Executive Summary

I am recommending a position in the Land’s End Term loan due April 2021, currently trading at ~93 (16% YTM, 12% absolute return). This opportunity is a result of apparent refi risk and a (largely understandable) market distaste for anything retail, with the market creating the business at 4.7x 2019 EBITDA through the Term Loan. While this might seem reasonable for a retailer in the current environment, Land’s End is not your average brick and mortar-based apparel business facing rapidly declining SSS:

• Land’s End is almost entirely DTC with only 4% retail sales (the retail stores are more for facilitating the customer experience than driving revenue)
• Pre-Covid, Land’s End had seen ~6% organic revenue CAGR since bringing on a new CEO in late 2016. eCommerce (76% of revenue) had been accelerating, with 11% YoY growth in Feb 2020
• Relatively low fixed cost; the majority of CapEx is growth-based and can be delayed
• While sales were initially hit hard in March, management reported that May eCommerce was back on track and up low double digits

Land’s End has historically been seen by investors as a sleepy catalog-based company and intertwined with Sears; neither of these are the case any more as the Company exited its last Sears locations.

An argument could be made for the equity having considerable upside, but with the current environment I believe that the TL offers an attractive return for relatively limited downside.

Business Description

Founded in 1963, Land’s End is a retailer of casual clothing, accessories, footwear and home products. They operate out of Wisconsin, describing themselves as “ a classic American lifestyle brand with a passion for quality, legendary service and real value, and seeking to deliver timeless style for women, men, kids and the home.” The customer base skews largely towards middle-class, older women; as of 2019 the customer base was 80% female with an average age of 58 years old. Positively, average age has recently trended down by a couple years due to new customer acquisitions. 

Revenue breakdown as of FY2019: 76% eCommerce, 20% Outfitters (uniforms for businesses), 4% retail

For more information on the business and its history as of 2.5 years ago, it’s also helpful to reference recent equity writeups by TheEnterprisingInvestor and Ladera838. From these you can really see the tangible progress management has been able to make since putting in their original plans 3 years ago, including (1) turning around the Company’s growth profile and (2) distancing themselves from the Sears brand.

History / Missteps

From 2002 to 2014, the business was owned by Sears. For years, Lands End languished under the Sears umbrella; the current CEO Jerome Griffith has cited significant underinvestment in developing Land’s Ends full capabilities as an e-commerce based retailer. On top of this, the Sears customer base had few synergies with those of Land’s End. This resulted in underperformance and a total of 7 CEOs over the course of ~15 years, each with an average tenure of just 23 months. 

Still, as you can see below the core Direct business was relatively stable up through 2014 when they brought on Federica Marchionni (former Dolce & Gabanna President) as CEO in Feb 2015:

Marchionni was brought in to make Land’s End more fashion forward and youthful, but this ended up alienating the existing customer base focused on more “sensible” and “bland yet practical apparel”. Some of the specific missteps under her included:

• Introducing slimmer-fitting designs, a new line of athletic wear as well as a series of pop-up shops in trendsetting locales like New York’s Fifth Avenue and SoHo neighborhood

• Poor brand optics including working from NYC rather than moving to Wisconsin 

• Bringing on the “Canvas” clothing line with sleek ads and models really not appropriate for Lands End’s core customer set

• A short-lived marketing relationship with noted feminist (received backlash from conservative customer base initially, then underwent an even greater fire storm from liberal side upon retracting the relationship)

So what’s the point of highlighting all of this? I believe that it speaks to the fact that underperformance in the business was much more created by specific strategic errors and a store portfolio largely located inside the ailing Sears empire, than impairment of the underlying brand. You’ll also notice the only 2 years of direct sales declines over the past 7 occurred during this stretch. 

Turnaround Under Current CEO

Enter current CEO Jerome Griffith, who was brought on in early 2017 – he was previously CEO at luggage maker Tumi Holdings which was sold in 2016 to Samsonite International for $1.8 billion. His two biggest focus areas were: 

1. Getting back to their core customer base: “So we were not selling product to our customers that our customers wanted. In fact, previous management was selling product that was extremely expensive and oriented towards high fashion. Lands' End customer is not a high-fashion customer. Give the customer what they want. You have to love our customers.”

