Description

Please follow this link to see a version with exhibits: https://www.dropbox.com/s/d5j4qc7hj8dxwln/DXLG%20Write-Up%2003-2014.pdf

Thesis-

I expect DXLG will decrease by over 30% over the following 9 months due to the following three reasons:

1. DXLG will miss consensus and management sales per square foot targets – Current expectations are for the new Destination XL locations to generate sales per square foot of $230 by FY 2016.  To achieve this target these units will have to grow comp sales close to 12% in 2014, 2015, and 2016.  I estimate that same store sales will average 6.4% for the four years leading up to FY 2016, implying a FY 2016 sales per square foot of $187 for the new banner.
2. Stated 4-wall contribution margins for the new banner will prove too high- Management states that 4-wall contribution margins of Destination XL locations are between 25% to 30%, 600 to 1100 bps higher than the Casual Male XL stores they are set to replace.  However, I demonstrate that contribution margins of the new banner are not higher, but likely LOWER than the stores they are replacing.
3. FY 2014 operating margin expectations are too high, a re-base is highly likely- Management’s guidance offered in its March investor presentation suggests a FY 2014 operating margin of 4%.  Consensus expects FY 2014 operating margin to be 2.0%.  I believe that FY 2014 margins will equal -1.1%; which will create a $5 million EBIT loss, well short of the consensus expectation of $8.3 million in operating profit.

BACKGROUND ON DXLG

Business Description:

Destination XL Group (DXLG) is a men’s apparel retailer catering to the big and tall market.  As of Q3 2013 the company operates 375 units, 301 under the Casual Male XL, Rochester, and Casual Male XL Outlet banners, and 74 under the Destination XL banner.  DXLG is currently going through a transition.  Management intends to roll-out 215 to 230 Destination XL concepts and close all traditional Casual Male XL units (excluding outlet locations) by year-end 2015.

The Destination XL transition really began during H2 2011.  Initial plans projected a moderately paced transition.  However, upon witnessing the cannibalization of existing Casual Male XL locations, the transition was accelerated. 

The new Destination XL (DXL) locations have just under 3x the square footage of an old Casual Male location (CMXL).  DXL’s have over 3x the style choices, a higher mix of brands (closer to 70% / 30% private label / branded at DXL, while CMXL’s are closer to 80% / 20%), an on-site tailor and many other upgraded features and amenities.  The idea is that the DXL concept will be more productive and much more profitable than the stores it replaces.

Management has set a target of 215 to 230 Destination XL units and the closure of all Casual Male stores by the end of 2015.  The management team expects to leave open approximately 55 Casual Male outlet locations and 3-4 Rochester stores.  This transformation is expected to drive 2016 sales to $600 million, while the EBIT margin  is guided to reach 10%. 

DXL stores have not, up until this year, been aggressively marketed, if at all.  In Q2 2013 the company rolled out its first nationwide marketing flight.  This marketing program lasted for 6-weeks and started in May.  This campaign drove sales at DXL stores open more than a year up 16.5% (higher than Q1’s 4.7%).  In addition to driving sales awareness improved, and the company increased the percentage of sales driven by smaller waist customers (<46”).  Smaller waist customers represent a large potential opportunity as they are underserved by traditional retailers and represent a large portion of the big and tall market.  Small waist customers are also younger, more affluent, and highly focused on brands.  In addition to the campaign driving comps while it was airing, it also generated strong performance in July.

The second flight of marketing started in late September and ran 7-weeks.  The last two weeks fell into Q4.  Comps were again strong and there was continued strength in smaller waist customers. 

DXLG recently pre-announced Q4 sales with DXL stores open more than a year growing comparable sales 13.9%.  However, unlike in July, the campaign’s impact did not bolster December sales.

Marketing costs for the campaigns were projected to be an incremental $10 million in 2013.  The budget was expanded another $2 million, but this was covered by a reduction in catalog costs.

