Description

Specialty retail apparel is a brutal business. Consumer tastes are fickle and fashion trends change rapidly. Retailers have also had to contend with negative factors, both secular and cyclical, that have broadly afflicted the retail industry: the rise of ecommerce, declining mall traffic, and an over-construction of retail square footage, to name a few. Now, a world-wide pandemic is all but certain to disrupt retail traffic and threaten the existence of many retailers. 

However, the Unicorn Hunter believes that there is one retailer in particular – Express, Inc. (Ticker: “EXPR”) – that is well-positioned to navigate this tumultuous environment and represents a compelling deep value investment. The stock has fallen victim to pricing dislocation so severe it is being valued for near term insolvency despite having tremendous financial flexibility. As of 4Q19, EXPR had access to nearly $405 million of total liquidity, consisting of $207 million of net cash on the balance sheet and access to a covenant light ABL revolver. Despite years of poor execution and strategic missteps, a new CEO is now at the helm and detailed a compelling strategic plan less than four months ago. This plan revolves around three key areas: fixing the product, increasing conversion, and right-sizing expenses. The Unicorn Hunter believes that EXPR is well-positioned for a resurgence and has 10x multi-bagger potential over the next 2-3 years.

The key points of the investment thesis can be summarized as follows:

• The board fired the previous CEO in early 2019 and appointed a new CEO in June of 2019 who will serve as the primary agent of change for EXPR; while EXPR has suffered brand dilution in recent years, the company has a 40-year operating history and this damage is not irreparable
• Refocusing on product and merchandising will restore brand equity which should drive a return to sustainable, positive comparable sales
• Executing on initiatives to increase customer engagement and retention should help close the gap between industry standard conversion rates; closing even half of this gap will result in +MSD comparable sales 
• Right-sizing the company’s cost-structure will provide additional runway to navigate the Covid-19 crisis and will produce ~$0.68 of EPS growth even in the absence of positive comparable sales
• EXPR has maintained balance sheet flexibility to execute on this new strategic plan; as of 4Q19, EXPR had access to $404.8 million of available liquidity including $3.16/share of net cash on the balance sheet

While the core tenets of this thesis are more qualitative in nature than I prefer, I believe the collective aggregate presents a compelling investment thesis underpinned by realistic, perhaps conservative, assumptions. I believe the new CEO accurately characterized his strategic vision with the following quote from EXPR’s 2020 investor day: “Much of what we’ll talk about will sound like retail 101, and to a certain extent, it is, because over the last several years, Express had lost some of its focus on fundamentals, and the brand and the business suffered as a result.”

New CEO to Serve as Agent of Change

The board fired the previous CEO in early 2019 and hired Tim Baxter as the new CEO in June 2019. On Jan 22, 2020, Express held an investor day where they outlined their new corporate strategy, which revolves around restoring EXPR’s brand, focusing on the right product/fashion, implementing a new go-to-market process, improving inventory optimization, fleet rationalization, and right sizing the company’s cost structure. 

We can look to American Eagle Outfitters (Ticker: “AEO”) as a past successful analog and instructive case study. In a strikingly similar scenario, AEO failed to adapt to evolving fashion trends and had fallen out of favor with their teenage customers, who migrated towards high velocity fast fashion brands and off-price outlets. In early 2014, AEO brought back their previous CEO who outlined a similar strategy: refocusing on product, reducing inventory levels, and rationalizing the fleet. AEO’s strategy was successful, which led to a return to positive comparable sales and margin expansion, despite a decrease in the total number of stores:

(Source: AEO SEC Filings)

While it will take time for EXPR to prove out the strategy, AEO offers a recent example of success, with a new CEO serving as the agent of change. As outlined above, I believe the core strategic vision can be distilled down to three key points: fixing the product, increasing conversion, and right-sizing EXPR’s cost structure. 

Refocus on Product 

Over the past several years, EXPR lost touch with evolving fashion trends. EXPR’s design and merchandising became very conservative and the company invested too heavily in the wrong products. This drove a divergence between sales and inventory trends: from 2015 to 2018, inventory increased 4.9% on a 9.9% decrease in total sales. EXPR was left with an inventory overhang that coincided with an elevated promotional cadence and an aggressive expansion of the outlet channel; at this point, competitors were turning inventory ~20% faster than EXPR. The result was inevitable: EXPR alienated their customer base and the brand lost relevancy. The extent of EXPR’s past product and merchandising failures should come as no surprise since the company had no merchandising leadership in place for nearly two years. Rather, all product and merchandising decisions rolled up to the previous CEO who served as the de facto Chief Merchandising Officer in the absence of other leadership.

