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: