Description

Investment Thesis: R.G. Barry (DFZ) is a mis-priced small cap stock in the footwear/apparel sector. I believe a significant transformation in the Company’s business model and growth prospects associated with two recent acquisitions, which has notably increased DFZ’s intrinsic value, has gone unrecognized by investors. By redeploying its excess capital effectively, DFZ’s business model has transitioned to one with higher margins/EPS, improved ROIC, increased cash flow and accelerating growth. This shift in the Company’s business has the additional benefits of reducing DFZ’s seasonality and customer concentration profile. Some of these benefits have already begun to materialize in the Company’s quarterly results while others will follow in future quarters. As this transition is fully recognized, I believe investors will reward the shares with a higher valuation. The stock is attractive relative to the Company’s underlying EPS and FCF generating capabilities of about $1.50 per share and ~$20 million respectively in calendar 2013. Selling at roughly 8.5x calendar 2013 EPS and 3.8x on an EV/EBITDA basis with a FCF/EV yield of 16.5%, the shares are attractive on an absolute basis. Additionally my valuation analysis shows that each of the Company’s businesses (footwear and accessories) are valued at a significant discount on their individual earnings compared with other public companies in each respective sector. Thus, investors are getting two business for the price of one. I believe the recent underperformance of the shares during the last two months (which follows a history of underperformance in the stock during the Company’s seasonally weak selling season), presents a buying opportunity and note that the shares are selling significantly below intrinsic value of ~$18 per share.

Key statistics:

Expanding From a Position of Strength: DFZ’s core footwear/slipper business has a number of attractive attributes that should be appealing to investors. The company is the leadingUS manufacturer of slippers, with a market share of roughly 30% (vs. its nearest competitor, who has less than half of DFZ’s share). Within its core consumer base, the Dearfoam’s brand is well regarded for quality and value as a result of its broad distribution and 65 year history. As evident from sales trends during the last few years, the product has recession resistant characteristics. The Company discontinued manufacturing its slippers in 2004 and transitioned to more of a flexible, variable cost centric model, outsourcing its products from various manufacturers, principally inChina. This business generates a healthy 15%-20% ROIC and strong FCF. Given the Company’s market share and the dynamics of the market, growth prospects approximate mid-single digit levels, with new opportunities centered on expansion into new North American countries.

Two Transformational Acquisitions: Following a patient and extensive search, DFZ acquired two companies during Q1 of calendar 2011. On January 27^th, the Company purchased Foot Petals Inc., a privately held developer and marketer of premium insoles and comfort solutions for footwear problems for $14 million in cash. On March 31^st, DFZ acquired Baggallini, a privately-held manufacturer of women’s handbags and travel accessories for $34.6 million. Detailed information on both companies can be found in DFZ’s 10K/Q filings and on the Company’s web site at: http://www.rgbarry.com. I believe the combination of these two acquisitions has significantly transformed the Company and increased its investment appeal. 

While management has not provided pro-forma financial details on either business, the footnotes of the Q3 FY 2011 10Q and the FY 2010 10K filing provides enough information for investors to broadly gauge the size, returns and financial impact of these two acquisitions. Using the data for Q3 and Q4 of FY 2011 (which does not take into account seasonality) “back-of-the-matchbook” pro-forma estimates for each of these two acquisitions is illustrated in the table below. Both companies have excellent high margin business models that will have a significant positive impact on DFZ’s overall profitability and financial returns.

Increased Earnings Power: The major benefit of the acquisitions of Foot Petals and Baggallini (the Accessories Division) is that both companies will significantly increase DFZ’s financial returns, earnings power and cash flow generating capabilities. The operating margin for the new accessories division is roughly in the mid 20% range. Thus, the profitability of DFZ new accessories business is ~2x-3x that of the 9%-12% historic margins in DFZ’s traditional footwear/slippers division. Immediately following the merger DFZ made additional investments in both companies, (especially Baggallini) to better position the companies for future growth. These investments center on expanding both brands’ growth opportunities through increased distribution and the broadening the product line. These actions have depressed operating margins in the accessories division during the last few quarters and have hidden the accessories division’s true earnings potential. As these investments begin to moderate over the next few quarters, greater margin expansion should become apparent. In addition, with the accessories division now viewed as the Company’s primary growth vehicle, management has been actively restructuring or eliminating some low margin business in its footwear division. While this has negatively impacted recent sales, this should help maximize footwear profitability and cash flow beginning in the second half of calendar 2012. The overall margin leverage coupled with the more rapid growth opportunities inherent in these accessories businesses (roughly mid-teens versus low-single digits in the footwear division), should translate into a meaningful increase in earnings and cash flow in the future.

