Description

Situation Analysis

Following a proxy fight worthy of a shout out to Gordon Gekko’s run at Teldar Paper, Destination Maternity (DEST or the “Company”) is a retailer whose board will soon be replaced by a new slate of shareholder friendly directors put up by Nathan Miller, a 9% owner of the Company who successfully won the proxy fight on May 23, 2018.  On May 30th, following its win, the activist investors recently announced a new CEO with a track record of demonstrable value creation in her previous roles.

Without going into details regarding the contentious fight between management and the activist (I would encourage those who do enjoy this stuff do peruse filings), DEST, the world’s largest designer and retailer of maternity apparel, will now have a fresh set of eyes and perspective that could lead to tremendous earnings power and equity upside from its current share price ($3.40 a share).

In its solicitation case, the activist slate communicated that it thinks it can drive $2 a share of earnings power within a twelve-month period.  The slate also opined that fair value for the stock is $16-20 which represents a 500-600% return from current levels. Even if such targets are not achieved, I do think there is room for improvement and significant upside as DEST will now have more focused management team.

What gives me some solace in proposed improvement of the business from here is old management’s recent commentary that ~10% of its store fleet is currently losing money and these units can be taken out of the system in relatively short order.

Before being replaced, DEST mgmt. guided to low single digit comps and 35-45% EBITDA growth from LTM levels ($13MM), translating to $.50-60 of levered free cash flow per share (15-17% yield).  So even assuming the original guidance for earnings which is far lower than the activists game plan, the value of the equity still seems cheap.

Obviously, investors need to see progress and execution before rerating the shares.  While there are several fundamental and competitive headwinds to consider, the category seems relatively stable and the logic to improve margins from fleet rationalization seems to make sense.  

What originally attracted me to DEST was the positive inflection in the top line over the last couple quarters (driven by online sales that comped 40% last year).  While grossly mismanaged, the business does not seem to be broken and there are multiple ways to win here.

The stock is a microcap ($50MM mkt cap) and currently does not have any sell side coverage.   

I think it is reasonable to assume a 100% equity upside case for the stock with reasonable execution and if management really performs, the returns could be significantly higher.

Fundamental Overview

For starters, I am the furthest thing from a maternity apparel expert, or a retail expert for that matter.  One important lesson I learned early on in my career is that retail equity performance is all about comps and earnings.  While a simple concept, it really has proven true over the years.

Names I have done well with in the past (ODP, Charming Shoppes, etc.) have generally been left for dead retailers that have self-help opportunities to create value by exiting unprofitable locations (addition by subtraction), which is very accretive to the overall P&L.

DEST is a dominant player in a niche category and while I do fully acknowledge that birth rates are at 50-year lows and competition does exist, the category seems like a decent one that lacks fads or trends.  Furthermore, most of the Company and board was run by middle-aged to older men, so perhaps a new slate of female executives and directors could add a fresh perspective on merchandising initiatives.

Business Overview

1,124 retail locations including 487 stand alone stores in the US, Canada and PR and 637 leased departments located within department stores and baby specialty stores (Macy’s, etc).

Nameplates include:

Motherhood Maternity:  408 stores, fashion assortment ranging from wardrobe essentials to special occasion merch. 1,800 sq ft. in regional malls, strip malls, 97 outlets. In 2016 opened 7 new stores and closed 24.

Pea in the Pod:  26 stores, fashion-forward higher end assortment, designer labels.  2,000 sq. ft stores in high end retail locations (Bev Hills, Water Tower Chicago, South Coast Plaza, Marin, etc.). In 2016 opened 4 and closed 1.

Destination Maternity:  81 stores with avg of 4,200 sq. feet.  Carries brand (Motherhood and the Pea).  Includes 33 Destination Maternity Superstores.

E-Commerce Initiatives

Management was late to the game in terms of establishing an e-commerce presence, however the investment in the e-commerce platform (representing ~20% of total sales) comped 40% in 2017 which lead to an inflection in overall store comp growth, including +5.2% last quarter (Q4).

While comps have been positive the last two quarters, it seems that the leverage to the bottom line that one would normally associate with comp growth has not come through.

·         Old management offered a jumbled answer regarding the lack of leverage citing increased marketing and ad spend to drive comp growth.

·         Bottom line profitability is key to this story and I am hoping that new mgmt. will be able to provide some clarity and results with expense leverage.

Proposed Value Creation Plan

SG&A as a % of sales is among the highest of DEST retail peers at 53-54% vs an average of 34%

A $10MM reduction in SG&A all else equal represents approx. 5% of sales or $.50 a share of earnings power.  On a stock that currently trades $3.40, this is a meaningful number

The activists have laid out the following roadmap to drive shareholder value

(https://www.sec.gov/Archives/edgar/data/896985/000119312518150868/d578920ddfan14a.htm)

Cost reductions of 5% (cut SG&A from $220 to $200MM) with $20MM dropping to the bottom line

Net pricing increase of 5% (raising revenue from $400-420MM) with $20MM dropping to the bottom line

Resulting in:

Raise EBITDA margins by 10%, EBITDA by $40MM, Cash flow by $40MM, Net income by $30MM and increase incremental EPS by $2

Implies $16-20 of fair value to the stock priced from current levels (10x EPS / 6x EBITDA)

It is possible that the activist laid out lofty targets here and in a competitive retail environment pricing initiative are challenging to obtain but if mgmt. can take at least $10MM of costs out of the business and generate some meaningful cash flow, the stock should work

Numbers and Valuation

I took a stab at trying to determine how productivity initiatives could help drive earnings from here.  Below are a few reasonable scenarios juxtaposed with the activist’s proposal to shareholders:

Per management, 10% of their stores that are not four-wall profitable.  50% of their lease portfolio will mature by the end of 2019 so there are multiple opportunities to exit and/or renegotiate leases to drive profitability

Risks and Considerations

Inability to execute:  new management screws up and doesn’t do with they say

With that said, the recently elected CEO does seem to have a decent track record which    includes time at Lands End which was a favorable turnaround story:

https://www.linkedin.com/in/marla-a-ryan-6530716/

Major shareholder and Board intentions (two major holders own 20% of shares)

If you read through the proxy, you will learn that the current activist (Nathan Miller who owns 7.5% tried to acquire the company for $2.75 a share – not sure what his longer-term intentions are here but at least you are aligned with him after they won the slate

Additionally, another contentious shareholder (Orchestra-Premaman S.A.) who tried to also historically waged a proxy fight (and lost) to try to take over DEST, owns 13% of the shares.  One would think that both shareholders are interested in driving the value of the stock, but I just highlight that as one consideration

Competitive Threats

Principally competes with Old Navy (Gap), Target, Walmart, Zulily, H&M.  Maternity clothes are generally an ephemeral purchase, so shoppers could be price sensitive however fit is an important consideration, so it may not be as easy for a shopper to go for the cheapest items of clothing.  Furthermore, DEST seems to be the only retailer that offers higher-end products for its shopper.

Catalyst

Continued positive comps and improved earnings 

Articulation of earnings opportunity