Description

Weyco's stock has been left behind in the reopening rally thus far, but low valuation multiples, recovering sales, and significant but unheralded cost reductions set up shareholders for a double over the next 1-2 years.

1. Elevator pitch

• Despite the rollicking rally in small caps, Weyco has lately been stuck around half its all-time highs (mid-2018) and only very recently started to climb off its 2020 lows. At 8.9x 2019 adjusted EPS (before COVID-19 struck), 1.01x book value (1.26x tangible), 0.57x EV/2019 sales, and a 4.9% dividend yield—all buttressed by a fortress balance sheet—there's a lot of old-school value here.
  
  
• Of course, metrics like these are often associated with businesses in secular decline or worse. Weyco had a poor run from 2007 to 2017, which may still weigh on investors' view of the stock. But management used those years to diversify its product lineup and sales channels, positioning the company for a stronger recovery from the current downturn compared with the last one.
  
  
• We also believe Weyco is an undiscovered restructuring story. Its first quarterly losses in more than three decades threatened the controlling Florsheim family's ample dividends, prompting quick action—the scope of which we think we've uncovered with regression analysis. We believe earnings could return to peak levels even without a full sales recovery, particularly if perennially lossmaking foreign operations are cut loose.
  
  
• While the trajectory is somewhat COVID-dependent, we think the destination is pretty easy to figure out. Weyco is positioning itself to surpass its pre-COVID peak in profits, probably as early as this year. Assuming the stock can respond to rapidly recovering sales and earnings by reaching the 2010-19 median P/E of 17.5x, the stock would reach $40. If we're wrong, we believe a low initial valuation, high tangible asset value, and the financial interests of the controlling family ought to limit our downside.

2. From 30,000 feet: Why should anyone care?

Nike this isn't. We’ll happily concede that as a business, Weyco is almost as boring as it gets. It’s small, representing less than 1% (at wholesale) of the $80 billion U.S. footwear market. It's uncovered, unloved, and not even hated (the 69,000 shares sold short at January 15 represented only 4.3 days’ worth of average daily volume).

Founded in 1906, the Milwaukee-based company designs, imports, markets, and distributes footwear, mostly in the United States. Its brands are Florsheim, Stacy Adams, Nunn Bush (these three being mostly men’s dress and casual shoes), BOGS (outdoor shoes and boots), and Rafters (sandals). Weyco says its products are sold in over 10,000 retail outlets as well as online; no one customer accounts for more than 10% of sales. Manufacturing is contracted out to Chinese factories (recently around 70% of volume), with India in the lead among other countries of origin. 

The North American Wholesale segment (80% of 2019 revenue, 103% of operating income) sells to third-party retailers as well as Weyco’s other two segments. The first of these is North American Retail (8% of 2019 revenue, 10% of operating income), which over time has deftly transformed itself from a traditional brick-and-mortar business into an e-commerce platform. The Other segment (12% and negative 13%) comprises operations outside North America, primarily a lossmaking brick-and-mortar retail footwear business in Australia. (Corporate costs are included in the North American Wholesale segment.)

According to the most recent 10-K filing, the Florsheim family controls 50% of the stock, but they did not found Weyco as such. Instead, a scion of the original Florsheim business (Thomas Sr., still chairman emeritus) jumped ship for the Weyenberg Shoe Manufacturing Company in 1964. With the business rechristened Weyco Group in 1990, this branch of the family managed to buy the original Florsheim operations out of bankruptcy in 2002. 

In absolute terms or when compared with the Russell 2000, Weyco’s stock performed respectably in the 1990s (10-year total-return CAGR of 12.9% vs. 12.0%, according to Bloomberg) and quite nicely in the 2000s (12.4% vs. 3.8%). However, the 2008-09 recession and drawn-out recovery thereafter were rough on Weyco. Too much of the business was in dress shoes as the world slid toward casual. Too much of the business flowed through department stores as department stores lost relevance and revenue. Operating income (ex-items) fell by nearly half from 2007 to 2009 and had not fully recovered even by 2019. The stock returned only 4.1% annualized in the 10 years through December 2019, falling well behind the Russell’s 11.8%. In particular, the stock began to slump from mid-2018 onward, with noteworthy underperformance in May 2019 amid higher tariffs and considerable uncertainty on Chinese imports.

