New Long Idea – Designer Brands (DBI), which we think is a 3-bagger over a 2-3-year time frame. This is an underfollowed and misunderstood name that has earnings power of $2.50-$3.00 over a TAIL duration, with the Street currently sitting at recovery earnings of $1.09. This is a forgotten name that is hated by the sell side, as the biggest (and only) bull has a price target a whopping $1.50 higher than the current share price. The name isn’t without its hair, but I’m fairly certain that we are going to see a steep positive revision cycle starting in 2H21, at which point an upgrade cycle will follow as people realize that at $9, the name is trading at just 3x underlying earnings and a 35% FCF yield. The name isn’t overly shorted like some of our recent calls – 12% of the float short – as it is not necessarily hated by the buy side…it’s simply forgotten. There’s sheer apathy towards DBI, something that will change dramatically as key levers on the P&L inflect meaningfully to the upside. That’s when I think we’ll see a low-mid-teens multiple on something closer to $2.50 in earnings – or a $30-$40 stock vs the current sub-$10 level.
What Is DBI? Designer Brands is the former DSW – Designer Shoe Warehouse. Owner of ~500 stores in the US and Canada. The stores carry thousands of SKUs of predominantly dress footwear, though it has a limited athletic selection. It also carries discounted handbags and accessories. It has the same ‘treasure hunt’ format that you find at high-multiple retailers like TJX, ROST and BURL. In 2018, it teamed with Authentic Brands Group (ABG) and acquired the Camuto Group for $375mm, which brought a wholesale arm to the company. Camuto owns licenses for Jessica Simpson footwear, Lucky Brand, Max Studio, Vince Camuto, Enzo Angiolini and others. The products are sold in more than 6,400 doors worldwide. DBI also owns The Shoe Company and Shoe Warehouse in Canada. Overall the DBI represents approx 5% of total footwear transactions in North America.
Need to Understand Recent History To Appreciate the Path to Getting Paid
- 2010-2016: For more than the first half of the last decade, this was a remarkably steady mid-single digit comp story with 31-32% Gross Margins and 21%-22% SG&A and 10%-11% EBIT margins. It had rock steady mid-teens ROE, and 20% ROIC. The stock traded consistently at a 15x-20x PE, 10x EBITDA and mid-single digit FCF Yield. Stock exited the Great Recession at $13, peaked at $45 as comps headed to the mid-teens.
- 2016-2018: Sharp slowdown in comp for FY16, as the company had several merchandise misses, not the least of which was a shift toward athletic – a category that DSW did not take seriously at the time (but was up to 25% of mix as of the latest quarter). Merchandising margins imploded by 200bp for 2-years straight, and SG&A went up by 150bps due to investments in systems and IT to facilitate online transactions – an implementation that did not go well. The company faced several management changes and there was a significant lack of focus in the C-Suite. Margins fell to 7%, and the only driver to the model was square footage – which annuitized EPS at ~$1.50 per share. ROIC fell by 500bps, and the stock reverted back to the mid teens.
- October 2018-Jan 2020: DSW Buys the Camuto group, which added $450mm in annual revenue for the FY ending Jan 2020. The market initially liked the deal and the diversification it brought to the model. It also gave DSW insight into the cost component of the footwear manufacturing part of the supply chain, which it could use as intelligence in negotiating with vendors for better gross margins. But ultimately, the deal got dinged as it added $450mm of China sourcing exposure right ahead of steep tariff implementations out of the Trump administration. Accretion from the deal got pushed out a year to 2020, but obviously the $160mm in debt the deal cost DSW did not. In March of 2019, the company rebranded to Designer Brands (DBI). At that point, the bottom fell out of the valuation, as this was viewed as a broken retailer that did a defensive and failed acquisition, and the model in aggregate was relegated to the world of ‘small cap low margin junk retail’.
- March 2020-Present: Covid hits. Stores are obviously deemed non-essential, so they shut down entirely. Upon reopening, work from home trend nullified the need for dress shoes, handbags & accessories, and demand in the newly ramping kids and athletic business hit a wall. Comps down 43% for 1Q and 2Q of 2020, with only a slight improvement to -30% by 3Q. Gross margin turns negative in 1Q – a near mathematical impossibility in retail -- recovered to just 25% by 3Q, which is 500-700bps below DBI’s prior run rate. Dividend pulled, share buyback halted. Takes on ~$250mm incremental debt to fund working capital and operational losses. Stock troughs at $4-$5 (where management bought stock) before trading to its current $9 with the retail rally.
