Description

I started shorting DXLG right before Orion’s excellent write-up early last year. http://www.valueinvestorsclub.com/idea/DESTINATION_XL_GROUP_INC/114763

Orion’s short recommendation was based on short-term expectation/EPS estimate being too high. The story played out almost exactly as he forecasted, and the stock had come down from high $5’s to $4.5, where Orion closed the recommendation. I have kept my short since I believe the aggressive and expensive transition from legacy Casual Male XL stores to the new Destination XL stores will prove far less profitable than mgmt guidance. We are almost four years into this transition, and while mgmt will give you a myriad of encouraging metrics such as SSS/conversion/four-wall returns, the bottom line is that the new store economics have never been proven, and DXLG has been losing money on an operating basis for two years now, and will likely be loss making again in ’15 and ’16 (per their own guidance). Balance sheet has been wrecked after mgmt spent $170m+ capex from ’12 to ’15 and will likely continue to deteriorate. Yet inexplicably, the stock trades at 0.7x EV/sales, even though the company has not made over 5% op margin in last 10 years. Even if I give mgmt credit assuming success on roll-out to 250 stores (beyond 2017), DXL will do $30m EBIT @ 8% op margin and $200/sqft. This compares to current EV of almost $300m, hardly a bargain. I think a marginally profitable/flaky retail chain with little prospect of store growth should not trade more than 0.2-0.3x EV/sales, and DXLG will eventually head there once SSS moderates from the natural ramp-up off a low base.

Story: DXLG is the largest Men’s Big & Tall specialty retailer with $400m sales. Mgmt believes the overall market size is $3.5-4B in sales. Starting in 2H 2011, the company has embarked on an ambitious transition replacing essentially all legacy Casual Male stores at 2.5-3k sqft to the new Destination XL (DXL) stores at 8.5k sqft. At end of 2014, we are half way through the transformation, with 138 DXL stores (40% sales) out of a fleet of 350 stores. The company will continue to open around 40 new DXL stores and close 40 CM stores each year for the next 2-3 years.

Bull Case: The bull case has been that the new DXL stores will ramp from $150/sqft in the first year to $220/sqft in Year 5 @ 25%+ four-wall cash flow margin. The chain itself will then do 8-10% op margin on $400m sales (250 stores at 8k/sqft and $200/sqft).

Actual Financials:

Despite the rosy projections, one just needs to take a quick glance at reported financials to see something is awry. Legacy CMRG chain used to do $400m sales @ 4-5% op margin, nothing to write home about, but certainly a lot better than loss making in ‘13/’14 and most likely ’15 and ’16. Even operating cashflow (before capex) has been going down the last two years. Having followed CMRG/DXLG on/off for 10+ years, it remains a mystery to me why current mgmt is so intent on destroying the old chain and building a new chain so aggressively for maybe $10m incremental EBIT in a best case scenario while spending $150m+ cold hard cash. In addition, this transition flies in the face of conventional wisdom in retail – you don’t start rolling out new stores so aggressively until the model is proven (hardly the case here) and you don’t borrow against revolvers to fund new stores.

What about the strong SSS? Indeed, the most powerful bull case for DXLG is the robust SSS reported by DXL stores. In the last 6 quarters, DXL stores at least 13 months have posted 11%, 14%, 13%, 11%, 13% and 16%, which are impressive to say the least. I will counter with two points. The robust SSS has not translated into much profit as shown above, and the SSS came off a low sales/sqft base juiced by an unusually high marketing spend (over 6% of sales in ’14).  I will quote Roark from the discussion thread.

Do they get credit for the double digit real-comp increases?  I mean, barely.  Open a large off-mall niche clothing store with no existing brand name and you are going to get some kind of ramp nine times out of ten, whether the concept works or sucks.  The key to calibrating that ramp is starting point and duration.  We already know the starting productivity is low, and there is just no real duration information yet.  What we do know is that the marketing budget of $28 million is in large part directed toward a chain that has a 2013 run rate of like $120 million opening in the lows $100s psf.  I think I could comp a Bill Ackman Burrito Hut with that setup.  I mean, they even point out that early vintage DXL's were already flatlining before they started their heavy advertising flights, and then they started popping again.  

Off top of my head, I can think of two similar precedents. The first is the old TWB converting all Tween Brands stores into Justice stores overnight. TWB was facing serious pressure from WMT/TGT/KSS of the world and chose to cannibalize themselves with the lower priced Justice store formats. The switch at least made some sense as Justice had over 250+stores at the time and had been more profitable and comping double digit consistently. TWB was eventually sold at a much lower price to Ascena after Justice slowed down in a tough consumer tape. The second is Coldwater Creek, a copycat of Chico’s aggressively rolling out big stores. Coincidentally, the concept was also doing double digit comps off a low base, even though profitability was never proven over any meaningful cycle. The chain eventually went bankrupt after years of negative SSS.

Valuation:

Admittedly, this is a tricky exercise as the company will not make much earnings any time soon. In fact, it is kind of amusing to read the valuation methods in the sell-side reports.

The upside case is the chain will make $30m EBIT @ 8% normal op margins (at least 3 years out), vs. current EV of $300m. I will point out that the company has $200m NOL which could be worth $40m (almost 80c/share) if the company indeed becomes sustainably profitable, but I highly doubt the upside scenario. The nice thing about a short in names like DXLG is that (hopefully) it won’t get a high ending multiple like the open ended growth retail names, though I will concede names like TUES had taken longer and multiple had marched higher than I had expected.

My experience has been that flaky retailers such as DXLG with marginal profitability trade below 0.3x EV/sales in a more normal environment vs. 0.7x today, suggesting plenty of downside. If one wants to speculate/pair trade, I would point out names like PSUN or BEBE with positive SSS and at least a historical record of profitability trades at 0.3-0.4x EV/sales (much lower at beginning of the year).

Personally, I believe a downside scenario is far more likely -- after 2016, the company is still loss making and has close to $100m net debt (0.2x sales), and equity becomes a call option. My contention is this call option is worth far less than 0.5x sales.

Perhaps the biggest risk is a take-out with activist Red Mountain owning 15% of shares. There was an interesting back-n-forth between Utah and roark on the previous thread (has the side bet been settled?). Personally, I am in roark’s camp that I find it hard to believe anyone would pay $400m+ for this concept with no proven profitability, but we live in bizzaro world right now, and I have felt the same with HOTT before. So never say never.

Catalyst

slowdown in SSS?

Investors demand cold hard cash?