DBI - Designer Brands: Worth Another Shot With Improved Performance Depressed Share Price

Summary

• Designer Brands weaker Q3 results have caused the shares to decline by more than 30%.
• The company has successfully transformed and strengthened itself during the pandemic years.
• The current valuation is more than reasonable given the company's potential growth and its ability to rapidly repay its current debt balance.
• Even with zero growth in the coming years, the company can easily generate a total return of 80%.
• If Designer Brands is able to clear that low bar, returns could be a lot higher.

It has been almost two years since my first article on shoe company Designer Brands ( DBI ). Enough interesting developments have taken place that a follow up is warranted. Furthermore, it also gives me the opportunity to analyze the conclusions of the first article.

In this article, I will first discuss Designer Brands’ performance over the last two years. Secondly, I want to quickly dive into my conclusions of two years ago. Lastly, we will discuss why Designer Brands at the current valuation is very likely going to be a good investment over the coming years.

Recovering from the pandemic and transforming the business:

The last two years have been a mixed bag for DBI. While the business has performed well enough in the uncertain COVID recovery era, it was also just that… a recovery. When the company report its full year 2022 results they will most likely come in with sales a bit below or at par with the last pre-COVID full year of 2019.

However, I think investors should applaud that performance. DBI’s business was especially hit hard by the pandemic because of their large offering of formal and dress shoes. By retaining their strong position in this category while growing the sales of casual and athleisure footwear, DBI had a strong recovery year in fiscal 2021. Net income came in at $150+ or more than $2 a share. Only sales lagged still compared to fiscal 2019 being $300 million lower coming in at $3.2 billion. Still this result was great as the profit for fiscal 2019 came in at only $94 million.

All seemed to be going well right up until the end of 2021 when Nike ( NKE ) announced it would stop selling shoes to DSW . Nike for the last years has been slowly moving away from selling its brand through other retail chains in favor of its DTC channel and its own retail stores.

With Nike accounting for 7% of fiscal 2020 sales, it was a sizable if not surmountable hit for DBI. In the first 9 months of fiscal 2022 it looks like DBI has been able to cope with the setback reasonably well. Earnings for the first 9 months have come in at $1.60 a share. Full year expectations are DBI will earn around $1.75 a share. Comparing this to pre-Covid 2019 when the company earned $1.47 a share and it shows how well DBI has been able to cope with the pandemic the last 3 years. While “executive victory laps” on earnings calls should be discounted, I believe the following quote by CFO Jared Poff sums up DBI’s accomplishments quite well:

It seems that the 2018 Vince Cameo acquisition and joint venture and the increased focus on athletic footwear have transformed DBI for the better. With owned brands now generating 27% of revenue in Q3 of 2022 (compared to 22% in Q3 of 2021) DBI is has increased its potential to increase gross margins. With the company aiming to get owned brand sales to 33% of revenue by 2026, there is potentially more upside on this front.

With the pandemic now squarely in the rearview mirror (knock on wood), DBI has been able to really transform the company in the last couple of years by increasing digital penetration, diversifying its product range and integrating the Vince Camuto and Canadian retail acquisitions.

It seems that DBI’s long-term CEO Roger Rawlins came to the same conclusion as he stepped down beginning of this January in favor of the President of DSW, Doug Howe. In the press release DBI hinted this was a transition planned well in advance. The fact that Rawlins will remain in the role till April 1st and then serve as an advisor to the company underscores this. While CEO transitions always create some uncertainty, this one does not seem to change the equation much. However, I do believe Rawlins has been a great CEO for DBI, so therefore the change can be seen as a slight negative as the new CEO has a high bar to clear.

In the same press release , DBI mentioned an important piece of information. During the customary accolades bestowed upon Rawlins in the press release Executive Chairman Jay Schottenstein stressed something important:

"Roger has been at the forefront of Designer Brands' transformation from a shoe retailer to a brand builder. From launching DSW.com, which now accounts for over $1 billion in demand,….”

If DBI’s e-commerce activities are generating $1 billion plus in sales this means at least 30% of current sales are digital. In my opinion this high digital penetration is a great indicator of the recent successful transformation the company has been through. With gross margins and profits above pre-pandemic levels while generating 30% plus in e-commerce sales shows Designer Brands has been able to profitably transition part of their sales online.