On the Company’s recent conference call management stated that in the fiscal year ended June of this year about 30% of earnings will come from these acquired companies and projects this figure will rise to 35%-40% next fiscal year. My forecasts show that in calendar 2013 the accessories division will account for close to 40% of DFZ’s overall earnings. Given the earnings leverage associated with this business, I estimate that DFZ’s will have earnings power of approximately $1.50 per share in calendar 2013, which will translate into FCF of roughly $20 million. By my estimates ROIC for the Company will rise to roughly 20% (and exceed 30%, excluding goodwill and intangibles) during this time. Given the higher returns and growth prospects in this business, this higher quality earnings stream should command a premium valuation relative to that which the lower margin/growth slipper business has traditionally been accorded.

Additional Benefits Should Help The Stock Valuation: I believe there are a number of additional benefits of the Foot Petals and Baggallini acquisitions that should increase the valuation of the stock and improve investment psychology. These benefits include:

• Reduced Seasonality: Historically DFZ’s earnings and cash flow are quite lumpy due to the seasonal retail purchasing patterns in the footwear business. The December quarter (Q2) had been the Company’s largest revenue quarter, accounting for about 40%-45% of full-year sales, followed by the September quarter (Q1), which comprised roughly 23%-28% of yearly sales. Thus, the first half of the fiscal year had accounted for about 65%-70% of sales, while the second half accounts for only 30%-35%. The impact of this seasonality has even been more pronounced relative to profitability. The Company has made all of its profits in the first half of the year, while profitability in the second half of the fiscal year had been breakeven to a modest loss.

This seasonality has translated into heightened volatility in the share price, especially during the first half of the calendar year. As illustrated in the following table, during the last few years the share price has recorded periods of both absolute and relative underperformance during the first half of the year. I believe this volatility is directly correlated to the seasonality in the Company’s business. Historically, investors who have taken advantage of this period of relative share weakness have been rewarded later in the year. I believe the current weakness in the share price presents another opportunity for patient value investors to purchase the stock.

Foot Petals and Baggallini exhibit only modest seasonal patterns in their businesses, therefore, the overall seasonality in the Company’s business will be moderated. The combination of less seasonality in these businesses and their significantly higher margins should eliminate DFZ’s first half operating losses. DFZ’s recently reported Q2 (March) results highlight the reduced seasonality in the Company’s financial results. In what has historically been a seasonally weak quarter for the legacy footwear business, marked by breakeven to a moderate loss in the period, DFZ’s March quarter results showed profitability. Reducing the volatility in the Company’s earnings should translate into a less volatile stock and a higher valuation.

• Customer Concentration Issue Moderated: One of the factors which may have contributed to DFZ’s low valuation is the customer concentration issue associated with Walmart. It is important to note that this relationship is not new and has been in place for ~30 years. Highlighting the depth of the relationship, Wal-Mart allows DFZ access to its IT systems to manage the retailer’s inventory and be a fulfillment agent. Given DFZ’s expanding retail presence, the percent of revenues generated from Walmart has been declining in recent years (38%, 35% and 32% in FY 2009, 2010 and 2011 respectively), prior to the recent acquisitions. Foot Petals and Baggallini currently reduce Wal-Mart sales to about 26%-27% of overall revenues and are projected to be roughly 24% in 24 months. Moreover, the impact on profitability is even more pronounced given the combination of the significantly higher margins and more rapid growth in the accessories division along with the favorable pricing Wal-Mart likely receives. My estimate is that by the end of fiscal 2014, Wal-Mart will account for no more than 15% of profits. While still meaningful (and a good customer for DFZ to have), this lower customer concentration should translate into a higher valuation for DFZ’s share price.

• A Modest Acceleration in Overall Growth: Historically some investors have not found the shares appealing due to the Company’s low growth profile. Given DFZ’s large share of the slipper market and existing relationships with most of the relevant retailers in theUS, growth opportunities have been modest. The focus for growth in the footwear business is leveraging its retail partnerships to expand internationally intoMexico andCanada. Given this expansion and modest price increases, management believes growth in the footwear division should approximate mid-single digits (I have modeled low single-digit growth to be conservative). Following a period of eliminating some low margin business in FY 2011, which negatively impacted footwear sales, growth should resume in the second half of calendar 2012. The recent acquisitions of Foot Petals and Baggallini (and potential future acquisitions) add a new growth dimension to the DFZ investment story. Management targets growth for its accessories business in the low-to-mid teens. This growth is likely to come from leveraging DFZ’s retail relationships and increasing distribution (i.e. door count) for both Foot Petals and Baggallini among independent and full price big box retailers (i.e. Dillard’s and Nordstrom’s). The Baggallini product line is being broadened from basic lines to include more fashionable products while price points are being increased on the upper end. With the addition of Foot Petals and Baggallini, DFZ’s total revenues should show a modest acceleration and grow in the 6%-7% range during the next 24 months. Possible future acquisitions could accelerate growth even further. While, not likely to be categorized as a traditional growth company, this should help address one of the issues that has restrained the stock’s valuation.

• An Indication That Management is a Good Allocator of Capital: I believe these two acquisitions show that management is a smart allocator of capital. Despite criticism from some investors, management was patient in waiting for the right opportunity and appears to have selected wisely. With a forecast of ~40% of earnings in calendar 2013 coming from the two acquisitions (or roughly $7 million), this translates into an impressive after tax return of 14.5% on the $48.5 million cost of both acquisitions. That is important given that an important management goal is to redeploy the excess capital in its business for future potential acquisitions. Similar to Foot Petals and Baggallini, management is targeting acquisitions of strong existing bolt-on type businesses/franchises (as opposed to turn-around stories) which it can purchase at a reasonable price, and will accelerate the Company’s growth and financial returns. The discipline management has demonstrated and potential returns in both Foot Petals and Baggallini, should give investors greater confidence in management’s ability to execute on its plan and increase shareholder value.

 An Attractive Valuation, Selling Significantly Below Intrinsic Value: I believe the shares of DFZ are attractively price on both an absolute and relative basis. Currently, the shares are valued at a P/E of roughly 8.5x my forecast for earnings power of $1.50 per share and are selling at an EV/EBITDA multiple of only 3.8x. From a FCF perspective, the FCF/EV yield of my $20 million forecast is 16.5%. As illustrated in the following table, DFZ is also attractively priced on a relative basis when compared with both public footwear related and handbag accessories companies.

I believe that DFZ’s valuation reflects the fact that most investors have not recognized that ~ 40% of the Company’s earnings will be coming from its faster growing, higher margin/return new accessories business. It appears that the valuation accorded DFZ’s current overall business is more consistent with comparable footwear companies. In segmenting the earnings attributable from each division, one could make the case that little value is being accorded the higher margin accessories business. As illustrated in the table, investors have clearly valued the public handbag accessories-related companies at a significant premium relative to the footwear-related companies as a result of their higher growth and returns. This disparity highlights the investment opportunity in the stock tied to properly valuing the earnings stream of each of DFZ’s businesses at more appropriate levels.

I believe that the best way to gauge the intrinsic value of the Company’s stock is to properly value the earnings stream of both of its major businesses. My analysis shows that in calendar 2013, DFZ’s accessories business will contribute roughly 40% of profits, or $0.90 per share, while 60% of earnings, or $0.60, will come from the Company’s traditional footwear/slippers business. To be conservative, I value each division at a discount to their peer group average. Thus, valuing the footwear business at a multiple of 10x and the accessories business at a multiple of 15x leads to a stock price of $18 per share. This represents appreciation potential of about 40%, or about a 30% discount to intrinsic value. Also, a dividend yield of roughly 2.5% provides current income to investors.

Catalyst

• An accleration in overall sales, earnings and FCF growth.
• Expanding margins.
• Less seasonality.
• Greater buy-side coverage.