Description

Summary

Seasoned retailer management with significant skin in the game, at the early stages of realizing the benefits of an omnichannel position serving the value footwear market. This should be a short duration asset which might be well suited to an uncertain world.  If online sales continue to play out post-pandemic according to my understanding of the company’s natural advantages, a 100% dividend pay-out ratio should be resumed, producing double digit yields on current prices.   

Valuation

In October 2020 this traded at 1/3 the current price, which in hindsight seems dirt cheap but was pre-vaccine, when business survival was in question because much of the business was forced by the government to close.  Now failure is unlikely, and the valuation is attractive with the stock down 25% from February 2022 highs.

Market cap is £60m with zero net debt at seasonal low, or £14m net cash at seasonal high.

£11m of EBIT or £10.8m FCF (adjusted for working capital changes and losses on disposal of right of use assets) was delivered in the 52 weeks to 2 October 2021 in a pandemic year when stores were only open for 36 weeks.

That’s 5x EV/EBIT or 5.5x P/FCF TTM.  Cheap and safe?

Reasonable people can disagree on future profitability.  Last year received government support and was a rebound from the prior year’s losses, with held over inventory probably flattering gross margins (27% vs 16-19% typically) and therefore operating margins (9.2% vs 6.1-7.1% normal range).  But some of that should be sustained by mix if online sales sustain their growth as a proportion of total (26% in 2021), because online has consistently higher contribution margins at 24-28% than the stores.

There are macro headwinds and lots to worry about right now.  But for a debt free business with robust online economics that are only beginning to play out, paying 8.6x trailing 10-year average FCF seems to have adequate margin of safety.

“the Street misses the point on retail.  Most analyst reports focus on how this company will do in Oct?  How will this company be affected by Katrina or higher heating prices for Christmas?  These are all relevant questions, but not relevant if this is a good business.  Fundamentally it will be around. If you buy it at the right price, it really doesn’t matter what is happening to the customer today because they will be around and they will continue to buy.”  Linda Greenblatt, 2005

Business Description

Shoezone is a value footwear retailer that only sells in the UK, through Digital channels and 410 stores (51 Big Box: 5,000 sq ft, 650 styles per season; 343 Original stores: 1,400 sq ft, 300 styles per season; 16 Hybrid stores).  Original stores sell mainly own brands (e.g. Lilley & Skinner) which are directly sourced from Chinese factories by inhouse buyers.  About 50% of styles carried at a Big Box are higher priced 3rd party ranges including American brands (Skechers, Wrangler), and European (Rieker, Kickers).  The strategy in recent years has been to close smaller less profitable Original stores, open new Big Boxes, and grow the Digital channel. 

Average retail price is about £10 ($13) per pair.  The company understands its customer demographics well, with demonstrated resilient demand for a limited but well-chosen variety of discount footwear for different use cases (school, work, office, sports) and predictable repurchase cycles. 

A target customer works for minimum wage in an e-commerce warehouse and pays for their own steel-capped footwear.

“The Shoe Zone target customer is from the C, D and E demographic groups and seeking low cost, quality footwear.”  2014 IPO Prospectus

Shoezone’s head office and single distribution center is in Leicester, where the UK footwear industry had been historically strong, but now its key advantage is being exactly in the middle of the UK for road logistics[2], from where company drivers deliver to each of the stores at least weekly.

The second half of the financial year (end date: October 2) is strongest with summer shopping and the crucial back-to-school season.  Cash receipts are highest at the end of this season, meaning about £11m net cash is required at year-end to maintain positive cash at the lowest points (end October and end March).

Management

CEO Anthony Smith (55) and his brother Chairman Charles (56) grew up in the family business when it was much smaller.  They worked during school vacations in the company warehouse and talked about the business at home over the meal table.  Both brothers continue to hold significant stakes: 30% and 24%.  Anthony became CEO aged 30 in 1993.  Under their leadership the company acquired failing competitors and adjusted to the relentless change of the retail landscape.  After going public in 2014 and hiring an external CEO while remaining executive Chairman, Anthony took back the CEO role shortly before the pandemic hit. 

