Description

Summary

DSW is the largest fashion footwear retailer in the US with around 5% market share of the adult footwear market.  The Company is an off-price and discount retailer offering in-season department store brands at everyday low prices of 20-35% below MSRP and department store prices.  Women’s fashion footwear is the Company’s largest category at 61% of sales, but it also sells men’s footwear (18% of sales), athletic shoes (12%) and accessories & other (9%).  The stock is currently at $33 with $5 per share of cash for an enterprise value of about $2.5 billion.

The company was written up by pgu103 in December 2007, so we recommend reading that write-up for some additional background. 

This is an opportunity to buy a best-in-class retailer and category killer with substantial revenue growth opportunity, run by a solid management team, at an attractive price due to some recent short-term headwinds and concerns.  The stock is trading at a NTM ex cash P/E of about 14x compared to a median P/E of 17x for footwear specialty retail and 18-19x for off-mall specialty retail.  We believe that they will beat consensus earnings estimates in the short run (this quarter and year) and have a short-term price target of $40+.  Moreover, we believe earnings can compound in the double digits for the foreseeable future driving a roughly 20% IRR over the next several years.

Over the next few years as environment normalizes and the Company begins to leverage its multi-year merchandise and omni-channel IT investments, we believe the Company will earn $2.70 per share.  Assuming an ex cash multiple of 17-18x plus cash build would lead to a $57 stock.  Even at that point we believe there is significant runway for growth domestically and internationally.  While DSW is the #1 player in US fashion footwear, it has only 450 stores and 5% market share in a fragmented market.  Other retail category killers get to much higher store counts and market shares (10-25%), and DSW has double digit market share in its more mature MMAs, illustrating that there is plenty of growth left. 

The balance sheet is clean with $5 per share in net cash.  The Company has had a $100 million buyback authorization in place since mid-2012.  Compared to most buyback plans which we think are at best value neutral, this one is actually used opportunistically and should be value accretive.  After sitting patiently for a couple years, management made its first share repurchases in 2Q14 after the stock had fallen 40% from peak, repurchasing $55 million of stock at an average price of $27.60 or about 14x a depressed E.  They repurchased another $30 million in 3Q14 at an average price of $30.19.  In November 2014, they increased the authorization by $50 million.

Business

We believe that DSW is a high quality business.  We believe that DSW has a strong moat given its scale and buying model, which is strengthened by its focus on assortment, value and convenience.   

DSW is the #1 fashion footwear retailer in the US.  It has a concentration of sales in fashion footwear (fragmented supplier base) whereas most of its off-mall peers have significant exposure to athletic shoes.  It is by far the dominant off-price footwear retailer and its buying power is particularly consolidated in women’s fashion footwear.  There is no other Company that can match its bargaining leverage, a point which is significantly strengthened by its buying model. 

DSW’s genesis was a traditional off-price retailer which can be a very attractive business model for the leading players in a category.  Similarly to TJX Companies, DSW has morphed over time to do more upfront purchasing.  This was driven both by a consumer insight and out of necessity.  DSW realized its shopper knew what she was looking for (ie, shoes to match a particular outfit) rather than a “treasure hunt” experience.  At the same time, as DSW grew it became impossible to fill hundreds of stores with 20,000 pairs of quality fashion shoes in perfect size runs with only opportunistic purchases.  As such, the buying model evolved to include more upfront buys, largely driven by special make-ups.  Even as DSW morphed, it maintained the key characteristics of the off-price buying model:

• “Clean business” or leveraging all of their purchasing power upfront rather than asking for advertising support or markdown dollars. 

• Maintaining a liquid open-to-buy position so they can “chase” during the season as they identify trends or opportunistic deals arise.   

• Buyers are shoe specialists, have significant autonomy and accountability, and are in the market every day.  Department stores would give shoes to a multi-category junior buyer who places orders twice a year and has the safety net of markdown dollars or returns.