3. On closer inspection … 

Let’s stipulate that if Weyco can recover from COVID—if earnings can reattain the 2019 peak of $2.17 a share (adding back $0.07 a share of store-closure costs in Australia)—then its stock is cheap. The following charts show the company's valuation at historically low levels if we omit the COVID-induced plunge in sales and earnings (the denominators of P/E and EV/sales are held constant at full-year 2019 levels).

Using more cyclically-stable metrics such as book value and dividends, the stock also shows up in favorable territory relative to its own past. 

Data through Feb. 4, 2021. Sources for graphs and data: Company reports, Bloomberg, author's analysis.

Don't even get us started about industry comps. We agree that Weyco may well deserve to trade at wide discounts to Nike or Deckers, and probably something of a discount to the group medians. After all, it is much smaller and somewhat less profitable than these points of reference. But we find it very hard to believe the discounts should be this wide. (Note: Here we use current market values against 2019 financial results as a pre-COVID base for historical multiples, and 2021 consensus for forward ones—except for Weyco, where we've used our own 2021 estimates in the absence of any published consensus. We describe the basis for our 2021 estimates below.)

To be fair, there's not much about Weyco's financial performance in 2020 that makes the stock attractive. Through the first nine months, sales dropped 39% (including 72% in Q2) and operating income ex-items swung from positive $15.9mm to negative $6.5mm. For the stock to work, the company has to bounce back from COVID—and stay back.

We think it will, and point to several promising signs.

* Amid intense competition for footwear in general, cultural headwinds for dress shoes in particular, and the dwindling ranks of mid-tier department stores, Weyco has survived with strong niche brands and by broadening its product portfolio. The early 2011 acquisition of BOGS/Rafters was a key event, adding boots and outdoor shoes to the company's mix for the first time. Since then, change has been more evolutionary than revolutionary, with the company introducing more dress/casual and outright casual products under its three dress brands. Though sales growth has been far from spectacular, a CAGR of 2.5% for the North American Wholesale segment from 2011 to 2019 implies that the company has at least held its own, most likely with a little volume growth given that industry inflation has run at only 0.8% a year in the same period. More important, this segment has shown relatively stable to gently improving gross and operating margins over time.

* We are also impressed that the company navigated the effects of higher Chinese tariffs with almost no pain. For all the fanfare and fear, in only one quarter (Q1/2020) did Weyco's gross margin suffer as higher-cost inventory was sold through. Including this impact, and then the dramatic falloff in volume, we estimate the North American Wholesale segment's gross margin is down only 100bp YTD (34.1% vs. 35.1% in the first nine months of 2019).

* At the top line, Weyco's North American Retail segment barely grew from 2009 to 2019, but it's a bit more impressive in light of the fact that the company closed (net) 28 of 36 brick-and-mortar stores that operated at year-end 2009 and fully replaced those sales with the company's own e-commerce sites. Profitability improved considerably in the transition through 2019. This transformation continues in 2020, with 3 more stores closed through September, but year-over-year sales falling only 15% in Q3 and the segment nearly back to break-even before restructuring charges.

* As for Weyco's "Other" segment, comprising operations mainly in Australia but also elsewhere in Asia and Europe, there's not much good to say except that this business has become a drag on results, masking in part the progress of the rest of the business. It's still mainly a brick-and-mortar business, and at least as long as Weyco has owned it, the Other segment has always had lower gross margins than the North American Retail business. In addition to the difficulties of traditional retail, management has cited the weak Australian dollar for the segment's problems, since it imports its goods in U.S. dollars. It hasn't been profitable on a full-year basis since 2017. In 2019, the Other segment lost $3.5mm (including $940,000 of store closure and impairment charges). Finally, thanks to COVID, the segment lost more than that ($3.8mm, with $2.8mm of charges) in Q3/2020 alone. As we see it, the opportunity here is simple: Just stop these losses, without which we estimate Weyco would have earned $2.37 a share in 2019 and which accounts for two-thirds of the company's year-to-date operating loss in 2020.

4. Management is (finally) taking firmer control of Weyco's destiny.

We think Weyco has demonstrated a sufficient amount of long-term staying power for us to be intrigued by the stock's low valuation. Though there's a bit of an interesting past here, we also find that management has been friendly to shareholders in recent years. The company has a long history of share repurchases and an even longer one (at least 30 years that we can vouch for) of escalating annual dividend payments. In this respect at least, we believe managers' interests are strongly aligned with shareholders: It appears that both CEO Thomas Florsheim Jr. and COO John Florsheim collected more cash for themselves through dividend payments in 2019 than they received in paychecks.

It follows that anything that might threaten those dividend payments would get management's attention—fast. 

"We're reexamining every aspect of our business. And, you know, for a while, I think, [the] company's had the luxury of funding some things maybe weren't that profitable because we're making a fair amount of money in other areas of our business. We are literally studying every single expense line in our company right now ..."

     — Weyco Group CEO Thomas Florsheim Jr., Q2/2020 conference call, August 5, 2020

Based on results in Q3, we believe Mr. Florsheim meant what he said. Weyco may not be able to control the volume of its sales in the midst of a pandemic, but it can control costs. Both Q2 and Q3 were extremely sloppy, with one-off items ranging from the write-off of receivables from the bankrupt J.C. Penney to government wage and rent subsidies. We presume that the sloppiness and the uncertainty will last as long as the pandemic does. What we really want to see is how much cost is actually being taken out of the business.

First, we used regression analysis to develop a model for selling & administrative costs (excluding all named items in the K's and Q's) in the North American Wholesale segment. (This is one of the attractive aspects of seasonal businesses—simple statistical techniques can reveal a lot about a company's cost structure.) For the relatively placid stretch from 2012 to 2019, 32 quarters in all, a straight regression against sales had an R-squared of 0.6463. We found a tighter fit with gross profit dollars: an R-squared of 0.7853 as shown below. Intuiting that fixed costs were not necessarily "fixed" over eight years, we added an inflation component (core CPI) to develop a two-factor model for S&A; the R-squared of this multiple regression rose to 0.8225 and is shown below at right. The average variance from predicted to actual was $496,000 per quarter, or about 3.6% on average.

Data through Feb. 4, 2021. Sources for graphs and data: Company reports, Bloomberg, author's analysis.

A model like this can do a good job predicting results in an "ordinary" business environment. 2020 was hardly ordinary, so we shouldn't be surprised to see the model lose some predictive power—or, given the model's assumption that fixed costs are indeed "fixed", the model might instead alert us to changes in the company's cost structure. Q1/2020 was close to in-line with our model. In Q2, with sales down about 80% both sequentially and year over year, costs didn't fall quite as fast as the model predicted (costs were 2 standard deviations above forecast). We attribute this to the speed of the shutdowns relative to management's ability to respond. But with sales bouncing back sharply in Q3, selling & administrative cost in the North American Wholesale segment (again, this excludes all one-off items cited by management) was slightly down from Q2--and $2.1mm lower than what our model would have predicted (fully 4 standard deviations below forecast).

Management is quite reluctant to give guidance, which makes sense, given the volatility of the retail environment in any quarter or year (let alone the impacts of COVID-19). However, combined with management's commentary about cost reductions on the Q2 and Q3 conference calls, we think it's likely that the North American Wholesale segment has shed roughly $8mm worth of annualized selling & administrative expense (from a 2019 base of $61mm). The depth of the cost cuts in Q3 may seem extreme (though we detect nothing unusual on the balance sheet in terms of accrual reversals, etc.). At the same time, we also suspect that not all of the savings were realized in Q3--the full run-rate impact might not show up until Q4, and so could be even larger.

