DXLG - Destination XL Q2: No Respite In Sight Reiterate Hold

2023-08-28 13:07:09 ET

Summary

• Destination XL reported a strong Q2 topping analyst estimates as it focused on driving sales growth while taking some hit on margins.
• While the company has done remarkably well transforming post COVID, it is facing macro headwinds squeezing consumer wallets.
• DXLG has revised down its full-year guidance again to reflect the continuing ongoing pain while it has been taking initiatives to support growth in the medium term.
• We believe there are limited catalysts in the near term for any rating upgrade and potential downside risks. Reiterate Hold.

Investment Thesis

In continuation of our previous coverage , we rated Destination XL Group ( DXLG ) as Neutral given the current weak outlook and earnings downgrade amidst a challenging macroeconomic backdrop after a mammoth 850%+ rally over the past 3 years. We anticipated a lower comp digit sales growth for Q2 and it did beat earnings, however, it further revised its earnings downwards after already tempering in Q1 citing challenging macro conditions. The comp sales growth was driven by increasing markdowns and with elevated clearance levels, we believe there could be further downside pressure to gross margins. Despite shares falling 13% since our last article, we remain neutral on the stock due to limited catalysts in the near term and potential downside risks.

Earnings Recap

DXLG reported positive Q2 results where sales declined by 3.2% primarily as a result of 1.4% comp sales reduction. The comp sales decline was a result of lower units per transaction as well as consumers trading down due to macro headwinds and inflationary pressure. However, the trends improved month-over-month with May down 2.8%, June down 1.7% and exiting July with a positive 1.0% comp as DXLG upped its promotional activities. Gross margins declined 180 bps YoY to 50.3% as a result of decline in merch margin of 110 bps due to price markdowns and occupancy cost deleverage of 70 bps as higher rents outpaced slowing sales along with higher DTC shipping costs which were largely offset by freight tailwinds. SG&A leveraged marginally by 30 bps primarily as a result of decreases in marketing costs (+40 bps) which were partially offset by an increase in wages and payroll costs. Adj. EBITDA margins contracted 150 bps YoY to 16.4% primarily driven by a decline in gross margins. It delivered Non-GAAP EPS of $0.23, topping analyst expectations pegged at $0.18.

Inventory position improved down 10% YoY albeit taking a slight hit at the merch margins. However, clearance inventory levels increased to 9.3% from 6.9% in the year ago period and 7.8% in the previous quarter. Despite the clearance inventory below management's guide of 10%, this can still impact margins in the near term as it will lead to IMU deterioration. It ended up with cash balance of $63 mn with no debt providing ample cushion and flexibility.

DXLG further revised its full year guidance downwards after confirming meeting its lower end of the guidance at the end of Q1. It now anticipates sales of $540 mn at mid-point (vs $550 mn confirmed at the end of Q1) and Adj. EBITDA margin of 11.5% (vs 12.5% earlier) and EPS of $0.49 (vs $0.61 earlier).

Key Initiatives

DXLG has partnered with Faherty and Hugo Boss exclusively, bringing iconic brands into their fold which can bring more traction and drive store traffic. It also looks to partner with UNTUCKit and launch UNTUCKit, Fit by DXL for the big and tall man. It also guided for 3 store openings in the near term with first of the three stores (after 2018) scheduled to be opened later this year and it further plans to expand its store network and open 10 new stores in 2024 and 15 - 20 stores in 2025 in order to address the growing demand.

In our most recent consumer research across 2,500 customers and noncustomers, 49% self-reported they do not shop with us because a store is not near to them while 37% self-reported, they do not shop with us because a store is not conveniently located near them. We believe there are upwards of 50 net new store opportunities and as we hone our plans, we will look to drive even more. The new store development addresses another critical limiting factor to our growth.

- H arvey Kanter , President and CEO, Destination XL Group

We believe the company will benefit from the white space store opportunities (given its significantly small store footprint) as well as driving incremental sales through brand partnerships in the near to medium term.

Valuation

DXLG trades at 8x Forward PE in line with its long term pre-pandemic average and when the company was reporting double-digit comp growth and robust sustainable margins. We believe given the consistent earnings downgrades as a result of macro headwinds reducing discretionary spends, there are still potential downside risks for H2 2023 and beyond. We reiterate Neutral with a target price of $4 (at 8x 2023 P/E) as a result of lack of any catalysts for any ratings upgrade or PE rerating.

Risks to Rating

Risks to rating include

1) any improvement in macroeconomic environment that can lead to an increase in consumer spends

2) Management has resorted to markdowns in order to boost sales recently and with increasing clearance inventory, it can lead to declining gross margins in order to stem the sales downturn

3) Competitive environment as a result of consumer slowdown can lead to an increase in promotional activity which can further put pressure on their gross margins

Conclusion

DXLG had transformed itself since the pandemic where it was struggling with bloated inventories and higher debt to relatively better comp growth and higher margins. However, the company is challenged by the continuing macro headwinds and had to resort to back to back downgrades. We like the business model but given more potential for downside risks, despite falling 13% since our last publication, we reiterate a Neutral rating.

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