Description

SUMMARY

In a market where most valuations are (or, at least, were) stretched, I believe that DSW offers a relatively safe haven for the long-term investor. It is by a wide margin the dominant bricks and mortar retailer of footwear in the U.S., continues to grow its top-line (albeit at a modest rate), is very profitable (although margins are under pressure), and has a very strong balance sheet with $330 million of cash ($4.10/share) and no debt. Net of the cash, the stock is trading at just over 10x trailing earnings, which are depressed. Additionally, the dividend yield on today’s price is greater than 4%, providing both a floor to the stock price and some cash return while we wait. At a time when many bricks and mortar retailers are under stress, DSW’s strong market position, product offering (shoes, which customers like to try on), profitability, and balance sheet make it unlikely that it will experience financial distress, and the demise of some competitors could even strengthen its position over time. And if margins improve over time, as I expect they will, higher per-share earnings should drive the stock significantly higher.

DSW has previously been posted on VIC in August 2015 and in December 2007, and I recommending reading those two reports for background, particularly the more recent one. The 2015 write-up by newman9 focuses more on the qualitative aspects of DSW and its competitors and the impact of the growth in online retailing on the footwear industry to illustrate DSW’s strengths and why he thinks the company will succeed over time. I agree with his commentary, and because not much has changed in industry dynamics in the two and a half years since then, I won’t repeat his points. Instead, this write-up will focus more on financial aspects of the company, the economics of the business, the shareholder-oriented capital allocation of management, and why I think that profit margins should improve over time.

INVESTMENT THESIS

An important part of my investment thesis is that DSW is a business with very good economic characteristics, earning high returns on invested capital, and generating huge amounts of free cash flow, and that management is allocating this cash flow wisely to benefit shareholders. The other aspect of my argument is that shoes are not as much of a commodity as, say, books or music or razors. While many people seem willing to buy shoes online (and return ones that they don’t like or don’t fit), a large part of the population prefers to touch and see shoes, and try them on in a store for comfort and fit, before buying them. So, while the online share of shoe purchases may continue to grow, and many shoe retailers (both specialty retailers and department stores) will struggle and fail, DSW will thrive over time by virtue of its strong market position and cash-rich balance sheet, and it will gain market share among the bricks and mortar survivors. Additionally, DSW’s online business (DSW.com) continues to grow as the company invests in its digital capabilities, and its online business should nicely complement the physical stores.

The good news for an investor considering DSW today is that the TEV has declined from about $2.5 billion in August 2015 to about $1.17 billion today, or by more than 50%. This is a key reason for my recommendation of DSW at this time. In the meantime, revenues have increased from less than $2.5 billion in 2014 to $2.75 billion (TTM) currently, and the number of DSW stores in the U.S. has grown from 431 at the end of fiscal 2014 to 514 at the end of October 2017. The bad news is that profit margins have also declined, with operating margins down from 9.7% in 2014 to 6.8% (est.) in 2017, and operating profits declining from $242 million to about $191 million (est.) in 2017. But my belief is that margins will stabilize and gradually improve and this, combined with the company’s active stock buyback program, should drive EPS to record levels in the next few years. A combination of capital appreciation and dividends should result in decent returns for an investor at today’s price.

It is not difficult to imagine operating margins improving to between 7.5% and 8% over the next three years. With very modest growth in sales to $3.1 billion, this would translate to EPS of between $2.05 and $2.20, assuming the 39% tax rate that the company has paid in recent years. Even at this high tax rate (i.e. ignoring the recent tax bill), and factoring in the cash on the balance sheet (currently $4.10/sh), a stock price of $30 is easy to imagine, for an annualized total return including dividends exceeding 20% over the next three years.

THE BUSINESS

DSW (Designer Shoe Warehouse) is the largest footwear retailer in the U.S., operating 514 big-box stores in the U.S. (in 43 states, D.C., and Puerto Rico), selling branded footwear for women, men, and kids, and handbags and accessories. DSW sells shoes at everyday discounted prices in stores that carry approximately 22,000 pairs of shoes and average 21,000 square feet. The company also sells online through its website DSW.com. In each of the last three years, women’s footwear represented 69% of sales, men’s footwear 22%, and accessories and other (which includes kids’ footwear) 9% of sales.