Within eight months of the new CEO taking over the reins, EXPR has cleared out ~$42 million of inventory (down ~15% Y/Y on a gross basis) while building out the merchandising and marketing teams, which is still ongoing:

• EVP, Chief Marketing Officer, hired Sept 2019
• EVP, Chief Merchandising Officer, hired Sept 2019
• SVP, Planning and Allocation, hired Sept 2019
• SVP, Global Sourcing, Production and Supply Chain, hired Jan 2020
• VP, eCommerce, hired Jan 2020
• VP, Design & Merchandising Operations, hired Jan 2020
• VP, Performance Marketing, hired Jan 2020
• VP, Men’s Merchandising, hired Jan 2020

Denim serves as an illustrative data point of how far EXPR had fallen behind in key product categories: ~78% of EXPR customers wear denim yet only ~17% purchase their denim from EXPR. Based on my field research and discussions with the company, I believe that Denim, Women’s tops, Men’s suits, and Men’s shirts represent the largest areas of underperformance, and thus opportunity, for EXPR. Based on commentary in recent calls, I believe there are early signals that the new product strategy is resonating with consumers given sell-through trends of new product in Q4. For instance, EXPR introduced a new washable knit men’s suit that posted a double-digit comp in Q4, which is an encouraging signal that EXPR is beginning to successfully introduce more fits and styles into key underperforming categories. While EXPR’s ability to successfully identify new fashion trends requires a leap of faith from investors, the degree of success should be readily evident by Q3 as the Fall season will be the first to fully reflect the new product strategy.

EXPR also claims that remerchandising store layouts from wearing occasions to a mix/match layout in Sept/Oct resulted in an immediate lift in retail sales. EXPR is also backing off massive bulk ordering to selectively chase product with strong sell-through. While EXPR will always be a promotional brand, management is shifting its promotional cadence, working away from storewide clearance sales towards more targeted, strategic promotions. My field research indicates that EXPR is already becoming much more strategic in their promotional approach and appears to be pulling back from store-wide flash sales and Buy-One-Get-One deals in Q1 (though difficult to quantify exact impact/decrease).

Beginning in 2014 (and coinciding with the onset of mounting inventory problems), the outlet channel became a major focus for EXPR. In fact, EXPR became so aggressive that the total outlet channel expanded from 104 locations (~16% of the fleet) to 214 locations (~36% of the fleet) over the past three years, far exceeding their own target of only opening ~160 outlet locations. Perhaps more perplexing is that EXPR never used the outlets as an outlet channel. Instead, outlets sold separate made-for-outlet inventory based off best sellers from the prior year – this undoubtedly contributed to the inventory complications. Over time, EXPR will likely reconvert outlet locations back to retail stores to bring more balance to the fleet and start using the channel to clear unproductive inventory.

Increasing Customer Engagement and Conversion

Industry standard specialty retail conversion is ~20% and EXPR has disclosed that they do not convert at industry levels. My field research indicates that EXPR converts at approximately ~15-16%, which, if accurate, indicates that closing even half of this gap by 2022 should result in +MSD comps (closing the entire gap would likely produce +HSD comps). To be clear, I am not underwriting standard industry conversion rates – but it remains a significant opportunity for EXPR.

While there are many initiatives aimed at increasing conversion, this starts with re-solidifying the brand. Historically, EXPR has had very inconsistent representation of product across segments and channels; Women’s clothing, which sported a polished casual/chic look, was completely dissimilar to Men’s product, which veered towards informal/street casual. The in-store assortments did not resemble the online assortments, outlet had channel-specific inventory that differed from retail, and promotions were inconsistent between retail and online. Understandably, the result was a frustrated and confused consumer.

Representation of the EXPR brand has not even been consistent between store-frontage. Nearly 100 EXPR stores (>15% of the fleet) have a completely disparate red-and-white color theme that diverges from the original black-and-white theme:

Having two completely disparate color themes delivers an inconsistent brand message to the consumer. This example demonstrates the simplicity of correcting many of EXPR’s past strategic missteps. I expect that simple corrections, such as introducing uniformity across storefronts and product assortments, should have a meaningful impact on increasing conversion rates.