How Do You Get Paid?
- The first and most obvious lever is what we think will be a snapback in high-end/dressy/occasion wear. This is expressed in our long calls on JWN, DDS and RVLV, but will likely have an even more focused rebound on the core assortment at the DSW chain as well as on the Camuto brands. After what is likely to be a -36% comp for FY21 (Jan) we’ve got comps building from 20% to ~40% throughout the upcoming year. Gross margin is likely to double from 14% to 28% and SG&A should come down to 25% of sales from 32% over the past year. In other words, we get to $0.84 in earnings vs the Street at $0.25. From an earnings beat standpoint, that likely gets you to a mid-teens stock. That’s a nice 50% gain, but not what we’re really playing for.
- Fiscal 22 is what really gets you paid. That’s when we see a continued comp rebound post-covid, as the pent-up demand will likely last for 18-24 months of closet re-stocking – so we’ve got comps up another 15%. But then we start to see better merchandise margins as we see the benefits of…
- changing up sourcing model to mitigate tariffs that spanked DBI over the past 18 months,
- better pricing with brands carried at DSW as the company has transparency in sourcing costs given it has a fully owned/operated Camuto wholesale group to use as a benchmark for costing out underlying product inputs. This isn’t a smoking gun…but it’s good for 100-200bps in merchandising margin over a 1-2 year time period.
- the big nut here is the ability to take previously private label (outsourced) product and insource them through the Camuto group. The company currently has ~$300mm in private label product in DSW stores – on which it has to pay a third party to manufacture. That number can go as high as $700mm with Camuto manufacturing 80% of the volume at an incremental 1,000bp higher margin.
The punchline is that adding all these together we build to a 30.5% gross margin for FY22 – well below the 32% gross margin levels it was putting up the last time it comped +10%. In other words, we’re not being aggressive with our forecast. Tack on 100-120bp in incremental SG&A leverage (due to the comp) and we get to $2.40 in EPS power. Roll that forward a year and you’re at $3.00 in EPS power for FY23. If we’re right in our model, there’s going to be a simply massive acceleration in earnings revisions over the next two years, and our sense is that the market will begin to discount this sooner than later. As noted, this stock has been long forgotten by the investment community. I think that the first double in the stock will catch people’s attention – as it will then be about $2bn in market cap (ie investable again for most institutions). Then we still have $2.50-$3.00 in EPS power, repayment of debt, a return of the dividend, and accelerated share repo. Keep in mind that before-covid, the company was calling for $2.65-$2.75 as a ‘slam dunk’ number for 2021. Covid didn’t structurally impair this company. I think the accelerating earnings profile and sheer upside to consensus is worth at least a low teens multiple…let’s call it 13-14x. That suggests a $40 stock in 2-3 years. The real bull case is that this gets something between a footwear multiple (low teens) and off price (mid 20s). But I won’t make that call today.
Will the move be linear? Of course not. We’re still not out of the woods as it relates to re-opening, and might not see any real momentum until 2H21. The work from home trend will likely continue to pressure the category, making for a ‘slow motion rebound’ in DSW’s comps. In addition, while DSW benefits from department store consolidation/door closures, that will stress the Camuto side of the business – specifically Stein Mart and Gordmans where it got dinged (though that’s well telegraphed). The biggest knock on the model is that covid is ‘training’ the consumer to go direct to the brands (but the ‘treasure hunt factor’ will always be desirable). Also, while DBI exerts leverage over its suppliers now that it has the Camuto brands to arb against, we should expect some pushback from traditional partners that could lead to product disruption and stress to the supply chain. Is DBI expecting this and proactively managing around it? I think so. But management is no stranger to missing on its promises in the past. It’s a risk to the model. We can't ignore.
Ultimately when a forgotten misfit of a stock like DBI with such a messy financial model inflects, the fundamentals and newsflow will be just as volatile as the stock. So brace for that. This thing is gonna be a grind. But I think this stock is a double over 2-years, and if our model is right you’ve got a solid 3-bagger by year 3.
-- McGough
