GCO - Genesco: Is It Too Soon To Buy This Cyclical?

2023-06-14 01:41:58 ET

Summary

• GCO is a beaten-down shoe retailer, which has been facing decreased consumer demand and inventory buildup severely reducing recent cash generation.
• Despite these negative trends, the company is shareholder-friendly and appears able to survive an economic downturn, given its available liquidity.
• The company appears to be trading at a steep discount to our $530 million conservative estimate of fair value, indicating current prices offer a high margin of safety.
• The second quarter is expected to continue to have poor performance, so a better buying opportunity could present itself in the near term.

Executive Thesis

Genesco Inc. ( GCO ) is a shoe retailer and wholesaler incorporated in 1934, which operates retail locations through Journeys Group, Schuh Group, and Johnston and Murphy. It also licenses several footwear brands and distributes them to other retailers. More recently, GCO has been hit with a whirlwind of problems beginning with the coronavirus pandemic, followed by the bullwhip effect after the release in pent up demand, and now macroeconomic related consumer weakness. This has led to immense pessimism and indiscriminate selling in the sector to all except the very best retailers. I believe this provides a buying opportunity, and GCO appears to be an undervalued shareholder-friendly business that can likely survive this cycle.

Shareholder Aligned Business

There are a few hints that indicate GCO is a shareholder friendly business. First, there have been recent open market insider buys by both officers and directors. Additionally, the percentage of shares outstanding owned by insiders has steadily increase since 2015, indicating further faith in the common stock as a good investment.

Additionally, the company has steadily decreased shares outstanding over the last 10 years, indicating dedication to returning capital to shareholders. From 2013 to 2023, total shares outstanding have nearly halved.

As far as stock-based compensation goes, I unfortunately could not find exact information in the most recent 10K on what performance measures would merit increased compensation. I did notice that total stock compensation in dollar terms has increased heavily between FY 2021-2023, from $8.4 million in 2021 to $14 million in 2023. It's hard to imagine such a large increase in compensation in FY 2023 was performance based given the industry difficulties, so this needs to be watched closely.

Appears Able to Remain Solvent

There are a few reasons I am not too concerned about rising debt levels so far, the first being historic trends. The company is conservatively financed and appears to aggressively pay down debt when flush with cash and take out debt in periods of economic stress. This is exactly the kind of capital management that should be expected of a high-quality cyclical retailer. As of April 31st, the company reports having $200 million remaining on its revolver. Adding to potential sources of liquidity, are the reported owned distribution centers which presumably can be sold and leased back if conditions worsen. Debt and FCF can be visualized below, where in 2020 we see a similar trend to what is hopefully beginning to occur now, a rapid rise in debt followed by a quick reduction as profitability improved.

Additionally, the recent steep drops in free cash flow have been associated with changes in working capital, and particularly inventory has been a problem. Many retailers are having this same issue, as they recover from the bullwhip effect following intense pent-up demand after the coronavirus pandemic. Inventory can be seen below, as well as the rapid rise and fall in inventory turnover rate after 2020.

There will be no immediate recovery though, as management expects further margin compression continuing into Q2 with the high inventory resulting in further markdowns. Additionally, Q2 is a historically weak quarter, whereas Q3 and Q4 are buoyed by back to school as well as holiday shopping. I am cautiously optimistic that the company's closing of unprofitable stores as well as increased seasonal demand could help reduce inventory and improve cash flow by the second half of the year.

Valuation

I like to take a conservative approach when I value a company like this, and in my model, I assumed the company would operate at a $100 million loss for FY 2024. After that, hopefully consumer demand will improve, store closures would reduce costs, and better inventory management would lead to modest free cash flow generation for years to come. Of note, $70-80 million is a fraction of what the company has earned in the recent past and should hopefully account for stock-based compensation. I took a conservative 10% discount rate which is higher than the cost of debt and is likely the minimum return equity investors would expect. I additionally assumed no growth in my terminal value calculation as the company has minimal to no moat. This gives us an estimated PV of $530 million, as is demonstrated below:

Risks

Assumed Recovery In Consumer Demand

In my modelling, I assumed that macroeconomic headwinds would decrease, and consumers would be more interested in purchasing shoes in the midterm. If we instead enter a protracted recession, headwinds could continue for much longer and the company could risk further losses or bankruptcy.

No Moat

Shoe retailing has minimal to no moat, and though the company licenses certain brands, it's hard to imagine this gives it a large competitive advantage. In the long run, margins are likely to decline as competition continues to be fierce. I am purchasing shares more as a cyclical swing type play rather than a long-term compounding investment.

Change in Consumer Behaviors

The company has many retail locations in malls , and it has been trying to pivot away from these less popular locations. Though moving in the right direction, the company will likely face further headwinds and restructuring costs as the trend continues. Additionally, more and more consumers may decide to purchase shoes online where there is limitless competition.

Conclusion

I believe GCO to be a conservatively financed shareholder friendly business that has historically been able to survive periods of economic stress. Given there is plenty of remaining availability on its revolver and failing that untapped real estate assets, I do not see a high level of near-term bankruptcy risk. Retail is a highly cyclical industry, and the time to buy is not when business is booming, but when business is bleakest. Management does expect earnings to remain poor in Q2 before getting better in the second half of the year, so a better buying opportunity could present itself in the near term. As my estimates of fair value indicate a large margin of safety at current prices, I decided to purchase a position and may add more on weakness.

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