Anthony is an impressive, true retailing CEO.  Retail is detail and his energy, knowledge of the business, and drive to survive makes him a key attraction of this stock and an obvious risk.  He has personally spent years driving around the country visiting stores, renegotiating leases with landlords, and scouting new sites.  Buffett has talked about the importance of a CEO having “a money mind”.  I think this guy has one.  14 years ago, the company had twice as many stores.  But it made more cash profits last year - despite all stores being closed for about 1/3 of the year due to pandemic lockdowns.  He is not wedded to a particular model but has proven adept through multiple recessions at steering his boat to pleasant waters.  That is not common in any business field but is especially crucial in the low-margins and low barriers to entry of retail. 

Macroeconomic and geopolitical parlour games that we occasionally play on this site can I think best be solved by talented and hungry managers who operate in the complex adaptive system of the economy, rather than by us folk pretending to have deep predictive abilities on variables that might not even matter to stock prices.  Anthony has long understood that the crushing threat of ecommerce to retail also presented opportunities to negotiate rents down.  So, he kept average lease length short (currently 1.9 years, down from 2.6 five years ago) and mercilessly played landlords against each other.  He knows that customers will seek out his stores for the value proposition they provide, so moving across town for one year rent free is something they have done repeatedly.  Last year’s rents renewed at -53%, more dramatic than normal due to the pandemic, but the company has enjoyed average rent renewals of -17% to -27% in the five years preceding this crisis.  A CEO who knows how to find the profit opportunity presented by constant industry and macroeconomic changes seems especially valuable right now.

Business culture

Low cost everything is the way to win in value retailing.  Very little is outsourced, except the actual manufacturing itself.  This both reduces cost and improves agility.  This approach runs through the company and brings plenty of tiny advantages, for example:

·  All IT systems are developed and managed in-house ensuring maximum accuracy and flexibility, and lowest cost.  When management wants to get different information from the EPOS software, it can be quickly redesigned. 

·  When a store is closed down, all the fixtures are returned to HQ, the metal and wooden fixtures are re-sprayed and re-used in other stores. 

·  Logistics are not outsourced; the truck drivers that deliver inventory every week to stores and also bring back items to HQ are company employees.  These routes are crucial to lowest cost operations, so you want someone with attention to detail who works for the whole business, instead of feeling like an outside contractor.

·  Vacuum cleaners at stores (to keep interiors clean and appealing to customers) are one standardized model that is cheap and durable.  When they break down outside of warranty, company truck drivers pick them up on their usual delivery routes and return them to HQ, where the warehouse team look at them and if it makes sense get a local technician to repair 3-5 at a time. 

·  This is the way a small tight-knit company can operate, achieving a level of efficiency and frugality that is hard for larger, more diverse competitors to achieve.

Frugality is not stretched to meanness:

·  Most employees are part time, and industry pay is quite low (£9,700 total compensation per capital, or £25,300 per full time equivalent).  But if they don’t do what they should – due to incompetence or dishonesty - per store cash contribution of £50-100,000 annually would easily be wiped out.  So employees need to follow instructions, even when they are working by themselves or with only a handful of colleagues.  In store visits by the CEO and Chairman, each the largest owners, send the message that each person matters.

·  Despite the policy of minimizing capex “out back” of the store - everything not seen by the customer is functional instead of pretty – and yet there is a heater in the staff room so that employees can keep warm. 

·  2% of profits are donated into the Shoe Zone Trust, founded and run by the two brothers “for children in poverty/difficult circumstances locally, nationally and internationally.”

·  Charles especially seems to have excellent people skills and enjoys building long term relationships of trust with employees.  When redundancies become necessary, many times those same employees will re-apply to join the company years later, which demonstrates that they treat their people fairly.

Online economics

The acceleration in online sales that was forced by the pandemic, when UK government restrictions prevented stores from opening, has powerfully accelerated shoezone’s online business.  Post-pandemic, I expect omnichannel to be the long-term winner in this industry. 