EXPR is also overhauling some existing programs to improve customer engagement/retention:

1. Re-allocation of EXPR’s marketing budget: In 2019, EXPR spent ~$114.7 million on advertising, devoting too much of this towards low ROI channels like print-based advertising. EXPR has since implemented monitoring tools which allow the company to flex different advertising channels based on real-time ROI measurements. What was previously allocated to low ROI channels like print advertising will be re-allocated towards higher yielding, measurable channels like digital marketing, display advertising, paid search, and paid social.
2. Revamping EXPR’s loyalty and credit card programs: Though these programs existed previously, they were structured so poorly that few consumers received any benefit from participating. As an example, EXPR is expanding the loyalty rewards program from two to four tiers. While this may seem like a trivial change, consumers in the first tier received virtually no benefit and had to spend thousands of dollars to reach the second tier. The new four tier system will introduce more attainable thresholds that should incentivize consumer spend and drive retention.

EXPR is also shifting to a sales-oriented culture by implementing new training programs and refocusing in-store staff on selling activities and actively engaging customers. Previously, sales associates were burdened with unnecessary task-oriented activities, like needlessly changing store layouts and displays, endlessly moving product around, or processing online orders. The new reformulated training programs will help ensure that all sales associates are well trained and not reliant on overly expansive corporate materials (reportedly the previous buy-online-pick-up-in-store training manual was 400 pages by itself). Similarly, EXPR is implementing changes to store scheduling that will help ensure adequate sales coverage at peak selling times. 

I would tend to agree that these initiatives seem like Retail 101 – if sales associates can spend more time with customers, they will sell more product thereby driving higher conversion.

Right-Sizing the Company’s Cost Structure

EXPR is undertaking two primary initiatives to right-size the company’s cost structure: 1) a fleet rationalization whereby EXPR will be closing 100 stores, and 2) $80mm of additional annualized cost reductions. Of the $95-125 million long term EBIT target, $35-65mm is attributable to positive comparable sales contribution, thus ~$60mm should flow through to EBIT due to these cost cutting measures. In other words, these expense reductions will add roughly ~$0.68 to EPS even in the absence of positive comparable sales.

Fleet Rationalization

The fleet rationalization should eliminate ~$90mm of sales (net of sales transfer) with a ~$15mm expected benefit to EBITDA. Based on the information EXPR has provided, it is apparent EXPR has been operating a large cohort of highly unproductive stores. The average retail store EXPR is closing has average unit volume of ~$1.25mm, approximately ~39% below the average retail sales volume of ~$2.03 million. EXPR estimates that they will get approximately $35mm (or ~30%) of sales transfer volume from the closed stores. While this amorphous figure may prove to be optimistic, this would translate to an aggregate ~260 bps of comparable sales tailwind in the retail channel by 2022.

Based on the reported Q4 locations, the slated closures would appear to be well geographically diversified, supporting the notion that management took a comprehensive look market-by-market. With the looming impact of Covid-19, I suspect EXPR may have the opportunity to exit additional fringe locations or remain in certain locations for a longer period of time if rent concessions prove to be generous enough.

Cost Reductions

The $80mm of additional corporate cost reductions consists of two parts:

1. $55mm of corporate expense reductions, the bulk of which is driven by a 10% reduction-in-force at the corporate HQ and NY design studio
2. $25mm benefit from go-to-market process improvements, including increasing inventory turnover, consolidating planning calendars, reducing the number of seasonal product milestones, and better marketing integration

EXPR has been woefully deficient with respect to their internal systems, lacking the basic operational wherewithal that is now required of omni-channel brands. For example, EXPR is still in the process of rolling out functionality like ship-from-store and buy-online-pick-up-in-store across the fleet, which should be operational by the end of 2020; up until this point, EXPR has been managing an inventory pool that is still not integrated across channels. Updating centralized order management and assortment planning systems (also being implemented by the end of 2020) will unequivocally help optimize inventory, increase inventory turns and eliminate unproductive product. Furthermore, reducing the choice count and having more congruent inventory across retail, ecommerce, and outlet will also be a tailwind to easing working capital investment.

Balance Sheet and Margin of Safety

In contrast to many public retailers, one of the most appealing aspects of EXPR is the strength of the company’s balance sheet. EXPR ended 4Q19 with $207 million of cash on the balance sheet and no debt, equivalent to $3.16/fully diluted share. EXPR also had access to $197.7 million on their ABL revolver, of which they drew $165 million on March 20, 2020. Importantly, the FCCR covenant is not tested until cash plus unused availability falls below 10% of the borrowing base, which provides EXPR a tremendous amount of financial flexibility. Furthermore, the layering of inventory purchasing ensures that EXPR will maintain adequate availability on their line of credit throughout 2020 (ie. de-risks inventory collateral aging out of the borrowing base). In other words, EXPR has ~$404.8 million of available liquidity to navigate the coronavirus impact without being forced to do an extremely dilutive equity deal, raise additional debt, or file for bankruptcy.