Dissecting past predictions

Having discussed DBI’s performance over the last two years, it is only logical to look at how my conclusions from two years ago have fared. Anyone who is interested can read the full article here . The easiest start point is of course comparing my buy rating (arguably the most important conclusion in an article) with DBI’s actual performance. Unfortunately, for me this initial assessment does not look great.

DBI essentially traded between $12 and $20 for the last two years. Only recently did the share price decline meaningfully below this range to its current $10 a share. Therefore, at first sight my buy rating obviously does not look great. However, over the last two years I have not owned a share of DBI. Only recently as the share price dropped below $10 did I initiate a position. This seems contradictory, but it follows the strategy I laid out in my first article.

In the beginning of 2021 DBI’s performance was still hurting badly due to the pandemic while its balance sheet was weakened due to recent acquisitions, share buybacks and COVID-19 losses. At around $13 a share, with some weak quarters forecasted, I figured DBI’s share price might be able to decline back to mid single digits. I argued that if this were to happen (it did not) I would have bought a sizable position. The rest of the article I argued that at those depressed prices DBI’s future was bright enough to make a sizable return despite the still looming pandemic problems and its weakened balance sheet.

As one can see in the graph above, my expectation of a share price decline in the first half of 2021 did not occur as DBI’s share price actually marched further upwards towards $20 a share. I obviously did not profit from this price advance as I was only willing to buy shares into the single digits.

The main reason why DBI’s share price never hit my desired buying range was because it performed substantially better than I expected two years ago. But, the still present pandemic overhang and balance sheet problems also ensured that the share price never really took off.

The main takeaway of this little overview of my past predictions shows how volatile and uncertain the future of business can be. Of course it was even more true this time around because of COVID and the uncharted territory companies were in to predict how the recovery was going to play out. Even DBI itself thought it would do massively worse in 2021 than they actually did. However, it also shows once more why having a margin of safety is so important. This time around my expectations were too negative, which didn’t cost me anything (accept some potential gains). Had DBI’s performance been actually on par with my predictions or even worse I protected myself against buying the stock too high and would have only pulled the trigger at $7 or below.

But, in the end DBI’s better than expected financial and operational performance over the last two years supported the share price enough that shares did not reach single digits up until last quarter. That is the main thing we have to focus on for the remainder of the article. The past has been, but a new opportunity might be in front of us.

Valuation and future performance

So far we have established that DBI performed quite well the last couple years. This performance was overshadowed by the pandemic holding the stock price down. After initialing raising guidance during fiscal 2022 in the end management reversed back to its original guidance with earnings of around $1.75 a share for fiscal 2022. The reason they gave during Q3 was a significant slow down at the end of October that continued into Q4. As happens more often, investors were focused on these near-term headwinds and DBI has dropped around 33% since Q3 results were announced. I think that at the current price DBI is a great investment for the longer-term. The three main reasons for my view come from:

1. The current valuation
2. Potential future sales growth
3. Shareholder friendly management

Valuation

With 63.6 million shares outstanding as of the end of November 2022, DBI’s market cap is currently around 650 million dollars. In the latest 10-Q net debt stood at $350 million. However, the 10-Q also reported that DBI has finally received the majority of the tax refund it was owed due to the CARES act. This represents a cash inflow of $120 million while the last $40 million should be refunded within 12 months. Actual net debt will therefore be closer to $230 million in Q4 of this year (not counting on any free cash flow). This gives DBI an Enterprise Value of about $880 million.

As we saw, DBI’s current performance is actually better than before the pandemic. Furthermore, up till 2019 DBI had no debt while over the last three years net debt has hovered between $150-350 million. This has added about $20-30 million in costs to DBI over the last couple years. This debt was first taken on because of the Vince Camuto acquisition and was sustained probably longer than normal because of the pandemic. On top of this, DBI actually repurchased a significant amount of shares in fiscal 2022 - lowering share count by about 11 million shares by spending $150 million this year.

With the tax refund, net debt will probably decline below $200 million in fiscal 2023 and might be reduced further if free cash flow is used to pay down debt. As this debt has a variable interest rate the current rate environment might entice DBI to focus on debt pay down in fiscal 2023 and beyond. If made a priority, DBI could pay down all its debt within two years and thereby add an easy $20 million back to net profit.

