Description

Long shares of Lands End (LE).

This is a pretty non consensus idea in that it's a long idea in the Sears/ESL complex, I can feel the 1 and 2's coming already, but hear me out.  

Here's the thesis: 

Lands End is a brand and business model that's so resilient that a decade+ inside Sears and a few years of someone trying to turn it into a Madison Avenue instead of a Madison, WI brand couldn't kill it.  After a decade of neglect and several years of flat out mismanagement, the company looks to be getting back on its feet and doing what it does well:  selling quality, staple clothing merchandise direct to consumer via the internet and catalogue.  The company has a new, capable management team in place.  They appear to have a credible plan that is already starting to show results.  This business, at its core is pretty good gross margin, capital light, and has high incremental margins.  There is opportunity to further improve margins, inventory management, and drive a further recovery in topline.  As they execute, I expect the economics of this business to show through in the financials and the company to generate good cash flow.  

So what went on?

The Sears out of bankruptcy liquidation story is well known at this point.  Eddie Lampert is basically playing a game of Jenga with Sears' assets as the company heads towards a bankruptcy.  LE is one of the pieces he's pulled out, but unlike some of the other pieces, has a reason for being outside the Sears ecosystem and doesn't look to be a vehicle to funnel cash to the burning dumpster fire that is SHLD the parent, unlike say SHOS.  It's worth noting that ESL's equity interest in LE is now worth more than his equity in SHLD.  

Anyway, inside SHLD, LE was neglected.  Post-spin, they brought in a fly in/fly out CEO, she actually commuted to WI from NYC periodically, from Dolce and Gabanna to "refresh" the brand.  By "refresh" she attempted to make it more fashion forward.  This had predictable results and the company suffered as comps and margins declined.  What's remarkable is that it did not burn cash over the last 3 years, net debt 3 years ago was $405m vs $395m today, even as they upped capex investments in an ERP.  

In comes new management:

Early this year LE hired Jerome Griffith to be the new CEO.  His background is with fashion brands and his most recent gig was CEO of Tumi, which he sold to Samsonite in 2016.  His plan seems credible:  return the brand to its roots (http://host.madison.com/wsj/business/executive-qa/new-ceo-jerome-griffith-wants-lands-end-to-return-to/article_b03b5f44-5e37-59c3-aebe-1f5d63228d46.html), focus on the product quality and design, increase engagement with existing and lapsed customers through digital marketing, use data & analytics to better the customer experience (help point out things they might like, make sure things fit right, etc.), and look at additional distribution opportunities.  It's worth noting he has a lot of comp in stock and has made meaningful open market purchases at prices above the current quotation.  Since becoming CEO he's acquired 60k shares in the open market, on top of 20k he owned prior, at prices up to almost $20 and he has granted over 100k shares and nearly 300,000 options struck at $18.1.  

Green shoots:

The steps taken at the beginning of the year are beginning to bear fruit.  Comps have been turning and margins have stabilized.  According to management, that trend has continued into the holiday season.  To get a sense of the starting point they have, their active buyer count shrank 30% under prior management.  They’ve recovered 15 of the 30%, but they feel it may have been worse than 30% because an “active buyer” is liberally defined, so there’s opportunity to drive that recovery more.  The reengaged buyers returned with a smaller basket, and there’s opportunity to expand the basket as they return for a second round.  The company is already starting to see evidence of this.  Let's take a look at Q2/Q3 and est Q4 comps in their Direct business and their Retail business, as well as how these LE locations are doing compared to SHLD locations they are in.  

Revenue    Q4 2016    Q1 2017    Q2 2017    Q3 2017    Q4 2017 E

Direct        $398.50    $228.30    $259.90    $290.30    $418.43

Retail        $60.30    $40.10    $42.20    $35.10    $53.67

Total        $458.80    $268.40    $302.10    $325.40    $472.09

SSS Direct    -2.60%    -1.70%    5.50%        6.70%        5.00%

SSS Retail    -1.70%    2.10%        3.80%        -1.30%    -1.00%

SSS SHLD    -12.30%    -12.40%    -13.20%    -17.00%    >-15%

I think the strong performance of LE inside the dumpster fire that is SHLD is actually remarkable and indicative of the relative appeal of LE.  

The most important business is their direct B2C business, it is the largest and has the best incremental margin profile.  Essentially, gross margin dollars have a very high (80%) flow through rate to EBIT.  The things they're doing to thicken their buyer file seem to make sense and I think bode well for future comps.  Incremental margins for this business are pretty good, a gross margin dollar flows through to operating income at a high rate I estimate about 66%, so at a 42% gross margin, that’s about 28%.  That number could go up a bit as they scale back up.  

Sears Closures:

Presently, LE is in 188 SHLD stores.  All are up for renewal over the next 26 months, 48 of them in January and the bulk of them next January half the remaining in Jan of ‘19 and the rest in Jan of ‘20.  They have already renegotiated terms of the lease and rents for 34 of the stores, the term is 12 months and a significantly better deal for LE in terms of costs.  I'd expect them to deal with the remaining leases in a similar way, ESL's greater equity stake in LE relative to the dollar value of the Sears stake makes me think they'll be friendly about the next batch of leases too.  I estimate that LE will lose about $7m of EBITDA in SHLD this year, improved terms and/or only keeping profitable locations open will only improve that.  

