Description

• LTM EV/EBITDA < 1.5
• Price / LTM Pretax Cash Flow - 5.4x
• $32.3mm of Cash with no debt (62% of the market cap)
• 22.4% reduction in shares outstanding y-o-y through open market buybacks and recent tender offer.  Company continues to buy back shares aggressively.
• Business generates high cash adjusted ROE and good ROIC (LTM EBT/Cash Adjusted Equity - 32%).
• The CEO is talented, owns about 26% of the shares outstanding (voting class shares, increased from 20% via buybacks) and thinks like an owner.

Last Quarter Highlights

• Comparable store sales increased by 11%.
• Gross profit margin increased to 52.1% from 41.4% y-o-y due to improved merchandise planning and purchasing, a stronger Canadian dollar and reduced markdowns.
• 1.12 million subordinate voting shares repurchased through a tender offer (19% reduction in shares outstanding).
• Q3 EBITDA increased $5.0mm Y-o-Y.
• EBITDA for the first 39 weeks of the year sits at $15.6mm (Q4 likely to be slightly negative).

It appears that while the business is not terribly far from a net-net, the financials on a standalone basis are more than satisfactory given the price. 

Summary

This is a cheap and fine business which has very high cash adjusted ROE, capable management that think like owners, buys back every share the TSX allows and according to Canadian friends is a well known brand (one of my friends was actually wearing a Danier belt when I was quizzing him). 

Basically low risk / high return.  Take that EMH!

Business

Founded in 1972, Danier Leather is in the business of manufacturing and retailing leather (jackets and accessories) under the Danier brand name in 90 stores across Canada.  The business in largely vertically integrated and controls their leather sourcing, product design, domestic and overseas manufacturing and retailing operations. 

Danier's recently completed cost reductions have substantially improved gross and operating margins of the business, and historical operating results suggest it may still have significant room for improvement.  Further, the resolution of a longstanding lawsuit should additionally create cost savings relative to historical metrics while removing a longstanding uncertainty.  These changes have just recently become visible in the Company's operating results.

Share Repurchases

This company buys back a lot of shares at fantastic prices and management clearly understands capital allocation.  During the past several years Danier has consistently engaged in normal course issuer bids ("NCIBs") allowing the Company to acquire up to 10% of the public float of subordinate voting shares during a year long period.

Last 3 Years of Normal Course Issuer Bids

2010 Tender Offer

On January 29, 2010, Danier commenced a substantial issuer bid, offering to purchase up to $7 million of its subordinate voting shares by way of a modified dutch auction for between $6.10 and $6.45 per share.

The offer expired on March 8, 2010 and a total of 1.85 million subordinate voting shares were validly deposited, of which Danier purchased 1.12 million at a price of $6.25.

2010 NCIB

On May 4, Danier announced that the TSX had granted its application for yet another NCIB, allowing for the repurchase of up to 232,792 additional shares (10% of the Corporation's public float) before May 6, 2011.

Danier noted in the NCIB press release that the purchase of its shares at prevailing market prices may, from time-to-time, be a worthwhile investment for the Corporation as it enhances the remaining shareholders' value by increasing their proportionate interests.  I agree and would not be surprised to learn that the Company had already completed its repurchases for the entire year by mid July.  It would not have been overpaying at between $8 and $10 per share.

The below table shows both total shares outstanding and the book value per share over what was generally not a fun time to be a retailer.

Cost Reduction Initiatives

Danier up until recently performed a substantial amount of the manufacturing process in-house in Canada.  It has recently transformed its manufacturing cost structure and currently independent third party suppliers, mainly from Asia, manufacture over 85% of the Company's product.

During their Q3 2009 (June year-end fiscal calendar) it initiated the below cost reductions "Danier reduced its domestic manufacturing workforce by approximately 50% or 56 employees while also reengineering the manufacturing process to be more flexible and achieve faster turnaround times. The manufacturing workforce reduction is anticipated to reduce Danier's annual domestic manufacturing cost base by approximately $1.3 million. Danier has also reduced its 130 head office staff by over 20 employees for anticipated annualized savings of $1.3 million."

