Whether Spike Lee’s iconoclastic commercial with Michael Jordan or Imelda Marcos penchant for shoes, or my wife’s seemingly endless demand for the next pair of shoes, we believe you got to have some SHOES. As any value investor knows this has been an extremely challenging year buying anything consumer related.  Also, broken GARP has been even more dangerous.  The opportunity in DSW is a combination of both these factors,  We have followed DSW from its pre-public days within Retail Ventures Inc. (RVI) and have never been more excited about the longer term investment risk reward than today (maybe $5 a share downside with $20 to $30 a share of upside over two years).  In our experience, buying growth retailers with high ROICs at 10x earnings has always proven to be a profitable investment in the long run. 

 

This has been a tremendously challenging year for DSW particularly when viewing the earnings in isolation.  However, we believe the year should not be judged just on the earnings but also on the investments in future growth and accomplishing longer term goals.  This year’s dismal EPS performance (from $1.62 to 1.68 guidance to actual of $1.24 to 1.28) is nothing short of a failure.  As outlined below this failure was a result of four factors:

 

a.     Weather – we had snow in Easter and the warmest fall in record – which affected DSW’s two most important selling seasons. (and dramatically affected margins)

b.    Slowing consumer traffic (DSW is still looking to have a flat comp which speaks to  resilience of women’s (70% of sales) demand for shoes as affordable luxury)

c.     Fashion – lack of any “newness” in women’s shoes

d.    Investments in future growth – DSW has invested this year in IT and website (12 cents in EPS all expensed), logistics and allocations, cranking up store opening schedule from 30 a year to 35 along with a new smaller format and testing remodels.

 

 

 

 

DSW is a specialty branded footwear retailer operating 260 shoe stores.  They offer a wide selection of brand name and designer dress, casual and athletic footwear for women and men. The stores average approximately 25,000 square feet, with new stores approximately 15,000 square feet and hold approximately 30,000 pairs of shoes. In addition, they operate 364 leased shoe departments for four other retailers.

 

DSW went public in June of 2005 at $19 and over the next two years traded as high as $44.  Over its first eight quarters, the company constantly beat earnings estimates and was rewarded with an average forward PE multiple well in excess of 20 times.   Before the IPO, DSW was owned by RVI.  Today, RVI owns 63.0% of the DSW shares outstanding and has 93.2% voting power.  DSW has spent the last two years refining its strategy and store design.  They have gone from a “warehouse feel” store design (25,000 sq ft) to a more upscale feel store (15,000 sq ft.) with about the same number of shoes and about the same amount of sales per store (which should boost its ROIC).  DSW sells all first run shoes from leading shoe manufactures at competitive prices.  They compete mainly with Macy’s, Nordstrom and other branded footwear companies. 

 

DSW is similar to most successful specialty retail growth stories in that their competition is the in-store shoe departments of the major department stores.  The four value drivers to DSW’s customers are: assortment, brands, convenience and value.  DSW’s competitive advantage is their unique relationships and buying power with their vendors.  DSW offers top-line first run brands at compelling value relative to department stores (e.g., Cole Hahn’s at $120 vs. $180 at a Macy’s).  The concept is everyday value-based pricing.  DSW is the number three buyer of women’s branded shoes  While the major department stores may complain about DSW receiving similar product to them and offering everyday pricing under their initial mark up’s, DSW has enough buying clout to guarantee continued first rate supply.  The other compelling longer growth driver is taking share from a very fragmented market. DSW has an approximate 3% share while the three leaders in adult branded footwear (Federated, Nordstrom and DSW) control only an estimated 10% share combined.  In some of DSW most mature MMA’s, we believe the company has well in excess of 7% market share demonstrating the category killer nature of the DSW opportunity.     