This also addresses one of the challenges Weyco's past poses for investors. When sales fell in the 2007-09 recession, company-wide gross margin declined less than 100bp, but the operating margin plunged to 8.1% from 14.7% because management was slow to right-size the cost structure for a tougher environment. We detect a great deal more urgency on the part of management in this downturn. With the cost reductions recorded in Q3, the North American Wholesale segment returned to an operating profit before charges. Even with sales still down a whopping 35% year over year, the segment posted an adjusted operating margin of 10.8% versus 14.0% in Q3/2019.

In addition to the cost reductions in North American Wholesale, Weyco closed 3 more of its remaining (and lossmaking) brick-and-mortar stores in Q3, leaving just 5 of the old breed with the lights on. We suspect the cutting came late in the quarter as its selling & administrative expense was down only slightly sequentially and even less so year over year, so the bulk of the benefit lies ahead. Even so, the North American Retail business improved to a $184,000 adjusted operating loss in Q3 from $856,000 in Q2. The Other segment saw a substantial reduction in cost as well; while its $502,000 adjusted operating loss is discouraging, it was only half the loss of the year-ago, pre-COVID Q3/19, even with sales down 50%.

5. What we're expecting, and what we think it's worth (~$40 a share).

It's extremely difficult to contemplate what any one quarter might bring in this environment, but we're willing to stake a claim to the notions that (1) the virus will eventually go away and (2) life and business will resume some normal pattern that would be recognizable in the past. For modeling purposes, we articulate this idea by building a gradual recovery of sales in the North American Wholesale and North American Retail segment such that by Q4/21, these segments are back to 95% of their pre-pandemic annualized run rates (with 100% recovery by full-year 2022).

As for costs, we assume stable gross margins—we regard this as fair given the updrift in gross margins before COVID and resilience under the gun, and note too that an environment of rapidly recovering sales seems like an odd time for price wars. We use our regression-based modeling of selling & administrative costs, plus our assumption that roughly $8mm of annualized cost has been taken out of the North American Wholesale segment as of Q4/2020 and an additional $1mm ($333,000 per just-closed store) out of North American Retail. We fade these savings as the recovery unfolds into 2021 and then 2022 as we assume some reinvestment to support future growth, but we still expect improvements in operating margins.

Our boldest projection may be this: We think time is nearly up on the Other segment's losses. While as recently as the Q3 conference call management believed it still had a good market opportunity in Australia--even in brick & mortar retail--—we also note their accountants' decision to impair the segment's deferred tax assets (no doubt arising from past operating losses). We agree that there may still be some opportunity with wholesale or online sales for Weyco's brands in Australia, but we simply don't see the kinds of losses this segment generates being tolerated much longer. We think it's reasonable to simply exclude it from earnings post-2020, which we model through another 50% decline in sales in 2021 (and zero sales in 2022) but with enough cost reductions to leave operating profit around break-even. How things unfold, exactly, remains to be seen. Whatever happens, we assume there will be more restructuring charges, but the segment might be thrown into discontinued operations or otherwise excluded from ongoing results.

At the bottom line, we get a company that is smaller on the top line in 2021 than 2019, but thanks to cost-cutting is earning more ($2.27 a share ex items) compared with the last pre-COVID year. In 2022, a full recovery to pre-COVID sales volume for the North American segments gets our forecast to $2.64 a share. Can this pass the smell test? From 2019 to 2022, our forecast contemplates a $5.5mm improvement in operating profit; $2.5mm of that is simply the removal of the Other segment's operating losses. With identical sales for the remaining segments in 2022 compared with 2019, the $3mm improvement simply reflects cost reduction—about $2mm in North American Wholesale, or around 3% of pre-COVID overhead, and $1mm in North American Retail, which may only be running half as many brick-and-mortar locations on average as it did during 2019.

As our forecast implies that Weyco is a higher-margin, higher-ROIC business within a year or two than it had been on average over the past decade, we think the 17.5x median P/E of 2010-19 is a realistic target (especially considering how high multiples are across the U.S. equity market). On our $2.27 EPS forecast for 2021, the stock would reach $40 in a year, plus $0.96 a share (or perhaps slightly more) in cash dividends. Two years out, on earnings of $2.64 a share, 17.5x yields a $46 target plus $2 of dividends.

