Description

[Note: This was written over a week ago and submitted earlier this week as my VIC application].

Dr Martens was written up on VIC a year and a half ago. Its price has fallen by approximately 60% since then. I think it’s worth revisiting the business.

Quick Pitch

The market has placed Dr Martens in the sin bin for missing estimates due to operational issues at its new distribution center in LA and overly optimistic guidance that has had to be rolled back in its most recent trading update. As a result, Dr Martens is currently trading at 8x FY2023 estimated EBIT (fiscal year end in March). Given the strength of the brand and its proven ability to grow outside its home market of the UK, it seems to me that the market has overreacted. If the business delivers on a conservative estimate of its earnings potential over the next 5 years, an investment in DOCS could earn an IRR of over 25%. If management fails to deliver, there is a significant margin of safety at its current valuation.

Company History

Dr Martens is a footwear brand. It started out making boots in the 1960s in Northamptonshire, England for men in working class jobs. Over time, Dr Martens’ boots were adopted by various youth subcultures often associated with music such as punk, new wave and grunge. 

Under the ownership of the Griggs family, Dr Martens expanded in the 1990s both in terms of geography and product categories, introducing clothes and leather accessories. The Griggs family’s emphasis on growing sales rather than cultivating the brand, particularly by overselling into wholesale, resulted in overexposure, diluted brand value and, ultimately, a decline in Dr Martens’ sales.

In 2014, the Griggs family sold Dr Martens to private equity firm Permira, who refocused the brand on its core footwear product and implemented a strategy that is typically used at the large European luxury brand conglomerates: prioritize sales through owned and operated channels, tightly control sales into wholesale and focus on elevating the brand. 

The strategy has worked well with revenues tripling between FY2015 and FY2021 both through volume growth as the brand re-expands geographically and higher average selling prices (ASP) as more pairs are sold through owned and operated sales channels where prices are 2.5x wholesale. 

Not Fashion

Dr Martens’ sells an iconic product that transcends fashion in a way few apparel products do. 4 out of every 5 pairs of shoes sold are black. Their most popular shoe, the 1460, named after the date it was created (April 1, 1960), has remained unchanged for 60 years and has even been displayed at The Metropolitan Museum of Art. Sales of 1460s alone are responsible for approximately 40% of revenues (FY2021 earnings transcript). Together with the 1461 and 2976, also named after their dates, the “Originals” line of shoes contributes over half of revenues (FY2022 earnings presentation).

It is rare for such longstanding products to continue to remain popular and contribute such a large proportion of sales in the everchanging apparel industry. The only other example I can think of is Ray Ban sunglasses, whose iconic aviators and wayfarers have similarly universal appeal and are worn by people across a wide income range. Even brands such as Hermès, with their iconic Birkin and Kelly bags, or Chanel, that are seemingly immune to trends, don’t have such a large contribution to total revenues from continuity products. 

There are several advantages to having such a high proportion of continuity product. Other than the obvious benefits of increasing the durability and longevity of the business, it results in fewer inventory write downs and less discounting. 90% of Dr Martens’ sales are at full price and inventory write downs are minimal (FY 2022 presentation), contributing to higher gross margins than its peers. In FY2022, Dr Martens earned a gross margin of 64%. While that is not as high as higher end brands such as Burberry (71%) or Moncler (76.5%) who can push pricing further, it is significantly higher than Crocs (55%), Ugg maker Deckers (51%), Timberland maker VF Corporation (53%) and Skechers (48%). 

Other than the direct benefit to gross margin, there is a second order effect to minimal discounting which is that it elevates the brand. This has two benefits: first, and most importantly, over time it allows management to raise prices and, second, it removes the incentive to delay a purchase in the hope of getting a product on sale. Furthermore, in terms of inventory write downs, the high proportion of continuity product reduces the risk of investing in inventory, allowing Dr Martens to carry more inventory than a competitor who sells a higher proportion of seasonal items. This not only allows Dr Martens to be in a better position to fulfill demand, and thereby engender customer satisfaction, but also allows them to place larger orders with longer lead times with their manufacturers, lowering their cost of production. 

The benefits of being in the unique position of selling an unchanging product in an industry defined by changing trends, combined with the iconic status of the Dr Martens brand in popular culture, results in the business earning a return on invested capital of 90% (FY2022).  While no apparel business is immune to the cyclical nature of fashion, Dr Martens should be less exposed than most. In my view, this should translate into a higher valuation. 

What has happened since IPO

Permira took Dr Martens public in January 2021 at a price of £3.70 a share. The stock traded up to £5.00 in the first month. It has fallen 70% since, along with a lot of other businesses that came to the public markets during that euphoric period. 

In its IPO prospectus, Dr Martens management guided for “high teens” growth for FY2022 and “mid teens” growth for FY2023 and beyond. The business grew 18% in FY2022 and management upgraded guidance to “high teens” growth for FY2023 while reiterating “mid teens” growth over the “medium term”. 

In their H12023 results management guided to “high teens” growth for FY2023 in actual currency terms which was effectively a downgrade in guidance. Then, in their most recent Q32023 trading update, management downgraded guidance for FY2023 again, saying growth would now come in at “11%-13%” in actual currency terms. They also informed investors of an ongoing operational issue at their LA distribution center that had led to lost sales and would lower operating margins. 

The stock has fallen around 30% since the Q32023 trading update leaving us where we are now. The operational issue is temporary and management believes it will be resolved in H12024 though not without expenditure that will impact H12024 operating margins. The market seems to have overreacted to the issue and, in my opinion at least, is ignoring the quality of the underlying business. I guess Mr Market really doesn’t like it when you walk back guidance?

Valuation

I think if you are willing to look past the current distribution center issue and management’s communication missteps, you will find a high quality business for sale at an attractive price. 

Dr Martens’ earning potential boils down to two things: how many more shoes are they going to sell and at what price can they sell them for? In FY2023, Dr Martens will probably sell 14.1m pairs of shoes. About half will be sold through “DTC”, that is, through a combination of their own stores and their e-commerce properties, and half will be sold through wholesale. Revenues are estimated at approximately £1bn, implying an ASP of £71 a shoe. As a reminder, shoes sold through DTC have 2.5x the ASP of wholesale and earn 4x the gross profit. 

The core markets for the business are UK, USA, Germany, Italy, France and Japan. Penetration in the UK is by far the highest at 32 pairs sold per 1,000 (FY2022 presentation). Penetration in the USA is 17 per 1,000, Germany is 15 per 1,000, Italy is 8 per 1,000, France is 7 per 1,000 and Japan is 4 per 1,000. Dr Martens’ management believes they can get their North American and Western European markets to the same level of penetration as the UK (of course they do). This belief is predicated on CEO Kenny Wilson’s claim that it is unusual for an apparel brand to have so much higher penetration in one of the major European markets compared to the rest. Looking at other apparel businesses, such as Kenny’s former employer Levis, for example, I see that Kenny is right. Generally brands achieve roughly the same level of penetration across the large Western European markets, suggesting there is scope for Dr Martens to grow further in its core markets outside the UK. This is further backed up by the fact that the difference in brand awareness between the UK and the other core markets is narrower than the difference in penetration (FY2022 presentation). 

Conservatively, let’s assume no effect from population growth in any of the core markets. Let’s also assume no growth in the UK or Japan or any of the markets outside the core 6 (Nordics and Iberia for example). In 5 years time, let’s assume that penetration in the USA and Germany can get to ⅔ of the UK and France and Italy can get to ½. This gets us to about 5% a year volume growth for the business for the next 5 years which, for what it’s worth, is far slower than these markets have been growing in the last 3 years. 

In the company history section, I wrote about how Permira had reduced the importance of wholesale and focused Dr Martens on selling DTC when they bought the business from the Griggs family. In 2018, 40% of sales were DTC and ASP was £50. As previously mentioned, by the end of FY2023 50% of sales will be DTC and ASP will likely come in around £71. A 10% increase in DTC mix over the past 5 years, plus 2 price increases, has grown ASP at a CAGR of 7.5%. Management’s goal is to get to a DTC mix of at least 60%. In their favor is the continued conversion of distributor led markets to DTC. Italy and Iberia (Spain and Portugal) were recently converted to DTC and a clutch of stores in Japan are about to be transferred to Dr Martens from their distributor. These conversions will push DTC mix and, in turn, ASP up with scope for further market conversions over the next few years. If management can hit their DTC mix target in 5 years time and we assume no price increases, ASP will grow around 6% a year. For the sake of conservatism, let’s assume management falls short and ASP will only grow 4% a year for the next 5 years. 