In addition to its U.S. DSW stores and e-commerce business, the company has various related ventures. Its Affiliated Business Group (ABG) partners with department stores to help manage their shoe departments. As of the end of the third quarter, ABG managed 351 store locations within Stein Mart, Gordmans, and Frugal Fannie’s stores. (Gordmans has filed for bankruptcy, and management of those stores by DSW is being phased out.)

The company also bought a 49.2% equity stake in Canada-based Town Shoes in 2014 for $69 million, and intends to exercise its option to buy out the rest of that company in 2018 for an estimated $80 million. Town Shoes operates 181 stores in Canada under various names, including 24 under the DSW name.

In 2016 the company acquired Ebuys, Inc. which sells off-price footwear and accessories online. (This acquisition appears to have been a dud, and the company has already written off most of the $60 million cost.) Additionally, the company has a recent partnership with a company in the Middle East to open DSW stores in that region.

This report focuses on the main U.S. businesses -- DSW stores and DSW.com -- which account for more than 90% of the company’s revenues. The other businesses, with the possible exception of the Canadian Town Shoes business, are unlikely to move the needle in the near future.

FINANCIAL PERFORMANCE

Over the years, DSW’s financial performance has been very good, with a combination of top-line growth and high operating margins resulting in huge free cash flow and a remarkably strong balance sheet. But the company’s overall sales growth rate has slowed from rates exceeding 10% annually a few years ago to low single digits now. Simultaneously, the company’s operating margin decreased from 10.8% in FY 2012 to 7.4% in FY 2016, primarily because gross margins have been squeezed, declining by almost 300 bp over the four years. This trend continued into fiscal 2017, with overall sales for the full year expected to increase by about 3%, and the operating margin estimated to be about 6.8% for the year. Management has guided EPS of $1.40 – $1.45 for FY 2017.

DSW’s business has remarkably good economic characteristics, as measured by return on capital. The table below attempts to create a crude estimate of return on capital employed by the company to demonstrate the outstanding economics. Adding the current assets (excluding cash) and PP&E, and deducting current and non-current liabilities provides us with a rough measure of capital employed in the business. The pre-tax operating profit on this “capital employed” measure indicates returns that most companies can only dream about.

So, the important question is: Will margins continue declining, or will they stabilize and improve over time? My view is that this is not a race to the bottom. A competitor such as Zappos, owned by Amazon, presumably has deep pockets, but will likely want to start making money at some point. There are few other well-financed competitors, and numerous struggling bricks-and-mortar retailers. DSW’s fortress-like balance sheet gives it the staying power to benefit if other footwear retailers (whether specialty or department stores) fail. Additionally, management is increasingly focused on initiatives that will improve store-level performance, rather than adding more stores at a rapid pace. While the company added at least 30 net new stores each year from 2011 to 2016, it only added about 15 stores in FY 2017, and 2018 will probably have a similar number of net new stores.

The growth and profitability improvement initiatives include the e-commerce business, which has been growing rapidly (26% growth last quarter vs. the previous year). Better integration of the physical stores with the online business should improve sales and operating margins over time. Management also sees a major opportunity in kids shoes and has been ramping up this department. Kids sections in stores were introduced in 2016, and 60% of DSW stores now carry kids’ shoes. This will increase to 100% in 2018, which is expected to help improve same-store sales. The company is also experimenting with services in the stores. These include custom-made shoe installs for additional comfort; repair and refurbishing of shoes and handbags; and shoe storage and rental. It’s too early to tell whether these initiatives will pay off, but I consider it a positive that management is experimenting with using its retail platform to provide services that cannot be effectively offered by online competitors.

