DXLG - Destination XL Group: An Undervalued GEM In Big And Tall's Clothing Business

2023-10-22 00:43:19 ET

Summary

• DXL is a major player in the men's big and tall clothing business, with a wide selection and exclusive partnerships.
• The company has a strong management team that successfully turned the business around during the pandemic.
• DXL has a growth plan to increase brand awareness and expand its reach in the $23 billion big and tall men's apparel market.

Investment thesis

Destination XL Group, Inc. (DXLG) is a major player in the men's big and tall clothing business, boasting the industry's widest selection, enjoying numerous exclusive partnerships with clothing brands. Additionally, nearly 25% of its market value is held in cash. Despite these strength, DXLG's classification as a discretionary retailer is weighing on its valuation; DXLG currently only trades at a price-to-earnings ratio of around 8. We think this presented a perfect opportunity to patient and value based investors. When the market condition improves, we would expect the business’s price-to-earnings ratio multiples to expand to at least 15 to close the valuation gap and provides 2X reward for investors.

Furthermore, this business brought in an excellent management team that successfully turned the business around during the pandemic. They had a solid business growth plan for the next three years, which is highly likely to deliver additional value to both its customers and shareholders.

DXLG has a monopolistic like position in big and tall clothing business for men

At DXLG, big and tall is all they do and they sell men's clothes sized from 1XL all the way to 4XL only. They had 281 stores across 46 states in U.S. and 69% sales are transacted in stores while 31% sales transacted online. They are the only exclusively big+tall retailer in men’s apparel.

Unlike its competitors such as Target (TGT), Gap (GPS), and Macy's (M), who offer a piecemeal selection, DXLG provides a wide range of options that cover any occasion, from casual to formal, and from value-priced to high-end designers. Their inventory includes over 5,000 styles and features more than 100 national brands. Additionally, they offer a vast collection of exclusive national brands that can only be found at DXLG, catering specifically to big and tall customers.

Furthermore, the number of exclusive collections is continually expanding. During the 2023 Q2 earnings call , the management introduced two additional highly sought-after brands, Faherty and Hugo Boss, to their exclusive selections.

As I mentioned on our last quarterly call, we have two more iconic brands that are said to launch with DXL. I'm very pleased to report that Faherty and Hugo Boss are both joining our portfolio of brands this fall. Both brands will be available in selected stores and online. Faherty is exclusive to DXL in big and tall sizes, while Hugo Boss is delivering exclusive big and tall product capsules, meaning in both examples, you cannot find this product anywhere else.

These wide selections and exclusive collections have given DXLG two competitive advantages. First, since no one else offers such a wide selection of exclusive merchandise in the big and tall space, DXLG enjoys a very healthy profit margin. In fiscal year 2022, they achieved a gross margin of 49.9% and an adjusted EBITDA margin of 13.5%. This indicates that they have pricing power with their customers and do not need frequent promotions to move their inventory.

Second, thanks to their wide selection and exclusive collections, they have built a large customer base, making it easier to secure exclusive deals with highly sought-after brands. General retailers may find it more challenging to negotiate such exclusive deals due to offering fewer incentives for these brands. In fact, a large national brand, Old Navy, attempted to enter the big and tall category in 2021 but failed within just a year . This demonstrates how challenging it can be to establish a large presence in this business.

DXLG has an excellent management team

DXLG was a completely different company before the pandemic, but the new management team successfully transformed the business during the pandemic. The following financial metrics demonstrate the effectiveness of the new management team:

• The new management has eliminated all debt.
• They have built a strong balance sheet.
• The business is now generating healthy cash flows.

(Author's compilation based on data from the Company)

One of the crucial strategic decisions made by the new management team in 2021 was to reduce price promotions and discounts in the business. The new management team clearly understands the strength of their business in the big and tall category. They conducted an experiment that demonstrated they could run the business successfully without relying on promotions, and they subsequently expanded these initiatives. This strategic move paid off significantly in 2021, as the gross margin expansion enabled the business to generate $70 million in free cash flow, thereby strengthening its balance sheet.