Shoezone sells direct online from shoezone.com, as well as on amazon and ebay.  Here are the choices they present to direct customers:

https://www.shoezone.com/DeliveryAndReturns

Omnichannel should be the long-term winner, simply because whichever retailer successfully steers even a fraction of their online customers to Buy Online Pickup In Store (“BOPIS”, or “Collection” above), will always be the low cost producer, because the consumer handles the last mile themselves “for free”.  And some customers will always opt for collection in store because:

·   Quickest (can be 1 hour if in stock)

·   Equal cheapest retail price, same as home delivery in 2-4 working days, cheaper than next-day home delivery

·   More convenient.  Some customers find home delivery inconvenient.  8am-8pm delivery (no time slot) of a bulky item that does not fit through the letterbox if nobody is home

·   Ability to check size in store and verify fit

For some retail categories, this effect is mild and gets swamped by other variables.  But for bulky, value footwear, it can be the defining factor for how the industry organizes itself.  An average unit price of £10 per pair yields just £1.60-1.90 of store gross margin to absorb what shoezone has found to be an £1.90 average cost of standard home delivery using third party couriers.  All else being equal, online-only competitors would need to gain delivery cost efficiencies equivalent to the proportion of customers electing to pick up in store for an online-only retailer to match omnichannel economics. 

                                                         Breakeven economics

Omnichannel value shoe retailer                                                                                     Online-only value shoe retailer

Reduces average cost per unit by the proportion of BOPIS sales                               Needs to reduce the delivery cost vs the market price

                                                                                                                                                of 3^rd party logistics providers to match omnichannel

                                                                                                                                                economics

                                 ↓                                                                                                                                           ↓ 

e.g. 20% of customers collect in store                                                                              e.g. £1.90 home delivery cost per unit needs to be                                                              

                                                                                                                                                 reduced by 20% through last mile density gains,

                                                                                                                                                 such as Amazon Prime

But that only addresses delivery.  Variations in returns can prove even more important for footwear ecommerce.

Total return costs are return rate multiplied by cost of each return.  Some apparel categories, including shoezone’s competitors, have endured return rates of 30%.  When return costs (courier, checking, and re-entry into inventory) cost up to 25% per item, this can remove a further 7.5% of gross margin (30% * 25%).  Adding returns to delivery costs destroys 26.5% of gross margin – which is the entire gross margin of the online channel.    

Online-only should not be a sustainable business model for value footwear.  Sure enough, a quick search on amazon.co.uk today shows shoezone dominating their target market at the value price point:

Source: amazon.co.uk.  First page of results for search: “boys school shoes”.  Best seller Trux, first two results are shoezone own brands.  

Source: amazon.co.uk.  First page of results for search: “girls school shoes”.  Best seller Walkright and Amazon’s Choice Lilley are both shoezone own brands.  

Some barrier to new entrants therefore exists because they would either need to achieve economies of scale in buying (which requires volume orders) or higher price points to dilute the punitive delivery/returns economics at these levels.  If shoezone sticks to its current price-sensitive demographics, it should be able to repel new entrants that are online-only.  Amazon and ebay should therefore be additive platforms to shoezone, instead of directly competitive. 

But we know that retail is brutal, right?  Barriers to entry don’t really exist long term.  So who are the competitors to fear? 

The key competition would be bigger omnichannel retailers, supermarkets such as Asda (multi-category, Walmart owned).  A comparison as of March 2022:

1. Store network: 633 UK stores

2. Price: similar price range to shoezone

3. Delivery costs: more expensive; slower click & collect:

4. Selection:

Asda:             426 lines:  135 womens          150 girls      44 mens      97 boys

Shoezone:   4,034 lines:  1,992 womens         627 girls      978 mens    437 boys

So currently Asda has slightly better store coverage; targets a similar price point; but is slightly weaker on delivery costs and much weaker on selection (10% of Shoezone).  Sure, Asda will probably improve its delivery prices (or maybe shoezone’s prove uneconomic and will need to raise theirs).  But that selection difference is huge.  It doesn’t sound like a losing battle. 

