad as they look.
Duluth’s owner, Stephen Schlecht, returned to the helm of CEO at the end of 2019. Schlecht is switching Duluth back from growth mode to profitability mode. He really has no choice; the macro backdrop forces his hand.
Duluth is worth two times the price it’s trading at if only the company performs mediocrely. With high-quality products, a nice brand, and a renewed focus on operations, odds are it will; the pull of mean reversion is strong.
What about COVID-19? On a normalized basis, more than 50% of Duluth’s revenue is from direct sales (catalog and e-commerce), providing uninterrupted distribution in times of social distancing. Case in point: Duluth’s total sales in April increased by 5% compared to a year ago, driven by a ~70% surge in direct sales. Though much of this surge is explained away by aggressive clearance activity, it suggests a dampened impact from COVID-19. More than 90% of the company’s stores have now reopened.
Duluth’s balance sheet is unimpressive, but with access to close to $100mm in liquidity and a cash burn rate that shouldn’t exceed $15mm per quarter even in the direst of circumstances, Duluth will survive.
I value Duluth at $10.70/share, a ~100% upside to the current market price of $5.40/share.
Disclosure: After writing this report, I bought Duluth @ $5.90/share.
This guy was hired by Duluth to turn it around
A brief story of Duluth
Duluth is a retailer of apparel and accessories designed for customers with a hands-on lifestyle.
Founded in 1989 by two brothers in the home construction industry, Duluth started by selling one product, the Bucket Boss, a canvas tool organizer for construction workers. Soon the company expanded its portfolio to a catalog known as Duluth Trading Co.; products were sold only through direct mail. In 2000, GEMPLER’s Inc., an agricultural catalog owned by Stephen Schlecht, bought Duluth. In 2003, GEMPLER’s sold its original business and invested the proceeds in Duluth.
Between 2009 and 2014, Duluth grew revenues and operating income at CAGRs of 28% and 51%, respectively. In 2010, the company opened its first retail store. Duluth had nine stores when it went public, in 2015, under the leadership of CEO Stephanie Pugliese, raising $37.4mm used for opening more retail stores and renovating the company’s infrastructure (new POS systems, inventory and warehouse control, e-commerce, expanded distribution center, etc.).
Since the 2015 IPO, Duluth doubled net sales. However, margins steadily declined:
What went wrong?
Brick-and-mortar expansion strategy
For the last five years, Duluth was in the business of opening stores. Here’s what the company was thinking:
This strategy looks good on a slide, but, like everything that looks good on a slide, there are some caveats.
Struggling market penetration
Evidence:
1. Decreasing direct sales growth and sales per store
2. Customer anecdotes
Duluth says that stores are good because they attract many customers new to the brand. New customers are nice, but retention rates are paramount. How many customers keep coming back? Moreover, how many new customers does the company attract after the second year of opening? How is same-store sales growth going?
Alas, we don’t have that data. The data we have give no reason for zest:
Declining sales per store: Avg. sales per store declined from $5.8mm in 2017 to $4.8mm in 2019.
Management commentary: “In the second year of a store being in a market we do see some contraction in four-wall store sales.” - Q4/18 Call
Duluth also argues that markets with stores have 3x the sales of markets with no stores and that cannibalization of direct sales isn’t concerning, given that direct sales grow more in markets with stores after their second year of opening.
I’m not sure about that. Duluth’s direct sales growth declined over the last years. Considering that most of Duluth’s stores were opened more than a year ago, I’d expect a different trend.
There’s some anecdotal evidence suggesting that retail competes with direct sales. Duluth has been aggressive with promotions to keep driving direct sales in markets with local stores, which could be harming the company’s pricing and margins across both segments. Here’s a comment by a Duluth customer made on Seeking Alpha (I edited it for the sake of grammar and clarity):
As a customer I get at least 3 clearance/sale emails a week offering significant discounts. I know my clothing sizes from the first few purchases and because of having a new retail store nearby, I haven’t paid full price since my initial online purchase. They offer free delivery if I pick it up in the local store. With a local store to return it if needed after purchasing a sale item, why would I ever pay full price or even step foot in that store to shop when I get sale/clearance emails every other day? The local store is overstaffed, never busy, and beautiful. - Customer comment
A 4-wall 20% EBITDA margin is misleading
Evidence:
1. Attribution of operating expenses between segments don’t follow underlying economics
2. Contracting margins
According to Duluth, its stores have a 4-wall EBITDA margin close to 20%. Here’s why:
Income tax expense, and corporate expenses, which include but are not limited to human resources, legal, finance, information technology, design and other corporate related expenses, are included in the Company’s direct segment. Interest expense, depreciation and amortization, and property and equipment expenditures, are recognized in each respective segment. Advertising expenses are generally included in the Company’s direct segment, except for specific store advertising, which is included in the Company’s retail segment. - Duluth’s financials
In plain language: to get to a 20% 4-wall EBITDA margin, you attribute all operating expenses to Duluth’s direct segment, except for the ones that are specific to stores. Expenses for product development, inventory management, POS systems, advertisement, etc., are allocated to the direct segment.