That said, it is nearly impossible to model out the current trajectory of this business with any accuracy. Fortunately, EXPR was well positioned heading into the Covid-19 crisis given the fortuitous timing of the expense reductions. While I believe the company will continue with mission critical cash consuming initiatives (such as the implementation of new systems), EXPR has many levers at its disposal to further reduce cash burn. Taking early action to close stores and furlough 13k+ sales associates will greatly help extend the company’s runway. Based on retail rent collection data and the actions of several peers, I expect EXPR will also be able to receive favorable rent concessions. In my best estimation, EXPR likely has at least 8-12 months of runway with the entire fleet closed (and half of the fleet will be reopening by May 25).

Valuation

The critical assumption underpinning my valuation methodology is that the post-coronavirus world will revert to normal over the next 2-3 years and that EXPR has adequate liquidity to navigate the current crisis. Please note that I am also not giving effect to the company’s net cash balance or any potential share repurchases. To arrive at my price target, I am applying the average pre-coronavirus consensus EPS multiples for AEO and ANF (as of Jan ‘20) to my 2022 EPS estimate for EXPR, which equates to an undemanding <12x EPS multiple. The result is a $15.73 price target or 9.9x yesterday’s closing price.

Risks

Demand-side Coronavirus Disruptions:

On March 17, 2020, EXPR announced that they were closing all stores, effectively immediately. Last week, on May 4, 2020, EXPR announced that they expected to be opening 300 locations prior to Memorial Day and will be taking a phased re-opening approach as states reopen. While EXPR continued to process ecommerce orders during this period, the top line will experience disruptions. Aside from short-term oriented hedge funds trying to gamble on next quarter’s results vs. post-coronavirus expectations, I believe we have largely worked past coronavirus shareholder rotation and that EXPR has the liquidity to navigate the current environment. As such, I view this risk as temporal in nature and will not be impactful to those approaching this investment with a 2+ year time horizon. 

Supply-side Disruptions from Coronavirus:

From a supply chain perspective, there will be some impacts from coronavirus. EXPR noted on the Q4 call that they were not able to chase successful product more aggressively due to factory re-opening delays in China, which will have a lingering impact in late Q1/early Q2. Despite these disruptions, EXPR estimates that <5% of total finished product will be delayed 3-4 weeks. EXPR should be relatively insulated from major supply chain shock as they procure merchandise from over 111 vendors (top 10 vendors account for ~26% of merchandise) and 331 manufacturing facilities across 27 countries. The top five sourcing countries are, in order: Vietnam, China (represents <20% of total finished product), Indonesia, Bangladesh, and India. 

Poor Execution:

EXPR has been plagued with poor execution for years. While the Unicorn Hunter is optimistic about the new CEO, poor execution is a meaningful risk to this thesis, which relies on the company not only executing operationally but successfully identifying new fashion trends. I believe the new executive leadership in merchandising/marketing, new order management and assortment planning systems, and new streamlined processes help de-risk this area. Assuming a return to normal traffic and operating conditions over the next several quarters, investors should have a good read on whether management is successfully executing in this area, paying close attention to the under-performing product categories as well as the success of the Fall season assortment.

Secular Retail Headwinds:

EXPR is not immune to secular retail headwinds, including declining mall traffic. One mitigating factor is that EXPR has maintained extreme operating flexibility with their lease expirations, with approximately ~60% of their leases expiring in less than three years. From a brand perspective, EXPR aspires to be in top tier mall locations which is why the majority of the 100 store closures are in Class B and Class C malls. Refocusing away from second and third tier malls should help insulate against ongoing mall traffic declines, which are concentrated in lower tier malls. This risk can also be hedged with any number of over-levered, mall-based terminal retail shorts.

Catalyst

• Not going bankrupt
• Reporting 1Q20, providing an update on both EXPR’s liquidity position and additional details on managing cash burn
• Phased reopening of the entire store fleet and normalization of foot traffic
• Implementation of new order management and assortment planning systems
• Earnings growth from fleet rationalization and corporate expense cuts
• Return to positive comps from executing on product strategy, hopefully in 2H20
• Closing the conversion gap to industry standard levels
• Picking up additional sell side coverage