Below is what the management is saying about this strategic changes made in 2021.

We made a strategic decision to run our business essentially promotional free, with only two very short public tests of offers during the single most important promotional and transactional time of the year for almost all retailers. This was a marked departure from previous discount-driven holiday approaches.

We only offered private promotions at lower discount levels to drive retention and reengage lapsed customers without any public open offers for Black Friday or Thanksgiving weekend. We feel that this strategy paid off as we were able to maintain a very high gross margin rate in Q4 while remaining faithful to our vision of repositioning the DXL brand around differentiation as opposed to discounting.

DXLG has a growth leg in the next couple of years

The management team's role is to make crucial decisions for the business. They made the right decision to reduce promotions in the business and build a strong balance sheet. After achieving this goal in 2022, they are now making another strategic decision to further grow the business.

Another challenge the management team identified is that many customers simply aren't familiar with DXLG, and addressing this issue presents a significant opportunity for the company. The big and tall men's apparel market is valued at $23 billion and is highly fragmented, yet DXLG's current annual sales are only at the $500 million level. There is a substantial underserved population of big and tall men in this sector.

The new management team has reviewed the business's past brand awareness marketing efforts and determined that they lacked alignment with the brand's unique positioning, resulting in less effective ad campaigns. Subsequently, the management team expanded their marketing team and invested in customer perception studies to assist them in crafting consistent and compelling brand messages. What's even more significant is that they now possess a strong balance sheet that enables them to invest in strengthening the brand.

DXLG is currently a $550 million business with an EBITDA of approximately 13%. The brand awareness marketing efforts are aimed at increasing customer awareness of DXLG's services and expanding DXLG's reach to serve a larger share of the $23 billion market.

The management has previously made the right business decisions, and this new business initiative appears reasonable to us. If the brand awareness campaign were to underperform, we would expect the management team to make rational choices, potentially discontinuing this effort. In such a scenario, investors would still have a business that generates $550 million annually with a 13% EBITDA.

Valuation

We will base our business analysis on 2022 because the sales data in 2021 were inflated due to pent-up demand and pandemic stimuli. 2022 represents the first normalized year for DXLG. We made the following assumptions when model the FY`25 result: the overall sales grow 30% because of effective brand awareness marketing, the SG&A% will increase 2%.

(Author's compilation based on data from the Company and Author's own projection)

Using the above valuation model, we saw DXLG’s valuation could be between $700 million and $800 million. DXLG’s current market valuation is $260 million and this will provide investor at least 2.5X rewards.

Additionally, it's worth noting that DXLG maintains a strong balance sheet, and its buyback program could have a positive impact on its per-share financial data in the future. It's important to highlight that this aspect is not accounted for in our model.

Risk

The new weight loss drug hitting the market could disrupt the big + tall business

A new weight loss drug would likely have a negative impact on DXLG. DXLG is a retailer of big and tall clothing, and a significant portion of its customer base is overweight or obese. If a new weight loss drug were to be successful, it could lead to a decrease in the number of people who are overweight or obese. This would in turn lead to a decrease in demand for big and tall clothing. The management team has presented an interesting counter argument to the impact of the weight loss drug during FY’23Q2 earning call and thought this could make a positive impact on their sales.

If you're at 3x, you're going to maybe move to a 1x. So there is, first of all, a catalyst for as you diet and lose weight, you need new close. The other part that is interesting, and I'm not sure it's unfortunate it just what it is, it really requires lifestyle change. And so, I don't think anyone intends to be on that drug forever. And if you don't change your lifestyle, it unfortunately creates a yo-yo, and we've heard that already.

We believe that investors should keep a close watch on the impact of the weight loss drug on the market.

Summary

DXLG's business holds significant advantages over its competitors, boasting a strong balance sheet, healthy cash flow, and a well-defined growth plan for the next few years. Nevertheless, the business's multiple is currently low due to the high-interest rate environment, which impacts its valuation. We believe that when market conditions improve, its multiples will naturally expand, providing potential upside rewards for investors.

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