Asda in turn is facing competition from Aldi.  But they carry only 32 shoe lines as of March 2022, across kids, women and men.

Turns out not everyone wants to buy their shoes at the grocery store.  Bulky items like shoes don’t easily fit within a weekly grocery shop.  One dropped egg box and some customers would prefer separate visits to two separate stores.  Some consumers are always going to find a shoezone location more accessible to their workplace / home than an Asda supermarket.  Plus some consumers don’t want to buy their evening footwear at the same place they buy their detergent.  So long as there are some customers better served by shoezone, they can probably keep reaping the economies of scale that their volume buying generates. 

As a dedicated value footwear store, shoezone has two other advantages over competition.

1)  Physical store lowers CAC through footfall and the repetitive physical advertising of the consumer actually seeing the products displayed in store. Shoezone sales spike on days of extreme weather (snow, rain, sun) partly from consumers who buy items that they did not realize they wanted until they walk past a display. 

2) Low returns: shoezone’s 8.4% online return rate in 2021 - which may be depressed a little by pandemic friction from a more normal 11% in 2019 - is industry leading.  Of these, 80% (at last disclosure point in 2019) were returned in-store, for free, rather than the customer paying £2.50 to return via the online channel (using Hermes lockers).  That radically reduces the cost of returns for shoezone.  First, returned product goes straight back into inventory at the store level.  In the case of branded product, it gets picked up by their trucks that otherwise would be returning empty.  So it is very low cost.  Second, rather than pure cost on a completely lost sale, almost 100% of these in-store returns (at last disclosure in 2018) were converted into a sale in store, for the correct size.  These are sales that online-only never benefit from.

Store economics

As much as I like this story, I don’t think there is much growth potential beyond online.  The company’s experience over the past decade shows that although there might be some scope for store format changes, and per store economics look compelling, nevertheless store count has declined.  When the former external CEO talked about “the sky’s the limit” for Big Box openings, subsequent profits did not back it up, and he was replaced shortly after.  That does not sound like a long runway of new store openings to me.

Pre-pandemic, big box break even was typically 2.5 years.  In some cases, such as when they took over stores from a failed retail chain which offered rent free for the first year, this could be even lower as in this worked example:

Source: 2019 interim presentation

The good news is that the store footprint is already sufficient to achieve economies of scale in buying, as described in a section below, but also in inventory management.

“The key thing in shoe retailing is maintaining your size range.  If you fragment your size range it means disaster and you need high markdown, which is an absolute disaster.  So in terms of maximizing stock, minimizing markdown, stock management and distribution is absolutely critical.”  Former CEO Nick Davies, 2018

“Systems across the business are fully integrated so that we have a single view of stock across retail, the warehouse and digital. We can also identify when we need to recall stock from stores with low sales or a fragmented size range and consolidate and reallocate to better stores. On average we recall 30,000 pairs per week.”  Annual Report 2018

The ability to move 30,000 units per week to maintain decent size selection across the store estate represents about 10% of total annual units sold.  That is significant.  Another example where the lowest cost producer should win.

Real estate

For years, CEO Anthony and Charles Smith have visited every store every year.  When on the road, they can each visit 5 stores or more per day.  Their knowledge of UK towns and footfall is encyclopedic.  Name a town and invariably they can recall the exact location of their store, the approximate sq feet and turnover, as well as alternative locations that they are considering.  This sets them apart.  They each drive their own cars, rather than fly, unlike legendary Sam Walton.  But they share his thirst to know every real estate detail and, like him, find it possible at the current footprint:

“There’s no question whatsoever that we could not have done what we did back then if I hadn’t had my airplanes. I bought that first plane for business, to travel between the stores and keep in touch with what was going on. But once we started really rolling out the stores, the airplane turned into a great tool for scouting real estate. We were probably ten years ahead of most other retailers in scouting locations from the air, and we got a lot of great ones that way. From up in the air we could check out traffic flows, see which way cities and towns were growing, and evaluate the location of the competition—if there was any. Then we would develop our real estate strategy for that market. 

