Description

SUMMARY

I believe that Lands’ End stock, at its current price of $15.76, can appreciate by 200% or more over the next three to five years. This analysis explores the potential of this happening if a few things go right. The probability of this has increased under a new CEO. Founded more than 50 years ago, the company thrived and grew profitably through the 1980s and 1990s. However, for most of the last fifteen plus years, since being acquired by Sears in 2002, it was undermanaged by its parent, so that the size today (by revenues) is still at about the same level as it was then. It was spun-off by Sears in April 2014. The current CEO, who appears very competent, took over in March 2017. He has refocused the business on the core customer, and there is a new sense of urgency and clear signs of improvement in both revenues and profit margins since then. As his actions take hold over the next few quarters and years, sales should grow and profit margins should increase dramatically. If this happens, the stock is likely to provide a good return from this level.

INVESTMENT THESIS

My argument is summed up in the points below. I will elaborate on these later in the report:

(1)   Lands’ End is a strong, well-established brand, with a reputation for good products and great service and a long history of profitability.

(2)   The underlying business has excellent economics, with low capital requirements, and if managed well can generate significant free cash flow.

(3)   The company was undermanaged and mismanaged for well over a decade. Sears milked the company during its twelve-year ownership and underinvested in the business. One year after the spinoff from Sears, a former Dolce & Gabbana and Ferrari executive was named CEO. Her misguided vision was to transform Lands’ End into a high-fashion lifestyle brand. She lasted about 18 months.

(4)   New capable management was brought in almost two years ago.

(5)   There are clear indicators that the strategy of the new CEO is producing results.

(6)   There is potential for top-line growth and significantly higher margins.

(7)   This should result in a much higher stock price over the next few years.

A BRIEF HISTORY

Most VIC members are probably familiar with Lands’ End, and I won’t spend much time on the company’s history or its products. There is much information on the company’s website and in SEC filings. Founded by Gary Comer in 1963 to sell sailboat hardware and accessories, it only went into apparel in the following decade. The stated guiding principle of the company from its founding was: “Take care of the customer, take care of the employee and the rest will take care of itself.” This principle served the company well: it grew fairly consistently and profitably over the decades, went public in 1986, and continued its profitable growth until its acquisition by Sears in 2002. An important part of my thesis is that new management is returning the now-independent company to the principles which made it successful, and this will increasingly show in the company’s financial performance in coming years.

Lands’ End was posted on VIC by TheEnterprisingInvestor a year ago, when the price was $18.30. The author timed it well, recommending exit less than five months later, when the price was about $30, for a more than 60% gain. The fundamentals of the company have improved over the last year, but the stock is down 14% from the time it was previously posted, and down 50% from its 2018 high of over $31.

I encourage anyone interested in LE to read the January 2018 VIC report. My writeup will focus more on the quantitative aspects of the business, highlighting the favorable economics of the business, as demonstrated by both recent and longer-term financial performance, and quantifying the magnitude of margin improvements and revenue growth I consider possible and necessary for this investment to be successful.

HISTORICAL FINANCIAL PERFORMANCE

The table below summarizes the financial performance in the decade prior to the Sears purchase:

(For the purpose of this report, my preference is to focus on EBIT margins rather than EBITDA. For more recent years, D&A information is provided in the table below. With recent stepped-up capex spending, D&A has increased over the last two years, and is now running at about 1.8% to 2.0% of annual revenues.)

Revenue was $1.45 billion in 2001, prior to Sears taking over. Fast-forward to the last decade. Sales increased to $1.66 billion in 2008, $1.73 billion in 2011, and then declined for five consecutive years as Sears largely ignored Lands’ End while struggling with its own problems. And yet, the company continued to be profitable from operations, at the EBIT level:

Operating margins in 2016 and 2017 were the lowest in decades, as a new CEO (now former CEO) brought in in 2015 put the company on a misguided path to becoming a fashion-forward company. She was ousted in late 2016, and the current CEO joined in March 2017.

ECONOMICS OF BUSINESS

An important part of my investment thesis is that Lands’ End has attractive economic characteristics. This can be seen in the fact that the company continued to generate operating profits even under Sears. One way to quantify this is by using a crude measure of “Capital Employed,” which I assume to be the sum of PP&E, inventory, receivables, and other assets, less payables and other liabilities:

My conclusion from the table above is that a dollar of sales requires about 20 cents of capital. Interestingly, if we go back to the years immediately before Sears acquired Lands’ End, we end up with similar numbers. The table below shows that a dollar of sales again required about 20 cents of capital for the years 1993 to 2001. The big difference in the earlier period versus today is that the company was making healthy profit margins, ranging between 4.1% and 8.1% over the nine years, with an average of 6.1%. By comparison, the operating margin was 1.5% in 2016, 2.1% in 2017, and I estimate was about 3.0% for 2018 (which will end on 2/1/19).