People might think a SHLD bankruptcy would be disruptive to LE, but I don’t believe that to be true.  SHLD stores represent less than $150m or so in 2017 revenues (they have 14 company owned stores that we think do closer to 2m/unit), but they are attempting to run at breakeven.  There’s a little over $60m in assets tied up at SHLD locations, but that is basically inventory and we’re told that it is current and not unique to SHLD.  Closing locations actually generates cash for LE because they’d just liquidate the inventory and move on.  Quite frankly, I think this might be the best thing that could happen even if it creates some temporary revenue headwinds.  The stores locations aren’t great, according to the CFO “there isn’t one location we would open our own store in today”.  They’re B/C mall locations.  

FWIW, the Sears link seems to be a decent part of the reason people don’t like the stock.  This article was published recently, after what was a pretty decent quarter:  https://www.bloomberg.com/gadfly/articles/2017-12-05/lands-end-earnings-new-ceo-old-problems

Other opportunities:

The company has a clear opportunity to improve margins and inventory management.  Management describes the systems as “antiquated” and they’re implementing an ERP which they’re 80% through paying for and ⅔ the way through implementing.  They’re also working on getting lead times down to be more responsive in how they order inventory.  Presently it takes about 1yr of lead time, they’re working to get it to 39 weeks and think they can ultimately get it to 26 weeks.  This investment should help them with their gross margins in the future.  The CFO thinks he can take $40m of cash out of inventory, and it’ll be more than that if/when they close SHLD locations.  The inventory is apparently pretty fresh at this point too so that should help margins as well.  

There’s also the uniform business.  This is about $300m of direct sales.  And while it requires them to keep a bit more instock, the sales are committed and it occurs at a higher gross margin, close to 50% “would not be unreasonable”.  The business was not being run for growth, but to maintain current customer relationships.  The recent Delta win is indicative of the potential here and could be the start of better things going forward.  Delta will be their new largest customer, the previous largest being 8/9% of revenue.  The Delta win actually resulted in American reaching out to them about their uniforms, apparently AA’s RFP is about 1.5x Deltas.  On January 9th LE announced they won the AA business. While they did not disclose the dollar size of the contract, they disclosed they will be the sole supplier of uniforms for 70,000 employees which is 1.8 million articles of apparel items.  So it wouldn’t be unreasonable to think there is $30m of delta revenue (some may start to show up in Q4) and $45m of AA revenue, which is a pretty good tailwind on direct comps for 2018 before they do anything else.  Having not one, but now two flagship customers on board should also help the uniform part win more business yet.  

There is some opportunity for stand alones.  The kind of things where build out is maybe $1m and they hope to do $1.5m in sales and maybe do $300k of EBITDA in a unit.  Another part of the idea is that it will supplement an online/catalogue business.  They’re planning on 4-6 of these in 2018 and I expect them to be thoughtful about the roll out from there.  

Margins relative to peers and valuation:

LE's business model (catalogue/internet focused) is inherently pretty good and cash flow generative, as evidenced by the fact they actually generated cash through the most recent poopshow.  I think there are multiple ways to triangulate the valuation.  LE is capital light, with small amounts of D&A (just under $30m) and reasonable amounts of capex ($35-40m). 

Presently LE trades at a forward multiple of ~10-11x 2018 EBITDA (~$90m my estimate, up from maybe $65m or so when they close out this past year), which is a couple turns lower than peers.  The others in the category don’t have the same opportunity for improvement in revenues and margins that LE does (COLM, VFC, and others have gross margins in the high 40’s vs. LE’s ~40-42%), and this could very well be a much lower multiple than the peer set on 2019 numbers where I think $110-120m+ is pretty achievable.  It wasn't long ago that this business did $150m+ of EBITDA. 

This is the kind of thing that as it starts to go the other way and pick up steam, you get help from the business results improving:  revenue growth, marging improvement, and cash flow generation, which should also lead to a much better multiple.  It's not hard to see this as a $1.5b company.  Which if they delever it some along the way, which should happen with improving EBITDA alone plus cash flow that starts to get generated, and/or start buying back stock could mean good things for stock price.  

What’s interesting is once they’ve righted the ship, there’s a good amount of cash that should be generated and available to either reinvest or presumably, given ESL’s involvement, shrink the float.  Once the ship has been righted, this CEO has sold companies in the past and I could see this being an attractive asset to a number of folks.  

Ownership/Short Interest

ESL owns/controls about 67% of the shares.  Of the remaining 10m or so, nearly 3m are sold short, so short interest as a % of the float is high.  I also think, based on the results coming in, there’s also the potential for a pretty strong short squeeze on a low effective float.  So there may be opportunities to trade around this a bit along the way.

Risks

The green shoots turn brown (Comps/margins turn the other way)

There’s some leverage on this already

You're a passive minority investor in something that touches the SHLD universe

Catalyst

Improving results as management continues to execute a competent, coherent plan well