I loved doing it myself. I’d get down low, turn my plane up on its side, and fly right over a town. Once we had a spot picked out, we’d land, go find out who owned the property, and try to negotiate the deal right then. That’s another good reason I don’t like jets. You can’t get down low enough to really tell what’s going on, the way I could in my little planes. Bud and I picked almost all our sites that way until we grew to about 120 or 130 stores. I was always proud of our technique and the results we got. I guarantee you not many principals of retailing companies were flying around sideways studying development patterns, but it worked really well for us. Until we had 500 stores, or at least 400 or so, I kept up with every real estate deal we made and got to view most locations before we signed any kind of commitment. A good location, and what we have to pay for it, is so important to the success of a store. And it’s one area of the company in which we’ve always had family involvement.”

Sam Walton: Made In America (1993)

Buyers / Merchandising

“If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he's going to make a lot of poor decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying”.[3]  Charlie Munger, 1994

Product knowledge is high.  Experienced buyers travel to China several times a year for 2-3 weeks each time, sometimes with the CEO and Chairman, to place orders face to face.  This is currently a problem due to the pandemic.  They focus on a limited range (typically 300 styles per season) and order large volume runs for better pricing, which they can pass on to their customers.  At one factory the buyers saw the same boots rolling off the factory for a competitor.  The only difference was that the competitor’s order was for 1,000 pairs; shoezone’s was 25,000.  The competitor’s retail price was £34.99 compared to shoezone’s £17.99.  Economies of scale were at work not just in order size, but also the competitor had to pay agents, and someone was taking a cut all the way along the supply chain, whereas shoezone’s buyers were going direct.

Monday trading meetings go through the best-selling lines on a weekly basis, which the board monitors.  Markdowns have historically been low and industry leading:

“Direct sourcing continues to grow with footwear orders placed directly with overseas factories increasing to 85.0% (2017: 84.7%) of total footwear orders. Working closely with our source of manufacture has helped maintain high gross product margins as well as improving communication and control across the supply chain. A demonstration of our commitment to quality is shown by our complaints level of less than 1%, which is half of the industry average.

Our ‘right price, first time’ strategy which helps control the amount of markdown value as a percentage of turnover, continues to ensure we remain one of the industry leaders in low levels of markdown at 7.9% (2017: 7.6%).” Annual Report 2018, last disclosure

Capital allocation

Capex is guided at 3% of sales.   This includes IT and maintenance capex for all stores on an 8-year cycle.  Even the losing ones.  Management believes that this is the most cost effective, rather than getting behind on maintenance.  Occasionally the company also refreshes its branding and corporate logos.

The dividend was suspended during the pandemic.  Initially the company did not expect to be able to return to paying a dividend until at least 2025.  But due to better than forecast performance and cashflows, all debt was repaid in January 2022 and “if trading continues to be stable, we expect to restart modest dividends at our half-year results.”

The full reinstatement of pre-pandemic dividends would result in a 8.5-16.3% yield on the current stock price.  Dividend history:

2019:   11.5p

2018:   19.5p

2017:   10.2p

2016:   18.1p

2015:   15.7p

The CEO hates debt.  “This is what created so many problems with other retailers.”  Recessions: “when you have no debt, you can endure it.” 

Immediate challenges

o   Lock downs in China, the main product source

o   Inflation (product; container pricing; gas prices for deliveries)

Risks

o   Key man risk

o   Pension: a £6m pre-tax net deficit (10% of mkt cap) does not fully dimension the risks of trying to match fund £90m (150% of mkt cap) PV of gross retirement liabilities. 

[1] https://www.ukgeographics.co.uk/blog/social-grade-a-b-c1-c2-d-e

[2] Leicester is an optimal location for low-cost distribution of high volume, low value items evidenced by Pepsico running their Walkers Crisps UK distribution from there; and Nestlé and XPO Logistics chose the area for a 638,000 sq ft distribution facility

[3] https://fs.blog/great-talks/a-lesson-on-worldly-wisdom/

Catalyst

online sales sustained after pandemic ends