In Q1 2007, DSW had its first negative comp in at least 15 quarters with a -3.2% comp.  Even with the negative comp, they still had 34% earnings growth because of stronger merchandise margins.  The first real earnings disappointment came when they released Q2 2007 earnings and had a 550 bps decrease in gross margin which was driven by an unusually cold, wet spring and the company was stuck with too many sandals that led to additional markdowns and sales promotions.  The additional markdowns they took in Q2 gave management confidence to keep earnings estimates unchanged for 2007.  Through the additional clearance sales, DSW had cleared through much of their inventory and moved into Q3 very clean inventory and  less clearance than the year before.  In Q3 (their most important quarter), the weather stayed unusually warm for a long period and they began to see the same consumer slow down in traffic that most retailers experienced.  This led DSW to significantly lower guidance mid-quarter and to begin to lose credibility with the street.  Q3 EPS came in above initial expectations as the weather finally became more seasonal combined with the clean inventory position which led to more robust margins. 

 

DSW is trading below its IPO price and at its all time low of $17.50.  It has been punished in a weak consumer tape and a few recent “shoot first, ask questions later” quarters.  DSW has 260 stores today which management currently believes it can grow to at least 400 stores over time.  DSW is one of the few retailers with this much sq ft growth potential.  They are in the process of opening new, more productive stores and have been consistently raising AUR (average unit retail) which leads to higher merchandise margins over time.  We believe they can have average yearly earnings growth of at least 20% for a number of years.  DSW has stated a goal of 400 stores with 30% gross margins, 20% SG&A and 10% operating margins over time.  With these assumptions, we believe they would earn close to $4.00 per share. 

DSW has an impeccable balance sheet with $140mm in cash ($3.20 per share).  The stock is currently trading at a P/E of 13.6x based on “disastrous” company guidance of 2007 EPS of $1.24-$1.29 and under 6x EV/EBITDA.  Most recent analyst estimates project $1.44 for 2008E EPS, for a forward PE of 12x and only 10x ex-cash. We believe that with flat comps and only a slight recovery in gross margin, EPS will be at least $1.59 in 2008.  The company has already stated that they feel confident about exiting this year with a lean inventory position and will be conservative in their inventory purchases in 2008.  This gives us confidence that DSW should be able to recoup some of the lost margin. 

Looking into 2008 and beyond, we believe there is compelling value in DSW at these levels.  FY 2007, while very painful, should be chalked up to a year of investing in future growth, along with unseasonal weather, a slowing economy and lack of women’s fashion. DSW spent $8.5mm on an e-commerce site in 2007 with no corresponding sales.  The site is expected to go live in the first half of 2008.  Management also began testing and then implementing a new store protype.  Before the current management team joined DSW, there were many stores opened that were too large and in weak real estate locations.  All of these stores were four wall profitable, but they are not what would be considered successful stores.  This year DSW launched a small box that holds the same number of pairs of shoes as the bigger box.  They are seeing good results with higher sales per sq ft and better productivity.  All new stores will be opened in the new prototype.  In 2007, the company also filled out their corporate staff to take them in to the future.  They added a new head of real estate, added to the finance team and hired new merchants to support the ones they already had in place.  We believe they now have the people in place to grow to 400 stores.  In 2008, the company estimates they will have an additional $5-12mm in SG&A spend due to their shared services agreement with RVI.  Since the IPO, DSW and RVI have been sharing IT, finance and warehouse expenses on a pro rata basis.  RVI recently announced that it will likely be closing or selling their Value City chain by the end of the first quarter.  DSW will have an increase in SG&A from this closure which has been factored into our earnings estimates.  

DSW also has a first rate loyalty program that was re-launched in 2006.  Today they have 7.3mm loyal customers that continue to grow each quarter along with their retention rates.  66% of DSW sales in the 2006 was from loyalty members and is expected to be even higher this year.  Loyalty customers receive a $10 coupon after spending $150 in store.  They also receive special promotions and emails throughout the year.   DSW is excited about the cross marketing abilities they will have with the launch of their e-commerce site.

With the potential for another 150 stores, increases in IMU and gross margin expansion opportunities, we are very excited about DSW in 2008 and beyond.

 

 

Uncertain and certainly weak consumer environment

 

RVI wind down and share ownership – our estimates and streets incorporate the additional spend (and we are actually glad to take over this important function in-house sooner)

 

Continued multiple contraction across consumer space.  We would rather pay-up for the future growth DSW represents but both PSS and SCVL are cheaper on trailing metrics.

 

Online competitors – Zappos, Piperlime, shoe.com, shoebuy.com