Danier subsequently took a $1.5mm restructuring charge in 2009 which related to employee severance in connection with the initiative.  So it should be no surprise that the business has done substantially better in the current calendar year (for more reasons than this).

The cost reductions initiative has begun to be revealed in the substantially improved margins and profitability of the business.  In it's most recent quarter, the Company noted that y-o-y gross profit margin had increased by 10.7%, to 52.1% from 41.4%.  Adding to this improvement was improved merchandise planning and purchasing, a stronger Canadian dollar, and reduced markdowns.  But it appears that despite Danier's dramatically improved profitability Mr. Market has yet to rationally evaluate the true value of the business.

Product Initiatives and Working Capital

Outerwear (coats, etc.) represented approximately 65% of Danier's total revenue in 2009 while sportswear represented 11% and accessories accounted for 24%.  Danier has stated that its long-term objective is to continue growing the accessory line of business and further rationalize inventory.  Management in the most recent quarter commented that "inventory at the beginning of the third quarter of 2009 was better balanced, containing increased amounts of fast-selling items such as bomber jackets and handbags and decreased amounts of slower selling items such as longer coats"

It makes sense to sell items such as wallets and belts (accessories) since they should be less seasonal, higher turnover, lower fashion risk, take up less floorspace, etc.  One nice thing about selling leather is that unless you are shopping in a red light district everyone seems to like about the same type of apparel.  The styles appear to be primarily black and brown jackets and this at least somewhat diminishes the fashion risk. 

During 2009, Danier was able to free trapped cash from the system and position the business to run with less inventory.  I have not included changes in working capital into cash flow metrics; however, the trends on that front are very positive.  The business has carried substantially less inventory in the first three quarters of this year (About $9mm less in the first two quarters and $1mm less in the third) despite increasing company sales over that same period. 

Additionally, since the business is based on cash transactions Danier requires limited accounts receivable.  Returns on equity net of cash prove quite attractive at 32% LTM EBT/Cash Adjusted Equity and management knows how to allocate capital.

Income Statement

It seems likely that Danier does slightly better in this Q4 than last year's due to the awful retail environment in June, 2009, and the Company's substantially improved margins and general economics.  Even so, the current Price / LTM Pre-Tax Cash Flow of about 5.4x seems more than acceptable given the balance sheet.

Balance Sheet

Valuation

So what should the business be worth?

I think that this simple business, possessing ownership-like management with a demonstrated ability to effectively allocate capital and improve operations, should conservatively be worth 7x pre-tax unlevered cash flow.

I am assuming that Q4 2010 pre-tax cash flow improves slightly from last year to end fiscal year 2010 at $10.3mm.

This gets us to roughly

Of course you should use whichever method or metric you feel is appropriate to value this business.  The point to take away is not the precision but that this is cheap and should have relatively little downside with substantial upside. 

It is also worth noting that despite this year being quite positive (relative to prior year), the business earned between 10-13.5% EBIT margins between 1998 and 2002 and had EBITDA of between $18 and $26 million from 2000 to 2003 on similar sale levels.  It remains to be seen whether this level of profitability can again be attained but represents additional and substantial upside potential.

Side Notes

As a side note, the company still carries the land for its headquarters at $1 million.  If you quickly Google that location and zoom out a couple clicks you'll see that the headquarters is surrounded by residential housing, is about a block away from the public school and is a couple blocks away from the golf course (but also train tracks).  The plot is pretty big (bigger than I'd say it needs).  In the nearby area it looked as though pretty nice homes on regular lots were selling for around five to six hundred thousand.  This is not material upside but it may be worth noting.

The President & CEO, Jeff Wortsman, is a conservative jewish fellow who dislikes debt and has not wasted corporate cash.  He is listed as the primary investor contact on Danier conference calls (on the last one there was one question).

Risks

• Significant currency valuation increase of Chinese Yuan or a substantial change in the Canadian dollar relative to the USD (somewhat hedged).
• Increased leather prices.
• Jeff Wortsman goes all Harold Simmons.
• Fashion risk inherent in business.
• Retail operation becomes unprofitable and you have to ride out leases.
• Large option grants to insiders (2009 was aggressive but over long term have been reasonable and so far there have been none this year).
• Hindu becomes much more popular in Canada.

Catalyst