LE - Lands' End: Low Margins And Too Much Debt

Summary

• The results of Lands' End received a boost from COVID-19 lockdowns and are currently experiencing headwinds.
• The adjusted EBITDA margin fell to just 4.5% for the first nine months of 2022 while net debt increased to $371.1 million.
• I think that debt-free competitors with higher margins are likely to outperform LE in terms of the share price over the coming months.

Introduction

I like to write about companies that lack coverage on SA and today I'm taking a look at Lands' End (LE). It's a clothing retailer focused on the e-commerce segment that has adjusted TTM EBITDA of $73.6 million. Considering the company has a market valuation of just over $300 million, it looks cheap at first glance. However, Lands' End has been losing economies of scale since COVID-19 lockdowns came to an end while profits are being eaten away by interest expenses. With interest rates around the world growing, I think that debt-free competitors with higher margins are likely to outperform Lands' End in terms of share price over the coming months and my top pick in the sector is Reitmans (RET.A:CA) (RTMAF) (RET:CA) (RTMNF). Let's review.

Overview of the business and financials

The original Lands' End was established in 1963 and it was acquired by Sears in 2002 for $2 billion. In 2014, the latter decided to spin off Lands' End's catalog business as a separate listed company and today this business is the largest online retailer in the women's swimwear category in the USA. It's also the second largest online retailer in the total swimwear category and partners with about 4,500 schools for uniforms, which translates into a 12% market share. Lands' End also sells coats, bottoms, school uniforms, accessories, footwear, and home products among others and the business model relies on an existing buyer file that includes almost 7 million customers. The company utilizes automated marketing campaigns enabled by machine learning and leverages data to attract and retain customers. It's worth noting that Lands' End has a loyal customer base with an average tenure of 18 years.

About 81% of existing customers are female and the average age of clients is 59 years. Some 40% of Lands' End's customers wear extended sizes and more than 90% of the company's sales take place online. Lands' End's has only around 30 physical stores and small amount of products are also sold through partners.

This focus on online sales helped Lands' End grow its revenues and net income during the COVID-19 pandemic at a rapid pace. However, the company has been struggling with falling revenues since lockdowns ended as competitors reopened physical stores and some customers moved away from online purchases. Lands' End TTM net income recently slipped into negative territory.

Turning our attention to the financial results for the first nine months of 2022, we can see that the situation is continuing to deteriorate as lower sales volumes and cost inflation led to a decrease in the adjusted EBITDA margin to just 4.5%. Lands' End revealed in its Q3 2022 earnings call that gross margins were pressured by increased raw material and freight costs and that it experienced particular softness in consumer activity at the end of the quarter. The guidance for Q4 2022 doesn't look good either and I'm concerned with interest payments in particular as they have grown to $27.8 million per quarter.

Looking at the balance sheet, net debt increased to $371.1 million as of October 28, 2022 from $213.9 million on January 28, 2022 as Lands' End increased its inventories due to counter supply chain issues. While inventory levels are expected to return to normal by the end of the spring/summer 2023 season, I'm concerned that debt levels are at unsustainable levels at the moment considering margins have shrunk and major central banks across the world are still increasing interest rates.

Overall, I think that Lands' End is in a tough spot from a financial point of view, and that its share price is likely to underperform competitors with strong balance sheets and a focus on physical stores over the coming months. It seems that retail customers are still shifting away from online sales and my top pick in the sector is Reitmans. The company has just over 400 physical stores and was hit hard by the pandemic lockdowns. Following a restructuring completed in January 2022, Reitmans is now debt-free, and its margins look compelling. In my view, the financial results for the first nine months of FY23 were strong, and it seems Reitmans kept its best stores as sales rose by 24.8% to C$588.7 million ($438.4 million) while the EBITDA margin came in at 10.3%, more than double the one of Lands' End.

I think that Reitmans is likely to generate a net income of about $10 million per quarter in FY24. The company had C$64.3 million ($47.9 million) in cash as of October 29 and its market capitalization stands at $146.3 million as of the time of writing. In my view, Reitmans is likely to reinstate its dividend in the near future which paves the way for significant share price appreciation.

Investor takeaway

In my view, the financial results of Lands' End received a boost from COVID-19 lockdowns and are currently experiencing headwinds as some shoppers are returning to physical clothing stores. While I think that margins should improve eventually as freight rates decline and inventory levels return to normal, there are competitors that seem like compelling value stocks. I think it could be best to avoid Lands' End stock for the time being. In early December, the share price fell by over 20% when the company announced a surprise quarterly loss and cut its guidance and I'm concerned we could see a repeat of this situation when it releases its annual results around the end of March.

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