Relationships with the brands take years to build, particularly for discounters.  During our field conversations, suppliers have spoken very highly of DSW.  The suppliers know that their product will be treated well, a common concern they have with “discounters.”  While they give DSW big discounts upfront, given the “clean business” they know exactly how much money they are going to make from DSW, a certainty they do not have with other retailers.  Suppliers also know there is nowhere else they can go to move the types of volumes they can move with DSW.  These factors allow them to better plan their own business and give them the scale to do manufacturing runs in China or wherever. 

The scale and buying model leads to an approximately 20% cheaper purchase price compared to other shoe retailers.  The sales model is then akin to a discounter, with shoes sold in a big box warehouse-style store in lower rent off-mall locations with an open stock layout and “labor light” self-service model resulting in lower costs per square foot. 

As an aside, based on our field conversations, we believe TJX Companies actually looked at buying DSW in the past.  Instead, TJX unsuccessfully tried to organically replicate the DSW model through StyleSense, a concept they launched in Canada specifically to avoid competing head to head with DSW.  They shut this business down in 2012 after poor performance.  Despite being a best-in-class retailer with a buying organization considered one of the best, if not the best, in all of retail, they still couldn’t make it work.  We think this illustrates the durability of the DSW model. 

Opportunity

In very recent history, the stock has been weak on the back of some concerns around short-term fundamentals.  In particular, a research firm’s channel checks have suggested same store sales for 2Q15 of +3.0% compared to consensus of +3.5%.  Additionally, there are some concerns that less favorable weather and industry-wide discounting of port delayed goods have affected margins this quarter.  There has also been an ongoing modest headwind from the “athleisure” trend as DSW’s athletic shoe offering is lower margin and generally less compelling than its core fashion offering.

We agree with all of these points.  Except for the athleisure trend which has been around for a couple years, these concerns are short-term in nature.  We think these concerns are more than adequately captured in consensus.  Consensus expects 2Q15 EPS of $0.42 and FY15 of $1.90.  We are higher at $0.45 for 2Q15 and $1.99 for the year and believe numbers could come in even higher.  At 17x EPS of $2.00 per share plus cash would lead to a $40+ stock price.

The key difference between us and consensus is on margins and particularly gross margins.  In a nutshell, 2Q14, DSW had a disastrous quarter and lost about 390 basis points of gross margin year-over-year at the group level.  Merch margin was down 320bp due to aggressive clearance activity (210bp), mix in pricing (40bp), and increased shipping expenses (70bp).  Additionally, occupancy expense was another 70bp drag primarily due to one-time items.

Now in 2Q15, consensus expects gross margins to be +120bp to 30.5%.  We think that can be +150bp and could be much higher than that.  The clearance activity this year will not be as bad as last year, so they will recapture some of that margin.  While in 1Q15 they recaptured about 60% of the merch margin lost in 1Q14, we assume merch margins will be +100bp for a 30% recapture.  Additionally, a significant portion of the one-time items should be recaptured (these were truly 1x, appearing in 2Q14 and 3Q14 last year).  Because the company did not separate these charges in the release, most sell-side analysts have not separated them in their models. 

Longer-term, our EPS of $2.70 assumes stores of 500 (low end of guidance) and return to the FY11-FY13 average of $270 sales per square foot.  We believe there is further revenue upside from there.  We believe DSW has the potential to double or triple sales over time.  Management guidance of 500-550 store potential excludes small markets and small formats (10,000-12,000 sq ft stores) which are currently being trialed.  We would expect management to increase store potential guidance over time.  Granted, given increasing internet share an increase in store count may not be necessary and/or relevant to the significant growth of sales.  Alternatively, we can just look at 5% market share compared to category killers of 10-25% or DSW’s double digit market share in its mature MMAs.  

We assume 13% EBIT margins.  While 13% margins are higher than historical margins, it is worth noting that DSW has only been independently and professionally managed since 2009, so margins prior to that are not a good proxy for margin potential.  Furthermore, since 2010 the Company has had a significant multi-year IT investment program which has weighed on margins, but will begin to be a tailwind in 2015.  Margins of 9.7% in FY14 were weighed down by first half loaded markdown activity and a further 70bp of incremental omni-channel investments.  At $270 sales per square foot, margins were 11-12% and there is some 100-300bp of margin to be had from IT investments, primarily through lower markdowns and operating leverage on investments.  Margins of 13% would be quite reasonable in the context of off-mall specialty retail peers and particularly with relevant comps ROST and TJX.