I get it: retailers use 4-wall margins to assess the profitability of a store considered in isolation.
That’s fine for evaluating whether you should close a store that’s already built. However, you can’t justify a brick-and-mortar strategy on those margins, because this treatment distorts the underlying economics of opening and running retail stores.
The 4-wall margin can lead to misleading conclusions. According to Duluth, retail stores’ operating margin was ~16% over the last two years, while direct sales’ operating margin was negative. From this instance, Duluth’s margins should be expanding as retail stores become a larger proportion of sales. The opposite is happening.
In a more precise attribution of expenses, the store segment would have 5%-10% margins. Stores shouldn’t lose money, but they aren’t as attractive as Duluth make them.
Duluth’s expansion occurred at the expense of operational efficiency
Evidence:
Management confessed
I want to recognize that we have had some growing pains over the last year and a half. I want to see a slowdown on the pace of our retail expansion in 2020 and focus more on improving asset productivity and thus our operating margin rate. - Q2/19 Earnings Call
Poor operational performance is a bummer, but herein lies Duluth’s opportunity.
The company expanded swiftly, not only opening stores but also implementing new systems enterprise-wide. Inefficiencies surfaced. Now, with infrastructure investments done, management can focus on profitability. This is a chance for the company to pick some low-hanging fruit, halt margin decline, and retake the path to its long-term goal of 10% operating margins.
We have made some very important and timely investments over the past few years to enhance our brand presence and the customer experience, and they are beginning to bear fruit. Now is the time to focus on unlocking the full potential of these investments to deliver improved profitability and value creation. - Q1/20 Earnings Call
Duluth’s Q1/20 results, with year-over-year sales growth in April, +50% growth in the women’s segment, and +76% new buyer additions, are a harbinger of good things to come.
Nice brand, above-average products that customers love
Duluth tries to differentiate itself from the broader apparel market as follows:
Focus on singular products in which functionality trumps style. Duluth’s product development is top-notch for its public.
Whimsical way of advertising and telling stories fostering a charismatic brand.
Here are three examples of products created by Duluth and funnily advertised:
Longtail T-shirts to avoid plumber’s butt:
Fire Hose work pants built with extra pockets, durable materials, and flexibility (you can do squats in it):
Buck Naked underwear:
Duluth’s products are high-quality and many customers love them. For example, see this video about Duluth’s pants, or read some of these Reddit comments.
Duluth stands behind its products with a No Bull Guarantee:
If you are not satisfied with any item you purchase from Duluth Trading, return it for a refund within one year. After one year, we will also consider returns for items that are defective or don’t perform as designed. No Bull means if something goes wrong, we will always treat you right. - Duluth’s website
Duluth owns its distribution network as no third-party retailer sells its products (an omnichannel approach, in business argot). By doing so, the company controls customer service and product and brand positioning.
A good retailer
In some ways, Duluth is different from the broader apparel market; however, I think these differences may not be enough to sustain above-average profits. The retail business is tough; brand and product advantages are precarious; competitors abound.
Carhartt, a private company founded in 1889, is perhaps Duluth’s best comp. Carhartt focuses on the same niche market as Duluth and has more than 30 owned retail stores. Carhartt also sells through third-party retailers. Though we have no access to the company’s financials, Carhartt is likely larger than Duluth, as measured by sales.
You can watch a Carhartt vs. Duluth product comparison here. Duluth comes out ahead.
Other competitors include Red Kap and Dickie’s, both owned by the VF Corporation (NYSE: VFC), and other general apparel companies such as L.L. Beans, Land’s End, and Levi Strauss.
It’s hard to pinpoint a sustainable competitive advantage Duluth would have against these competitors, except in niche products (like fire hose pants). It’s a paradox: as Duluth grows and expands its addressable market (e.g. by broadening men’s product categories and developing its women’s division), it becomes more like other retailers.