Putting the volume and ASP growth estimates together, 9% growth a year from FY2023 onwards seems eminently achievable for the business. EBITDA margins from FY2020 to FY2022 were 27.4%, 28.8% and 29% respectively. FY2023 EBITDA margin is estimated at 25%, hurt by the LA distribution center issue but also dampened by an increase in marketing spend and the rate of new store openings. Management’s target is for EBITDA margins of at least 30%. This seems perfectly reasonable if DTC mix continues to expand, as higher gross margin will feed through to higher EBITDA margin, and the business continues to grow and benefit from operating leverage. Nevertheless, let’s assume we only get to a 27.5% EBITDA margin by FY2028.  

In terms of capital allocation, at IPO, management targeted dividends of 25%-35% of earnings and indicated they would consider returning capital to shareholders when net debt to EBITDA was consistently less than 1x. In FY2022 management paid out 30% of earnings as dividends and in FY2023 they will be paying out 35%. I’ve assumed management will pay out 30% of earnings a year as dividends over the next 5 years and the remaining cash will accumulate on the business’ balance sheet. 

Finally, we come to the question of valuation multiples. Dr Martens currently trades at 8x consensus FY2023E EV/EBIT. Footwear maker Crocs is at 10x. Cat and Wolverine maker Wolverine World Wide (WWW) is at 12x. Skechers is at 13x. Timberland maker VF Corporation (VFC) is at 14x. Ugg maker Deckers is at 18x and high end apparel brands Burberry and Moncler are at 16x and 19x respectively. None of these businesses are perfect comparisons. Crocs, Skechers, VFF and WWW are more mass-market than Dr Martens and engage in far more promotional activity, as evidenced by their lower gross margins. VFF and WWW are also more diversified, selling several other brands and a wider array of apparel. Similarly, Deckers has shown an ability to acquire small brands and grow them globally, suggesting it possesses a footwear brand platform that is deserving of a higher multiple. Lastly, Burberry and Moncler are more upmarket than Dr Martens and don’t have a focus on footwear but like Dr Martens their business is centered around an iconic product - the trench coat in Burberry’s case and the ski jacket in Moncler’s - and a brand with a culturally relevant heritage. 

Dr Martens’ brand sits somewhere between mass market and the top end of the spectrum. The discussion in the “Not Fashion” section should have convinced you that it is closer to the top end and deserving of the kind of multiples those businesses see. At the same time, Dr Martens’ is not as diverse as some of these other apparel businesses, possessing only a single brand and deriving 97% of revenues from footwear (FY2022). Balancing the strength of the brand with the narrow scope of the business, I believe that an 11x multiple is reasonable. Putting it all together, using the growth and margin estimates above, in FY2028 I have revenues of £1.6bn and EBIT of £320m with £550m in net cash, equating to a price of £4.09 a share using the current share count. Adding the expected dividends over the next 5 years gets us to an IRR just shy of 27%. 

One final point to note is that the business will be very close to 1x net leverage at the end of FY2023 and should be comfortably below that level in another year or two. Management has stated several times that they will look to return cash to shareholders when they are consistently below this level of leverage though they have not said how they intend to do so. Given the liquidity of the stock and the size of Permira’s stake, I can’t see them buying back stock. I can, however, see larger dividend payouts or a special dividend to get leverage back up to at least 1x. These kinds of actions would, of course, increase IRR further. 

A Quick Note on Management

I haven’t written much about management because I think the quality of the business speaks for itself. With that said, let me make a couple of points.

First, in terms of insider holdings, CEO Kenny Wilson owns a meaningful 1.1% of the business, which probably represents the vast majority of his net worth. CFO Jon Mortimore owns 0.6% of the business and, like Kenny, I’m fairly sure this is a significant proportion of his wealth. Finally, Chairman of the Board Paul Mason, the man who hired Kenny Wilson, holds 0.8% of the business. Given Paul Mason’s background, his stake is not as significant relative to his wealth as Kenny or Jon’s but it is good to see some of the Board have skin in the game. CEO/CFO compensation is reasonable enough with nothing particularly insane standing out. Broadly speaking, I think management has the right incentives and should be motivated to create value for shareholders. 

Second, Kenny Wilson talks a lot about the “brand custodian mindset” on Dr Martens’ earnings calls which basically means taking actions to maximize brand value over the long term. While this is a great idea in theory, it is difficult to implement in practice. The lure of discounting or channel stuffing to boost volumes in the short term is hard to resist but I’ve been impressed with some of the long term oriented decisions management has taken. For example, they have dramatically reduced the number of wholesale accounts they sell into over the last 5 years and they have mentioned not entirely fulfilling wholesale demand to create scarcity and “brand heat”. Even in their most recent trading update, management said they were looking at reducing sales into online only retailers in Europe because they felt these retailers weren’t differentiated enough from Dr Martens’ own e-commerce offering. They acknowledged this action would hurt volumes in FY2024 but said it would allow them to better control pricing online as well as drive sales to their own e-commerce site, where margins are significantly higher, in the long term. These are the kinds of actions that elevate the brand, build pricing power and consistently grow earnings over time. 

Questions

In this section, let me try and anticipate some of the questions that might be raised about an investment in Dr Martens. 

Aren’t we headed for a recession?

To quote Howard Marks, the only time we’re not headed for a recession is when we’re in one. Dr Martens shoes, like most apparel, are a discretionary purchase and demand will, no doubt, suffer in a recession. Looking back at the brutal recession in 2008/2009, Deckers and Burberry grew revenues quite significantly, Skechers was essentially flat and VF Corporation, Wolverine World Wide and Levis saw revenues fall between 5% and 10%. Crocs was the worst hit of the bunch, seeing revenues fall 15% in 2008 and 10% in 2009 though much of that was the result of the Crocs fad cooling off as revenues had grown 227% in 2006 and 139% in 2007. 

A 5%-10% fall in revenues in the event of a recession would dent our IRR but we would still be in a position to earn a favorable return on our investment assuming Dr Martens can get back to even moderate levels of growth. A Crocs like scenario is fairly extreme but Dr Martens would certainly survive such a significant drop in revenues though it would probably lead to a mediocre return on our investment. It seems to me that the current market price discounts all but the most dire of recessionary scenarios, providing a pretty favorable balance of risk versus reward to the investment.  

Aren’t earnings inflated from pandemic-era stimulus spending and the shift from services to goods?

In Dr Martens’ case, I think we have passed the period where these factors have an impact. FY2021 and FY2022 earnings probably did receive a boost but in FY2023 year-on-year growth in pairs sold will most likely be flat so I suspect FY2023 earnings represent a normalized baseline. Furthermore, stimulus payments were particularly large and distortionary in the US, which is roughly 40% of Dr Martens’ business. The remainder of the business comes from EMEA, which is slightly larger at almost 45%, and Asia-Pacific, which is around 15%. These regions did not see as much of a spending boost as the US and so Dr Martens’ has probably not been over earning to the same extent as apparel businesses that are more US focused. 

In terms of the risks around assessing normalized earnings more generally, I would add that Dr Martens has latent pricing power and so is potentially under-earning. At the moment, management has adopted a policy of only raising prices to match cost inflation, believing there is still significant volume growth to be had in the underpenetrated North American and Western Europe markets. This has led them to raise prices by around 6% only twice in the past couple of years. Each time they found that the price rises had virtually no impact on volumes. In addition, prior to conducting the most recent price rise, management carried out a pricing study which indicated that the perceived cost of Dr Martens’ boots was markedly higher than their selling price, suggesting there is room to push pricing further. In my valuation I assumed all the ASP growth was coming from a wholesale to DTC mix shift but management could certainly pull the pricing lever to drive ASP higher as well.

Could Dr Martens have reached the saturation point in its core markets?