We think $40 in a year, at least if our estimates are directionally correct, would foot reasonably well to the stock's history and peers. Admittedly $40 implies valuation multiples other than P/E that are at the upper end of Weyco's history, but we believe this would be justified given today's lower tax rates and higher multiples across the U.S. market.

6. What if we're wrong?

For Weyco to recover its 2019 level of North American revenue within three years, the post-pandemic world will have to return more or less to normal. Dress and dress/casual shoes are worn mainly in the workplace (meaning the wearer is onsite rather than online) or at social events (weddings, graduations, etc.). If the world has permanently shifted into a more atomized, socially distanced mode, it may be tough for Weyco to shift its product portfolio fast enough to stay relevant. But if sales do not recover as fast as we expect, we believe management can and will keep a tighter rein on costs for longer than we've modeled. If it takes until 2022 for the company to reach our 2021 levels of sales and profitability (an 88% recovery to pre-COVID run rates rather than 100%), we still think the stock would be $40, just in two years rather than one.

Our take on gross margins and overhead cost reductions could prove optimistic as well, despite the favorable data we've observed through the worst (we hope!) of the pandemic. Even so, we think the stock's downside from this level is limited.

* Although insider control necessarily limits the influence of outside investors, we believe the Florsheim family will prove willing to do whatever it can in order to maintain the current dividend. In a stable state, that means earning at least $1.20 a share to generate $1.00 a share in free cash flow (at the 2012-19 cumulative free cash flow conversion rate of 83%). If even a fully recovered Weyco earns only $1.20 a share, the stock is trading at only 16x, roughly equal to its 20-year median multiple and less than its 10-year.

* Speaking of cash generation, Weyco delivered $3.7mm in positive free cash flow in the first three quarters of 2020 despite (1) an $8.9mm GAAP loss and (2) elevated capital spending due to an expansion of its headquarters facility. From $7.4mm in 2019 and $3-$4mm guided for 2020, management expects capital expenditures of only $1-$2mm in 2021—half of depreciation.

* Certainly by the standards of this financially decadent age, Weyco's balance sheet is a fortress. At Sept. 30, the balance sheet held $6.9mm in cash and $13.7mm in marketable securities (both short- and long-term) against $5.2mm in short-term debt. Net cash was $1.76 a share. Weyco did have a pension deficit of $27mm, but in "other assets" it also has about $18mm worth of cash value in corporate-owned life insurance policies.

* Tangible book value at Sept. 30 was $14.63 a share, including $11 worth of receivables and inventory net of payables. And (despite what the accountants might force due to Weyco's low stock price at Dec. 31) we wouldn't dismiss the $4.60 a share worth of goodwill, trademarks, and other intangibles (total book of $19.59). In recent years Weyco has collected an average of $3mm a year in 100%-margin licensing revenue from partners selling non-shoe accessories (belts and the like) using its brand names. Even in some kind of liquidation scenario, we believe Weyco's brands would have ongoing cash value.

Finally, while our expectation that Weyco will cut off its foreign losses within a year or two may be the shakiest part of our forecast, Herb Stein is usually right in the end: When something is unsustainable (like shipping millions of dollars that could otherwise be paid out as dividends halfway around the world to subsidize never-ending losses), it tends to stop. Perhaps management will find a way to keep a presence Down Under with wholesale sales through other retailers while leveraging its e-commerce success in the U.S. But one way or another, it seems as unrealistic for management to continue tolerating multi-million-dollar losses abroad as it would for outside shareholders.

Catalyst

Sales recovery as retail reopens and people go back to work post-pandemic – which should be priced in like it is almost everywhere else, but hasn't been in this case (yet).

Cost cutting – a company-specific story that is below-the-radar and adds extra juice (as well as a margin of safety) to the sales recovery story. If our analysis is correct, we expect this to become obvious when Q4/2020 results are released on March 9.

Big year-over-year sales and profit comps starting with Q2/2021 draw investor attention to a story with classic value metrics, a strong balance sheet, and a hefty dividend yield.