A 10% EBIT margin would point towards a 14% EBITDA margin.  With $600 million in sales this would mean $84 million in EBITDA.  Keeping YE 2013’s capital structure constant and applying a 6.5x multiple would suggest a YE 2015 price target over $10.

I will attempt to show why it is unlikely this level of sales and profitability will be achieved.

THESIS SUPPORT

Margins-

I believe management’s margin guidance is overstated.  Management has suggested in the past that Casual Male locations carry 19% 4-wall contribution margins, while DXL units carry 25%-30%; I believe that these numbers are highly suspect.  As can be seen in exhibit 2 (February Investor Presentation), occupancy costs are similar, labor is likely to be close to the same on a per square foot basis, and the mix is actually a drag on gross margin (per Dennis Hernreich, CFO, in Q1 2013 call “brand product margins aren’t as rich as private label”).  Given all of these variables, I believe that management is hoping they can reach the $230 in sales per square foot in order to leverage fixed costs.

Q3 2013 shows how little fundamental improvement is occurring.  In Q3 2013, the company lost $0.08 per share, which included transition and marketing costs of $0.07, meaning an adjusted net loss of $0.01.  In the Q3 2013 release management states that in Q3 2012 the company lost $0.03.  However, going back to the Q3 2012 release, the company realized $0.04 in incremental costs associated with the DXL roll-out, meaning adjusted EPS was closer to a $0.01 profit.  In a quarter with square footage 1% higher year on year, comps at the new concept up 17.7% (11.3% using a true comps calculation), old stores comping up 2%, and direct to consumer posting higher profits (although DTC sales were down, margin expanded), it is troubling to see EPS actually fall from the prior year.  It is extremely alarming to think that the marketing expenses are benefiting the top line while getting excluded as a one-time item in costs, and STILL the company can’t improve adjusted profits.

Q1 and Q2 trends were similar.  The recent Q4 pre-announcement would suggest a loss of $0.03 on a GAAP basis, while last year’s Q4 was a $0.09 profit.  On an adjusted basis, excluding pre-opening, transition costs, and marketing, Q4 2013 will be close to a profit of $0.05 versus last year’s $0.12.  This is a key reason why I believe margins at the new concept are not better, but actually lower than CMXL locations.

Some might say there are more moving parts than just DXL’s and CMXL’s, and that’s true.  However, the following diagram should address that concern: (Please follow link at top to see exhibit)

Sales Productivity-

Before diving into sales productivity I should make one clarification.  The company reports two sets of comps.  Historically the company definition of Destination XL comps included “stores that had been remodeled, expanded, or relocated during the period ….most DXL stores are considered relocations and are comparable to all closed stores in each respective market area” (per Dennis Hernreich, Q3 2013 call, emphasis mine).  Therefore, it doesn’t matter how many Casual Male stores were closed, the Destination XL unit opened was still comparable.  This means it is possible to close 6,000 square feet of Casual Male XL (approximately two locations) and open 9,000 square feet of Destination XL (approximately one location) and include this market as comparable.  Assuming similar productivity DXLG could then report a 50% increase in Destination XL comp sales.

The company recently began reporting true comps, or the sales growth at Destination XL locations that have been open more than a year.  When I refer to comps below, I am referring to the latter definition.

Management was hesitant to release data surrounding the new concept, but gave the sales per square foot figure in a December 2012 investor presentation (see Exhibit 1).  The December presentation suggested sales per square foot of $175, slightly higher than the $166 at Casual Male.  However, in the firm’s February 2013 presentation (Exhibit 2) the company stated that sales per square foot at Destination XL was now at $147, below Casual Male’s $166 figure.  The presentation suggested a $230 sales per square foot figure was the goal for 2016.

A December 2013 presentation puts DXL sales per square foot at $147.  However, to be conservative, I assume that sales per square foot grew to $165 in 2013 ($147 from February presentation brought forward at 12.4%).  In order to grow this figure to $230 by FY 2016, the DXL units would have to grow comparable store sales close to 12% per year.

In 2013, after more than $12 million in incremental marketing, comps are expected to just surpass this 12% hurdle (Q4 pre-announcement guided to 12.4%).  This is going to be a tough hurdle to clear in each of the next three years.

The company has committed to similar marketing next year.  Even if the total budget is increased, the additional dollars spent on advertising are unlikely to produce the same sales lift as the first dollar allocated to marketing.  I believe this will leave management in the difficult position of choosing between sales growth and profits. 

Insider Selling-

Insiders have recently been selling down their stakes.  Although there can be many reasons to sell a security, two executives selling at the same time is telling.  On August 26^th, CFO Dennis Hernreich was approved for a 10b5-1 plan, authorizing up to 400,000 shares to be sold between September 1^st, 2013 and August 31^st of 2014.  The amount registered under this plan would equate to 57% of Mr. Hernreich’s pre-plan ownership. Since the plan was announced, Mr. Hernreich has sold 292,673 shares.  In January, Mr. Hernreich resigned.

David Levin, CEO, was approved for a 10b5-1 plan on August 29^th, however, it was terminated on December 2^nd.  Mr. Levin’s plan was authorized from September 4^th, 2013 through February 28^th, 2014, and allowed for 225,000 shares to be sold.  Mr. Levin’s sale, if executed, would have amounted to 16.5% of his personal stock ownership.  From the date the plan was issued through today, David Levin sold 126,928 shares.

VALUATION / TIMING / RISK

What’s It Worth-

To forecast future EBITDA, I assume that comp sales at Destination XL register 12.4% this year (using the right way to calculate comps), 7.0% in 2014, and 3% in 2015, 2016, and 2017.  The reason for the deceleration is explained above.  I forecast gross margins to remain consistent to recent levels, while adjusted SG&A grows slower than sales post FY 2013 (excluding pre-opening, impairment charges, and other one-time items, but including marketing).  This would point toward a 2017 EBITDA margin of 8.1%, which is more than 2011’s (pre-aggressive Destination XL expansion) 7.6%, and on higher sales ($549 million in 2017). 

I estimated that EBITDA will amount to $45 million in FY 2017.  I believe a 6.5x multiple is prudent (average of current EV to forward EBITDA of GPS, KSS, and M).  This would all point to a 2016 EV of $291.  I project 2016 debt to amount to $69 million with cash at $5 million.  Market value of equity under this scenario would equal $227 million, or $4.68 per share.  Discounting this back three years at 10%, would point to an intrinsic value at year end 2013 of $3.51.  This $4.68 equates to 0.4x 2017 sales.

Timing-

DXLG shares have been under pressure post Q3 due to a lackluster retail environment and a negative Q4 pre-announcement.  I believe that investors view the recent disappointments as non-DXLG specific and therefore they have not given up on the story.  I believe that over the next nine months additional negative news will surface causing investors to question the value being created by the new concept.

There are two catalysts on the horizon:

1. Q4 Earnings- 3/14/2014- Q4 is typically when management releases its estimates for the upcoming year.  This is the most likely time for operating margin expectations to be brought down.
2. Q2 & Q3 Earnings- As this will likely be the point where long term sales per square foot and margin figures are called into question. 

Where I Could Be Wrong-

I think the biggest risk is that the advertising slowly builds brand strength.  There is certainly room for increased awareness amongst DXLG’s core potential consumer.  Also, the management team was granted stock and cash in May 2013, 50% of which vests upon the achievement of sales and margin goals (interestingly margins must be at least 8%).  Incremental improvement in profitability would warrant a reassessment.

Full Disclosure: I am currently short DXLG.  I reserve the right to sell more, buy to cover, or close the position at any time.  This write-up is only my opinion, please perform your own research.

Catalyst

• Q4 Earnings- 3/14/2014- Q4 is typically when management releases its estimates for the upcoming year.  This is the most likely time for operating margin expectations to be brought down.
• Q2 & Q3 Earnings- As this will likely be the point where long term sales per square foot and margin figures are called into question.