To me this indicates the very favorable economics of the business, assuming that it can attain historical levels of profitability. If $1 of invested capital can generate $5 of sales, which produce between 4% and 8% of operating margins, the capital is earning pre-tax (EBIT) returns of 20% to 40%. Assuming that the business over time cannot grow faster than 10-15% annually, there will be meaningful free-cash flow remaining for creating shareholder value in other ways.

A look at Lands’ End financial statements prior to Sears confirms the strong free cash flow nature of the business. Between 1988 and 2001, sales increased from $455 million to $1.45 billion. This growth was all financed internally; with the exception of occasional short-term debt to finance working capital needs, the balance sheet was debt-free. During this same period, the company also bought back 25% of the outstanding shares, and paid out modest dividends in some of the years.

THE SEARS YEARS

In the years immediately prior to spinning off Lands’ End, Sears was clearing milking the company, upstreaming virtually all of the profits. It was also underinvesting in Lands’ End, with depreciation exceeding capex in each of at least the last four years of Sears’ ownership. Annual sales exceeded $1.5 billion in each of those four years, and net income ranged between $50 million and $121 million each year. Over the period, Sears took out $302 million in cash from Lands’ End, while investing only $59 million in capital expenditures, or $30 million less than the cumulative D&A for the period, probably spending only on necessary maintenance capex.

(Note: Data available only for 2010-2013 years)

At the time of the spinoff, Lands’ End paid Sears a dividend of $500 million, financed with a variable rate term loan of $515 million. About $483 million of this debt is still outstanding. With cash of $106 million at the end of the last quarter, net debt is about $377 million. The annual interest burden on the debt is about $30 million.

NEW CEO & EARLY SIGNS OF IMPROVEMENT

Sales declined every year for five consecutive years from 2011 to 2016. This trend has turned around recently, with year-over-year quarterly sales increasing each quarter over the last six quarters. This is despite the headwind from the loss of sales at the Lands’ End Shops at Sears, which have been shutting down as Sears stores close, and as Lands’ End leases expire and they can slough off unprofitable or undesirable stores (essentially all of the store within Sears).

Jerome Griffith took over as CEO in March 2017. Prior to that, YOY operating margins had declined for 11 consecutive quarters (including his first full quarter in that role). But starting with the October 2017 quarter, margins have improved in each of the five subsequent periods.

Despite this recent improvement, profitability is still pitifully low, and there is tremendous opportunity for increasing the operating margin from 2.1% in 2017 (and an estimated 3% in 2018) to perhaps 7% - 9% over the next few years. As recently as 2014 the operating income (EBIT) margin was 9%; over the four years prior to that it averaged 8%.

My belief is that in returning to its guiding principles of looking after customers and employees, and focusing on its core customer, the company has begun the turnaround process. Good things are likely to follow financially: top-line growth, significantly higher margins, and a stock price that could be at 2-3x the current price.

Management sees opportunities on several fronts. All of the Lands’ End stores in Sears stores will be gone by the end of 2019, removing a distracting and unprofitable business. (There were 174 of these stores at the end of 2017, 125 at the end of the last quarter, and about 49 at the end of fiscal 2018. These stores generated about $100 million of sales in 2018, and are expected to do about $30 million in 2019.) The company now has 16 company-owned-and-operated stores, and plans to have 50-60 within the next four years. They see opportunities in the uniform business, having won both Delta and American Airlines’ uniform business. They also tied up with the Weather Channel so that all on-air reporters on the channel will wear Lands’ End branded outfits. And more recently, over the holiday season, Lands’ End started selling its products on Amazon.

FINANCIAL PROJECTIONS

The table below shows actual numbers for 2017, my estimate for 2018, and projected sales and profit margins for 2022. My base case projection assumes EBIT margins of 7% on sales of $2 billion.

In some respects, I view the projections above as conservative:

(1)   The revenue projections depend on successful execution, but my 2022 numbers above imply annualized top-line growth of between 6.5% and 9% over the next four years, from the estimated 2018 level of just shy of $1.5 billion. These growth numbers don’t feel like a stretch.