2. Becoming more digitally oriented: Lands’ End had a wealth of customer data being highly underutilized, as the below illustrates:

1. “One of my first questions when I got to the Company and talking to our analysts was: tell me where customers come from when they join our website. I don't know. Tell me where customers go when they leave our website. I'm not sure. Tell me what customers look at when they are on our website. I don't know. I said, well, what the hell do you analyze? And they said where we send catalogs. I'm like okay. So we have changed that”

The changes that he instituted and shift back to the Company’s core strengths had remarkably quick results. In Q4 2017, Lands’ End saw their third consecutive quarter of sales growth following 11 consecutive quarters of sales declines, and subsequently reiterated their 5-year financial targets including growing revenue to $1.8bn-2bn and EBITDA margins in HSD (~$140mm). They had remained on track and reiterated this goal in Q4 2020. 

Strong 2019 and Early 2020 Status

Lands’ End was seeing continued strong performance in 2019, with revenue ex. Sears up 5.4% (US eCommerce +7.4%) and gross margin expanding by 50 bps. This led to 11% Adj EBITDA growth.

Other key recent accomplishments included:

1. US eCommerce had delivered 8% CAGR over last 3 years driven by dynamic promotions, price clarity and “key item” product strategy focused on basics 

2. Successfully launched two national accounts in outfitters with Delta and American Airlines over the last 2 years

3. Opened 20 new stores with consistent SSS growth that increase brand awareness and act as customer service centers

4. Kohl’s: Starting in fall of 2020, offering full product assortment on kohls.com and seasonal product assortment at 150 Kohl’s stores

5. Lands’ End has completed the exit of 300+ Sears stores since 2016 and has no remaining Sears retail footprint or shared services. 

In addition, the performance at the start of 2020 was highly promising.

• Global eCommerce revenue grew 6.2% in 2019 and was up 11.1% YoY in February 2020

• Customers continuing to positively respond to the value oriented, key item product assortment strategy focused on basics and seasonal fashion

• Opportunities for growth

• While Amazon is a small portion of the business, Lands’ End has a significant opportunity as over 75% of purchases through Amazon have been driven by either new or lapsed customers 

• Significant opportunity to expand customer reach in 2H 2020 with the fall launch of Lands’ End’s partnership with Kohl’s 

• Many demographic similarities

Key Valuation Takeaways

Obviously, the world now is not what it was 6 months ago, but I think it helps to think about the value of Lands’ End in a pre-Covid context, which I’d consider a mid-cycle normalized environment. So when thinking about a normalized valuation, my key considerations and assumptions are:

• 96% of sales are DTC, with 76% of that coming from eCommerce. This fact alone warrants a premium over the majority of retail peers

• 2022E EBITDA of $90mm (far below management’s target of ~140mm)

• Assumes ~4% revenue growth CAGR. 

• Steady Gross Margin at 43%

• SG&A leverage of 50 bps over 3 years (achieved 80 bps last 3 years)

• CapEx: Core business capital spending needs relatively low. Currently spending ~35mm annually on CapEx, but much of that is new store openings and IT spending catchup from the underinvestment of the Sears days 

• Historically spent 10-20mm annually in CapEx on $150mm in EBITDA

In addition, we can see their operating and valuation benchmarking pre-Covid below:

Operating Comps

Valuation Comps

On the operating comps, LE is meaningfully better than peers in all areas outside EBITDA margin. Most importantly for the current retail environment, their DTC penetration is far higher than all their peers. 

I see 7-8x as a very conservative downside EBITDA multiple considering LE’s mid-single digit growth trajectory, tailwinds as a DTC business, and ability to convert EBITDA to Unlevered FCF at a +60% clip (were doing ~$80mm/yr in FCF prior to the 2016 missteps). Once again, we can’t just look at it from a pre-Covid standpoint and say the TL is covered. There are obviously many more considerations today. Most importantly: how will the economic shakeout from Coronvirus impact retail spending, and can Lands’ End survive until a return to normalcy without burning loads of cash / needing dilutive capital? 

Lands’ End Coronavirus Performance / Cash Burn

Let’s assume that the current operating environment is with us until improvement begins in the back half of 2021 (by this I mean a return to normal living conditions, but potentially still being in a recession). We can take what we’ve seen from LE so far this year to try and evaluate what liquidity looks like.

Recent Performance During Covid

• eCommerce experienced a drop off in the middle of March to middle of April, with sales US sales decreasing 16.5% from the prior year in Q1 2020, while International eCommerce remained relatively flat for the quarter

• Global eCommerce sales rebounded in April and continued in May with the business accelerating to double digit revenue growth versus the prior year

• Q2 2020 Guidance: Overall revenue to be down mid-high single digits

Revenue Projections 

eCommerce

The graph below is pretty informative of the demand shock and subsequent rebound that occurred during the initial Covid lockdowns. 