I think that is likely to be the case in their home market of the UK. However, as I wrote earlier, it is unusual for an apparel brand to see penetration in Western European markets lag the UK by so much, suggesting there is room to grow in Western Europe. More importantly, when Dr Martens switches a market from distributor to owned and operated, penetration increases fairly dramatically and some of their core European markets have only recently switched to owned and operated so they should benefit from this tailwind for the next few years.

In the US, Dr Martens has taken a state by state approach to expanding their retail footprint. They have built a presence in California and the North East but have only just started in large states like Texas and Florida. Management has found that the opening of a retail store boosts e-commerce traffic and conversion in the surrounding area so as they continue to open more retail stores across the country there is scope to increase brand awareness further and, in turn, penetration. 

A few more points to consider. A large swath of franchised stores in Japan are being converted to owned and operated at the end of FY2023 which, as previously mentioned, typically boosts penetration. My valuation assumed no growth in Japan. I also ignored China. Currently, China represents a tiny part of Dr Martens’ business but management is building a team on the ground and is starting to build a retail footprint in the megacities. It is difficult to predict if the brand will achieve traction in China so I’m not assigning any value to the opportunity and just treating it like an out of the money call option. Lastly, one unusual characteristic about Dr Martens’ is that it is a footwear brand that sells equal numbers of pairs to men and women and roughly equally across age groups. The gender balance, in particular, is worth noting because most apparel brands shrink their addressable market by appealing primarily to men or women.

Isn’t Dr Martens at risk from the platform fad dying out?

Firstly, I would characterize the ever increasing ubiquity of platform shoes as more than a fad given the degree to which it has persisted over the last decade. Virtually every footwear maker across the price spectrum has incorporated platforms into their designs. With that said, Dr Martens has undoubtedly benefited from the growing demand for platform shoes with models like the Sinclair, Audrick and Jadon comprising about ⅓ of revenues. A diminishing of this trend would certainly impact Dr Martens revenues but the large proportion of sales from the unchanging “Originals” line dampens the degree to which earnings would be impacted. I would also add that Dr Martens has not jumped onto the platforms trend recently. They introduced their Jadon boot in 2013 and a subset of their customers who associate with certain subcultures have always been into the ‘look’ these shoes provide. The broadening appeal of platforms has been a recent tailwind but if it were to go away, there would still be plenty of appeal to the subset of Dr Martens’ customers who have always been into these shoe designs. 

I would also balance the risk to sales of platform shoes with the potential upside from sandals. Sandals represent only 6% of revenues at the moment (FY2022 presentation) but they are Dr Martens’ fastest growing category, proving particularly popular with Gen Z and riding the broader “casualization” trend. Dr Martens is a tiny fraction of the sizable sandals market. Market leader Birkenstock, for example, sold 23.8m pairs in 2019 and was acquired by LVMH backed private equity firm L Catterton for €4bn (around 5.5x 2019 sales by my estimate) in 2021. 

What about Permira’s stake?

Private equity firm Permira owns 36% of Dr Martens and I would assume they want to liquidate their stake at some point. Their stake creates a supply overhang which could, potentially, cap the stock price though I don’t see that as a big issue until the price gets quite a bit higher. In addition, I don’t see how Permira can meaningfully reduce its stake via open market sales given the low liquidity in Dr Martens stock. In my opinion, the best way for Permira to monetise its stake is to take excess cash out of the business which increases the likelihood we see management return capital to shareholders once net leverage is consistently below 1x. 

Catalyst

The most obvious catalyst is progress on the LA distribution center issue. We should get an update on the situation at the end of this week and if management signals the end is in sight then the cloud hanging over the business should lift. [Dr Martens Q4 trading update was earlier today and some progress on the issue was announced]

Another potential catalyst is if we see a couple of quarters where management hits their targets. The stock sold off significantly after guidance was walked back on each of the past two calls. I think hitting the most recent guidance and reaffirming it going forward might allay fears around the level of demand for Dr Martens’ products and convince the sell side that management is back on track.  

A longer term catalyst is some kind of return of excess cash by management via something like a special dividend. I think this is unlikely to happen in the calendar year 2023 but when it does happen, I think it will be significant in magnitude and shine a light on the business, its earning potential and its valuation.