(2)    Regarding EBIT margins: between 2008 and 2015, operating margins ranged between 5.2% and 13% each year, with only one year below 6%, and an average over the eight years of more than 9%. By contrast, my assumptions above are 6% to 8% margins, which again feels very reasonable. (Incidentally, under the benign neglect of Sears, Lands’ End had operating income (EBIT) of more than $200 million in both 2008 and 2009, on sales of about $1.65 billion in each of those years. So the $168 million of projected operating income on a higher sales base projected in the optimistic case above seems to me very plausible, and not just a starry-eyed fantasy of a perfect outcome.)

(3)   The projections above do not assume any benefits from any free cash flow generated by the business over the next four years, with the exception of financing capex and working capital needs for growth. I estimate that net income over the next four years should exceed $200 million. This should be far more than necessary to finance $500 - 600 million of revenue growth. By my calculations, the company needs less than $20 in capital to finance $100 of top-line growth, so $100 to $120 million of the next four years’ net income will be absorbed to finance the projected growth, with roughly $100 million available to reduce debt or for other purposes (maybe stock buybacks at some point?)

If Lands’ End does indeed achieve anything like the numbers in the table above, what should the stock be worth? In the “less favorable” scenario I’ve painted, with operating income of $114 million and EPS of $1.91, a price of at least $25 seems warranted. That would imply EV/EBIT of just over 10x, and a P/E multiple of 13. With the “more favorable” outcome, with operating income of $168 million and EPS of $3.14, $50 seems reasonable given the higher top-line growth rates achieved. At that price, the EV/EBIT ratio is about 12x with PE at 16x. (Note that I assume here that net debt remains flat at the $380 million level of 11/2/18. Net debt is actually likely to decrease over time. Also, given the seasonality of the business, net debt will probably be less than $300 million at 2/1/19, the end of the current fiscal year.)

INSIDER OWNERSHIP

Eddie Lampert and ESL own two-thirds of the outstanding shares of Lands’ End. So the outstanding public float of about 10 million shares are currently valued at only about $160 million, which makes the stock very volatile.

There was some insider buying in mid-December by several members of management, including the CEO (10,000 shares) and CFO (4,000 shares), and also by directors. These purchases were at prices of about $14 to $14.50.

LANDS’ END STOCK, VOLATILITY, AND TRADING SARDINES

Many in the VIC community are probably familiar with the apocryphal “trading sardines” story. A young guy, fresh out of college, gets a trading job on Wall Street. He is assigned to trade canned sardines, which he does, all day, every day. One day he realizes that he really has no idea what he has been buying and selling for a living. He decides to sample the sardines. Opening a can, he tastes a spoonful of sardines – and promptly spits it out in disgust. He goes to his boss to tell him about the defective product. The boss’s response: “Son, you don’t understand. These are not eating sardines, they are trading sardines.”

(That’s the version of the trading sardines story I first heard years ago. Seth Klarman’s version below is a little different, but the moral is the same.)

https://theconservativeincomeinvestor.com/seth-klarman-compares-bitcoin-to-trading-sardines/

I am certainly not suggesting that Lands’ End is a “trading sardine.” But the volatility of this stock sometimes makes me wonder whether it is an eating sardine (i.e. a good business that should produce attractive long-term returns) which should also be traded opportunistically on big moves. Retail stocks are inherently volatile, often more so than their underlying businesses, and generally more volatile than the overall market. In the almost five years since being spun-off, Lands’ End’s stock went from about $30 in March 2014 to $55 by the end of that year, back below $15 in mid-2016, up to almost $25 in May 2017, down below $11 late that year, back over $30 in June 2018, down to $14 in October, back over $22 in early December, below $13 in late December, to today’s level.

What’s a value investor to do? To me the right answer appears to be to hold a core long-term position, while being willing to buy and sell around this position on big moves. Sometimes it seems too cheap, as it does now, and I’m willing to have a big position. If there’s a meaningful upward move without big news, I will trim the position to a more moderate size, while continuing to hope for a double or triple over a few years.

RISKS:

Failure by management to execute in generating topline growth and margin improvement.

My fundamental thesis is wrong, and the world has changed, so that Lands’ End cannot generate the kind of profit margins it did historically.

Economic recession affects consumer spending.

Loss of top management.

Eddie Lampert, the controlling shareholder, does things that are not in minority shareholders’ long-term interests.

Catalyst

Improvement in financial performance over the next couple of years: top-line growth and higher operating margins.