E-Commerce / Omni-Channel

No discussion of a retailer would be complete without addressing the threat of e-commerce. As it stands we do not see e-commerce as a material threat to DSW and in fact see it as an interesting opportunity for the Company.  We will be brief, but there are several points worth highlighting:

• Omni-channel is a very attractive way for consumers to shop for apparel and shoes – browse online prior to visit, finding a store with the item in stock, ordering an alternate color/size while in-store, free shipping and then return to store, etc. After a multi-year investment program, DSW has one of the most advanced online offerings in all of retail and is in fact essentially to the point of “universal inventory” where stores are now effectively mini-DCs.

• Likewise, apparel and shoes are hard to buy strictly online.  Things like look, fit, and feel are immensely important and can only be appreciated in person.  Some skeptics have pointed out that online penetration of footwear is higher than most retail categories at 13%, suggesting people do not need to try before they buy.  However, we think that misses the point.  First, online apparel and footwear sales are predominantly driven by direct-to-consumer (ie, calvinklein.com) or B&M retailers’ (ie, macys.com) online sites, and often it is consumers purchasing after they did not find their size or color in store.  Second, returns in apparel and footwear are very high at 30% to even 50%+, suggesting customers do need to try before they commit.   

• Despite continued growth of online penetration, DSW has continued to take market share.  There have been no signs of DSW losing its price leader status.  Our pricing studies have shown DSW maintains its price leadership online.  Of note, this analysis is quite difficult to carry out since many of the styles and/or brands are exclusive to DSW, suggesting the ability of customers to showroom or price shop is limited.  Interestingly, Zappos (which was bought by Amazon) is expressly not focused on being low price and has discontinued discounting on its website last year.

• It is very difficult to create a profitable e-commerce business in general, but particularly difficult in apparel and shoes.  Unsurprisingly, we rarely see meaningfully profitable apparel and shoe e-commerce companies.  For example, even at $1 billion in gross sales, Zappos barely made EBIT.  Why is that the case?  We think there are a few reasons: customer acquisition costs in e-commerce are high, fulfillment costs in e-commerce are high (free shipping and returns), returns on online orders of apparel and shoes are higher than other categories like books or office supplies (driving higher fulfillment and handling costs), and suppliers want to maintain brand integrity (thus restrictions on pricing and who has access to what).

Risks

There are a couple risks worth noting, one is a cyclical mark-to-market point and the other is a more theoretical structural point. 

Even though we believe DSW has a strong and defensible business, it is still a single-category fashion retailer.  Compared to TJX Companies which has less of a fashion element and has more ability to shift floor space between categories, helping explain why it has had only one year of negative same store sales in four decades, DSW will exhibit more sales volatility with concomitant operating deleverage. Investors have a propensity to extrapolate these points.  However, even in the scenario that sales per square foot fell 15% peak-to-trough, similar to what was experienced in 2009, and margins compressed to 7%, the Company would still earn $1.25 and have $5 in net cash on the balance sheet.  At 12x, this would be a $20 stock on a mark-to-market basis.

We think there is very little risk of another company, whether brick & mortar or e-commerce, beating DSW at its own game.  However, there could always be a shift in the value proposition’s relative importance.  In particular, e-commerce opens up the opportunity for new models that did not exist before.  In other words, we see little risk to someone disrupting DSW’s ability to sell department store brands at EDLP of 20-35% below MSRP and department store prices, but are cognizant that this value proposition could take a back seat to, say, paying full price for the convenience of never leaving your couch, the experiential element of shoe clubs, or the allure of new e-commerce only brands.  We think “value” is a fairly enduring proposition, there is plenty of room for DSW to grow alongside other models, and it will take a very long-time for other models to make significant headway.  As such, we do not see this as a threat in the foreseeable future, but it is something we will monitor and remain cognizant of over the years. 

Catalyst

Above consensus earnings and subsequent estimate revisions

Opportunistic capital allocation by the company