As you can see, by far the greatest impact was in March with eCommerce down 25%. I don’t think this initial fall is very indicative of a go-forward worst case; in March things were hitting for the first time, states were on full lockdown, people were panicking. There wasn’t much thought on buying new clothing items for the spring season (who cares if you have a new outfit to wear around the house?) and in general people just had their minds elsewhere.

I think the April sales figures give more of an indicator of downside sales declines in eCommerce, and even that would be pretty harsh in a return to more stringent Covid rules, given the double digit revenue growth seen in May.

FWIW, the Company gave guidance for high-single digit revenue growth YoY for Q2 2020 in eCommerce and expects to see continued recovery through the back half of the year. 

Outfitters

Outfitters is probably the trickiest segment. It got hit pretty hard with March revenues falling from $16mm to $11mm and April revenues falling from $16mm to $6mm. 

Travel accounts (Delta and American) make up 60% of the national accounts segment, which will likely be hard hit for the foreseeable future. The school segment will likely buoy Q2 sales to some degree as many schools are resuming a portion of in-person education. The 60% declines seen in April seems like a reasonable Q3/Q4 downside.

Retail

Retail has been on a solid growth trajectory, with LE going from 11 company owned stores in 2017 to 25 in 2019, on SSS of 3.9% and 6%. The Sears headwind is entirely gone with LE now having exiting them all. Obviously if there is another complete shutdown scenario, retail would go close to 0 – my assumptions have down 50%. 

Management’s response to Covid has included reduced 2020 store openings from 14 to 6, helping cut CapEx in half to $20mm. These stores are a very small % of sales but act as customer service centers, allowing customers to come try on clothes if they’d like to do so. Management’s strategy seems prudent here.

Gross Margin

eCom expected to remain in 42-43% range as apparel stays under pressure by discounting in the sector. Segment breakdown as of 2019:

• eComm stable at 42%, outfitters at 46% but variable, and retail increasing to 42% from 38% as Sears stores leave portfolio

SG&A

The company aggressively reduced discretionary spending in the first quarter in response to COVID-19 by furloughing approximately 70% of its employees for 4 weeks beginning in early April, reducing base salaries, cutting distribution and call center hours and limiting operating expenses. 

Management expects SGA as % of revenue to be in line with historical given cuts they’ve been able to make, but some deleverage is appropriate on ~200mm lower in sales. I assume SGA as % of sales is 41% (last 3 years: 37.51%, 37.59%, 38.31%).

CapEx and NWC

CapEx for 2020 has been cut to $20mm from $40mm, as most of it is investing in IT upgrades and new store openings. They had planned to spend an incremental $10-15mm on their new EoM system.

Q1 saw an $88mm increase in NWC as inventory became elevated as a result of Covid; planned inventory purchase for the remainder of 2020 have been reduced based on recent demands. As a result, NWC is expected to be roughly in line with prior year levels by the end of FY 2020. I assume this ends up being a use of ~20mm for this year and is flat in 2021. 

Cash Burn and Liquidity Implications

Below you can see Lands’ End’s liquidity situation as of 5/1/2020. As of the end of June, they had paid down the entire balance of the ABL. Even in a downside scenario (see CF build and projections below), Lands’ End has substantial liquidity to get through to a “normalized” environment without impairing current investors.

Given the large and growing eCommerce segment, it’s hard to see revenue remaining depressed after this period unless there is a protracted recession. Even then the Company can cut costs to right-size the cost structure. 

Conclusion

I think lenders will look at this business and realize that medium to longer-term, its easily worth a 7x multiple on a growing $90mm of EBITDA for $630mm EV on $400mm in Net Debt (in which case we achieve the 16% YTW). If they don’t get a refi done, think it’s possible to get an amendment with better economics. And worst case owning the equity at 4.7x pre-covid EBITDA growing at HSD on a relatively low asset-intensive business is attractive. 

Risks

--Refi does not occur and there is value deterioration in a BK (unlikely – substantial equity value, CEO owns 50k shares and 230k of RSUs worth a total of 3mm)

--Company burns more cash than anticipated and chooses to raise incremental capital. Unlikely to impact priority of TL as general debt basket is $50mm (and if can’t refi, likely can’t raise substantial debt in any case)