I think Duluth has good brands, good products, and good positioning. The company has a credible path for profitable and steady growth through product expansion across categories (the women’s segment has been growing double digits for many years and is now +30% of sales).
Yet, I think the safest assumption is to treat Duluth as a mediocre retailer, with attractive attributes but susceptible to competitive pressures. I’ll let Duluth surprise for the best.
Management
In September 2019, CEO Stephane Pugliese, who’d been leading Duluth since 2015, left the company for Under Armour (she became President, North America).
I don’t know why she left. Perhaps Under Armour was a much better opportunity, but the truth is that Duluth’s operations dwindled during her tenure.
With Stephanie’s departure, Stephen Schlecht, who’d been CEO from 2003 to 2015, and since 2015 was Chairman, became CEO again. Duluth’s strategic direction immediately changed: easy on growth, focus on profitability.
Duluth is not rushing to find a new CEO and wants to get it right. Schlecht knows the company from inside out and owns ~30% of Duluth’s common stock. I like that.
Valuation
Duluth trades at a trailing EV/EBITDA of ~7x, which is in line with comps. Here’s the caveat: Duluth’s EBITDA margin is ~450 bps lower than those same comps. If Duluth improves operational efficiency in line with peers, it has enormous upside potential.
Even with the current operational inefficiencies, Duluth produces $25-$30mm free cash flow per year on a normalized basis. Note that this number is hidden away: you have to back out the growth CapEx, working capital investments, and pre-opening expenses for new stores. Considering Duluth is a small-cap, amid the COVID-19 market panic this normalized FCF may have gotten lost.
I’ve collected data on 10 retailers (e.g. Nordstrom, Macy’s, and V.F. Corporation) going back 20 years, and analyzed them across different time periods. I judge the 10-year period provides the best comparison framework for a full economic cycle. I’ve used those numbers, together with Duluth’s operational record, to inform my valuation.
Base case assumptions
Long-term sales growth: 3%
A mid-point between the average and the median for the 10-year timeframe, and lower than the 4%-4.5% growth (both average and median) over a 20-year timeframe. I have no data from Duluth’s retail stores’ organic growth, but Duluth’s direct sales’ organic CAGR since 2015 is 7%. Moreover, an EV/EBITDA of 7x implies a ~3% terminal growth.
EBITDA Margin: 10%
Duluth’s EBITDA margin was below 10% from 2017 to 2019; before that, margins were higher. Adjusting EBITDA for new stores pre-opening expenses, Duluth’s margin was close to 10% last year.
D&A (% of sales): 3.5%
D&A mirrors retailers’ CapEx spending over a 10-year timeframe. In 2019, Duluth’s D&A was 3.6% of sales; in prior years, it was close to 1%. Consider that more than 50% of Duluth’s sales come from an asset-light segment.
Working Capital (% of sales): 12%
I assume a number higher than Duluth’s 5-year average. Duluth’s asset utilization has been sub-par partially due to poor inventory management. The company has an inventory turnover of ~2.5x, while comps have a turnover of ~4x. Improvements in working capital are low-hanging fruits for management, but I’m cautious and assume no improvement.
Net debt: $126mm
I consider financial leases and traditional debt. I treat operational leases as an ongoing operating expense captured in the company’s operating margins.
Tax Rate: 21%
Discount Rate: 10%
My base-case DCF yields a fair value of $10.70/share.
In a worst-case scenario, I assume a 40% decline in sales over this year, no growth thereafter, and an EBITDA margin of 8%. In this case, I calculate the company is worth $3.00/share. Importantly, I don’t see Duluth going bankrupt. The company has access to ample liquidity (~$100mm), and cash burn shouldn’t exceed $60mm a year.
With only slight improvements in my assumptions (4% growth, 12% EBITDA margin), Duluth could be worth $20/share. I think this is a scenario with reasonable chances to play out. These roads have been walked by Duluth before: the company reached higher than $30/share in 2016 and 2018.
Risks
Execution: my thesis relies largely on management improving Duluth’s operational efficiency.
Balance sheet: I don’t think Duluth will go bankrupt, but debt is higher than I’d like (net debt/EBITDA of 2.5x).
Competitive pressures: the retail industry is highly competitive and dynamic, which could pressure Duluth’s margins further, or force management to adopt growth strategies which are a waste of shareholders’ money.
Next Steps
I’ll keep an eye on:
Sales growth in both segments (direct and retail).
Duluth’s search for a new CEO.
Improvements in operating margins.
Improvements in working capital through higher inventory turnover.
The pace of new store openings (I’d like that to slow down).