DSW has been spending heavily on technology and its e-commerce business in recent years. CapEx in the years 2012 to 2015 exceeded depreciation expense by about $30 million a year on average. This aggressive spending has abated now, and free cash flow will benefit going forward. As the benefits of the improved technology kick in, sales and margins could benefit. The weak same-store sales of 2016 and 2017 should stabilize and improve as the omni-channel capabilities become more streamlined, e.g. buying online for pickup in stores, or returning online purchases to stores.

The company’s customer loyalty program, DSW Rewards, has over 25 million members who generate 90% of the DSW segment sales. The company is further enhancing this program with a new loyalty program called DSW Rewards VIP, which will offer additional perks to members.

All of DSW’s U.S. stores are leased. As one of relatively few strong retailers in turbulent times, it is an attractive tenant for landlords, and should be able to negotiate better lease terms and lower rents in the future, particularly from landlords who have other weak retail tenants.

The impact of the tax bill on DSW is unclear. Its tax rate in recent years has been 39%. If this were to decrease to, say, 25% (including state income taxes), 2017’s estimated EPS would be $1.75 instead of $1.42. How much of this gain will actually flow through to shareholders? Some could be used for higher employee compensation, or passed through to customers. Regardless, DSW will benefit from the tax cut more than its less-profitable competitors, so the tax cut should be a positive for investors.

CAPITAL ALLOCATION

An important part of my investment thesis for DSW is that the business has very good economics, generating large amounts of free cash flow, and management is using the cash wisely. The table below summarizes some of the key line-items of DSW’s cash-flow statement for the last five years, to illustrate the company’s capital allocation over that period. Over the five-year period, the company earned aggregate net profits of $712 million. It spent $317 million on stock buybacks and $365 million on dividends, for a total of $681 million. In other words, virtually all of the profits were “returned” to shareholders, either in the form of dividends or share repurchases. CapEx exceeded depreciation by $132 million, and acquisitions used $60 million. Cash and investments on the balance sheet declined by $142 million over that time, but they still had $287 million at the end of FY 2016, and $330 million at the end of the third quarter of FY 2017.

CONTROLLING SHAREHOLDER

DSW has 80 million shares outstanding. 72.3 million are the publicly-traded Class A shares, entitled to one vote per share; 7.7 million are non-listed Class B shares, entitled to 8 votes per share, and convertible into Class A shares. Jay Schottenstein owns or controls virtually all of the Class B and 15 million of the Class A shares, effectively giving him voting control of the company. He has been Chairman of the company’s board since 2005, and was CEO from 2005 to 2009.

DIVIDEND

DSW currently pays a dividend of $0.80 (annual rate), amounting to roughly a 55% payout ratio on current earnings, for a yield of 4.2%. The company first started paying dividends in 2013, at an annual rate of $0.50, increased it to $0.75 the following year, and to $0.80 in 2015. There has been no change in the dividend rate since then, as operating margins have been under pressure and EPS has declined from $1.69 in 2014 to an estimated $1.42 in the year just ended. I suspect that the dividend won’t be increased until the EPS starts to increase again. Also, given the strong balance sheet, I believe that a dividend cut is unlikely unless profits plummet, and the relatively high yield should provide a floor for the stock price. In the meantime, we can hope that the company continues to repurchase stock opportunistically when the price is particularly depressed.

SHARE BUYBACKS

The board approved a $150 million share repurchase program in 2013, followed by an additional $200 million in November 2015, and another $500 million in August 2017. Unlike many other companies, DSW has actively bought back stock when it considered the price to be cheap. Between 2014 and 2016 the company spent $315 million in stock buybacks. In 2017, through the end of October, the company had bought back another 500K shares for $9.4 million. At the end of the third quarter, $524 million remains authorized to be spent on stock repurchases.

RISKS

Same-store sales and operating margins continue to decline.

Acceleration in shift to online vendors such as Zappos.

An economic downturn hurts sales of discretionary footwear purchases.

Catalyst

Near-term: Improvement/stabilization in same-store sales and operating margins.

Longer-term: Higher EPS through a combination of modestly growing revenue, stabilized or improving operating margins, and stock buybacks.