If we look at profits and cash flow over the last couple years, we can see that DBI consistently achieved operating cash flow in the range of $150-$200 million. With CAPEX between $50-80 million over the last couple years FCF of a $100 million plus has been the norm. Using this figure would imply DBI is currently valued at around a 8-9x FCF/EV multiple. While this is not expensive by any means it does not imply a bargain price either.

Nevertheless, I think that DBI has a lot of room to grow its financial performance in the coming years. Not only can debt pay down increase FCF by at least $20 million, DBI can now also fully focus on growing its business post 2018 acquisitions and the pandemic. The company has worked hard to make itself more resilient and ready for coming years. Key differentiators compared to a couple years ago are:

• DBI’s product line is more balanced and diversified.
• E-commerce accounts for 30% plus of its total sales.
• Its owned brands are growing rapidly and provide DBI with the potential for gross margin expansion.

Potential future sales growth

Furthermore, before the pandemic Designer Brands was also a company steadily growing its sales by 5-10% annually. Actually, DBI had grown its sales for 28 consecutive years in a row ( DBI investor Presentation 2019 ).

Only the pandemic was able to stop this impressive run. It looks like fiscal 2022 sales will come close to 2019. Therefore 2023 could be the first year sales surpass 2019 levels again and the company resumes its steady growth trajectory. Of course this is far from certain. The good thing with DBI is that investors don’t even need significant sales growth in order to be rewarded with stock market gains over the coming years. The company actually needs to clear quite a low bar to make it a profitable investment. To underscore this, let's assume the following scenario:

(Table made by author: numbers are based of most recent 10-Q, 10-K and 2022 Investor Deck)

In this scenario we conservatively expect that DBI will produce no additional FCF in Q4 of 2022 compared to the Q3 figure as it pays down accounts payables and accrued expenses. Furthermore, for the coming three years we assume no additional sales growth. The only improvement projected over fiscal 2022 figures is the removal of interest rates payments that have run annually at $20-30 million and a slight margin improvement.

If this scenario were to play out investors in the stock would own a company at the end of 2025 with a 100 million of net cash, while shares outstanding have been reduced by 15% from current figures. A six time FCF/EV multiple would yield a valuation of $1 billion or more than $18 a share. We shouldn’t forget that the above projected numbers are not at all a stretch. If any it is most likely too conservative knowing DBI is currently in a better position operationally than before the pandemic. Upside could be way higher. For example, if sales keep growing at 5% a year DBI would come close to 4 billion in sales in 2025. Management agrees with this assessment as they have guided for sales to hit $4 billion by 2026.

Shareholder friendly management

Lastly, we have to mention DBI’s historically shareholder friendly policies. Over the last decade management has consistently repurchased a substantial amount shares whenever they deemed the companies share price low enough. The company also had a reliable dividend that stood at $1 a share right before the pandemic. After cutting the dividend during the pandemic the company now pays a modest $0.20 a share per year. I believe the company's recent share repurchases are the reason the dividend has not been raised yet. The company knows as long as their shares trade below $15 a share it is way more beneficial to repurchase shares. But another good indication that DBI is currently undervalued is the fact that it could easily pay $1 a share dividend going forward. This would give investors a 10% dividend yield while the pay-out ratio would barely be 50% of a normal year of Free Cash Flow.

Conclusion

Over the last years Designer Brands has made its business more resilient and flexible while steadily recovering from the pandemic. With a solid e-commerce and owned brand business it has a solid foundation for future sales growth and margin expansion. With more than 25% of its current Enterprise Value being debt, the company has a solid opportunity to pay down debt increasing its financial foundation while raising profits due to declining interest payments. In the mean time investors can trust management to make shareholder friendly decisions with regard to share repurchases and dividends. Even a relatively mediocre performance over the coming years can easily result in a 80% plus gain. If DBI performs even a bit better than this, FCF can easily creep towards $200 million a year making the current market cap of $650 million look like a steal.

Of course, the feared recession might present itself in 2023 throwing a short-term wrench in DBI’s performance. However, this should not damage DBI’s long-term future or ability to achieve proper financial results. It might be even beneficial for shareholders as management might be given the opportunity to repurchase even more shares at bargain prices. I feel very comfortable holding a position in DBI at current prices and averaging down if given the chance.

For further details see: