ZUMZ - Zumiez: Don't Expect An Inflection Point Anytime Soon

2023-08-23 04:12:54 ET

Summary

• Due to Zumiez's volatile returns on invested capital, it is better to trade the stock rather than invest in it.
• It is best to buy the stock when industry ROIC and sentiment is lowest, as that is usually followed by an upwards inflection of earnings.
• The retail industry's ROIC is currently low, but I don't think this means it is the right time to buy Zumiez's stock.
• I estimate that FY2025 EPS will be below what analysts are currently expecting, which will cause the stock to remain stagnant over the next year.

Zumiez Inc. ( ZUMZ ) is clearly going through a rough patch due to the sharp shift from spending on goods to services that led to a softer demand and excess industry inventory. The decline in comparable store sales and margins has been clear and the stock has responded very negatively. The stock is down 15% year to date but is down over 60% from its peak in 2021.

Zumiez is not alone in its struggles. Almost all retailers have suffered similar fates due to the macroeconomic environment. Only the most premium and luxury brands have managed to continued growing topline at a high margin through this period due to the fact that their core consumer is wealthier and because of their pricing power.

Lululemon Athletica Inc. ( LULU ) is one of those more premium brands that have been able to maintain their operating margin. When other businesses have decided to mark down and liquidate their athleisure inventory due to overstocking, Lululemon is not forced to lower prices in sympathy because their competitors do not offer perfect replacements. Lululemon customers do not want just any athleisure attire, they want Lululemon and they will pay up even if others have lower prices. Lululemon’s operating margin in 2019 was 21.5% and it currently sits at 22% over the last twelve months.

This is also the case with true luxury brands such as Louis Vuitton, Société Européenne ( OTCPK:LVMHF ), a business that has expanded its margins since the start of the pandemic. This again speaks to the strength of the wealthier consumer, and the strength of the luxury brands under its umbrella.

Zumiez does not have either of these strengths but, unfortunately for the company, steady-state SG&A expenses and capital expenditures are elevated like they do.

Both SG&A expenses and capital expenditures now constitute a much higher percentage of revenue than they did prior to the pandemic, as they continue to open stores and hire employees like they are growing. This is despite the fact that same store sales and margins have been declining over the past few years. Perhaps it would be optimal to rethink this strategy.

I see Zumiez as a cyclical business. It may look like a growth story as the top line continues to grow due to new store openings but earnings and returns on invested capital will always be very sensitive to GDP. This cyclicality means it is best to trade in and out of this stock as opposed to buying and holding. Optimally investors should buy when industry returns on invested capital and investor sentiment is lowest as this is usually followed by an inflection point when earnings and industry ROIC start to rise due to reduced competition. Additionally at the point when sentiment is most washed out, capital expenditures and steady-state SG&A will likely be low which would further juice earnings and ROIC on the way up.

Is Zumiez at this low point? It’s difficult to say as this requires predicting economic outcomes, but I don't think this inflection point will come anytime soon. The stock is overvalued when taking this and its higher expenses into account. I believe FY2025 EPS could come in closer to $0.42, below the $0.65 that analysts are currently expecting. I believe this will cause the stock to trade down to a trough multiple of sales in 2025 which would put the stock at $16, providing no upside and high opportunity costs over the next year.

Business Overview

Zumiez is a specialty retailer of apparel, footwear and hardgoods. It markets itself as a retailer for young people to express their individuality through fashion, music, art, culture and streetwear. The company prides itself in providing premium brands to consumers and it maintains good relationships with these brands by not marking their products down, which maintains brand equity. The company operates stores primarily in the U.S., but also in Australia, Canada and Europe. The following image is from an 8-K around its IPO but the business is basically the same and caters to the same demographics.

The company claims that its competitive advantage lies in its brand recognition, distinctive customer experience, and deep-rooted culture. While Zumiez has had impressive staying power through many different economic cycles, I wouldn't go so far as to say they have a clear competitive advantage over its competitors. Through an analysis of the company's returns on invested capital, it seems more likely that Zumiez is the marginal supplier of commoditized products. This leads to volatility in earnings and dubious returns on invested capital.

Past Financial Results

Business moats can typically be seen through returns on invested capital. Compounding companies generally have consistently high returns on invested capital due to their moats that lead to high demand for their products and relative pricing power even in difficult economic times. While these businesses are likely to produce excess cash, they reinvest their earnings which in turn generate even more earnings due to their sustainably high returns on invested capital. As long as this cycle continues, shareholders will benefit as the business will return excess cash to them and earnings per share increases as the higher base of invested capital produces more earnings.

While cyclical businesses can have moats, their returns on invested capital are typically volatile as their earnings are very sensitive to changes in GDP. This makes investing or trading cyclical stocks different from investing in compounding businesses with moats. Often it pays to take a supply-driven approach to analysis versus a bottoms up, business first approach to investing and trading these stocks. It is usually better to invest in competitively advantaged businesses in whichever cyclical industry is in question, but even non-competitively advantaged businesses can provide great returns if the timing of the trade is correct in regards to the industry’s supply or changes in the economy.

Zumiez is not a compounding type of business. Rather, Zumiez’s returns on invested capital have been very volatile over the years as they continue to invest quite a bit of capital to open stores, all while demand for their products are very sensitive to changes in GDP and industry trends.

For investing and trading purposes, this makes Zumiez less of a buy-and-forget type of business and more of a cyclical business. For optimal returns, investors should buy when industry returns on invested capital are low and about to inflect up.

Outside of Zumiez’s returns on invested capital, the company’s earnings have not increased much despite opening stores at a seemingly breakneck speed.

Despite having 4x more stores open now than in 2005, the stock is only up 50% from its IPO in May 2005. Additionally, revenue has grown from $150 million in 2005 to over $900 million in the most recent trailing twelve month period. Operating income also grew from $12 million in 2005 to $62 million in 2019. Despite this, the stock was up only 170% in that time.

This discrepancy between earnings growth and the stock price has to do with the fact that investors understand that Zumiez's earnings will be volatile and that management will continue to invest in store growth that will generate volatile and dubious returns depending on when the investments are made. The stock has never commanded a premium multiple because of this, and likely will not going forward.

Valuation and Forecast

Zumiez’s current return on invested capital is low due to low earnings and recently elevated levels of capital expenditures as management sticks to its strategy of chugging forward with store openings both in the U.S. and internationally. This plan of opening new stores is currently having a two pronged negative effect on ROIC as it not only leads to higher capital expenditures and a higher asset base, but it also leads to higher steady state SG&A costs due to an increased employee headcount and increased rent costs. This is why the current reversal of operating leverage has been so sharp.

In Q1 2023 revenue dropped 17% year over year, gross margin was 27% (5% less than the same quarter one year ago), and operating margin was -11.7% due to the declines in revenue and gross margin, and due to the increased steady-state operating expenses. These poor results were largely expected going into the quarter.

Analysts are currently expecting $865 million in revenue and EPS of $(0.59) for the rest of the year. This puts the stock at about 0.43x FY2024 revenue. In FY2025, analysts are expecting $910 million in revenue, gross margin of 33.5% and EPS of $0.65. I think it is more likely than not that FY2025 EPS will come in below $0.65.

I am estimating that FY2025 EPS will be closer to $0.42 per share. To get to this estimate, I am assuming revenue grows 5% over FY2024 to $908 million, gross margin will be 32.5% for gross profit of $299 million, D&A expense will be $23 million, SG&A expenses will be $270 million, interest income will be $3.6 million, the effective tax rate will be 22%, and that there will be 19.43 million shares outstanding.

The biggest difference in my estimate versus sell-side estimates is in the company’s gross margin. I don’t think it will be quite as high due to economic weakness in 2024 caused by increased job loss and general consumer anxiety. This will cause a higher percentage of revenue to come from private label goods and apparel which will lead to a lower than expected gross margin.

If my estimates prove to be true, I believe the stock will drop to what has been its trough P/S multiple of about 0.35. With this multiple on $910 million of revenue with 19.43 million shares outstanding, the stock would trade at about $16. Due to the many better investment opportunities that I believe are currently available, I am assigning the stock a sell rating.

I don’t necessarily trust my ability to predict what will happen with the economy but I believe that at the current price of the stock, the market is betting that there will be a solid rebound in margin in FY2025. However I think FY2017 is be a good comparison of what FY2025 will look like for Zumiez.

The following is an excerpt from the FY2017 annual report about why the year was disappointing:

In fiscal 2016 teen retail in general faced a continuing challenging sales environment with many mall-based teen retailers experiencing declining sales and store closures. Following a fourth quarter 2015 comparable sales decrease of 9.5%, Zumiez comparable sales remained negative through the first half of fiscal 2016. By the third quarter of fiscal 2016, driven by the strength of several new brands, Zumiez comparable sales turned positive and remained positive through the balance of the year.

In FY2017, gross margin was 32.9% due to disappointing teen retail trends in the first half of the year that were offset by relative strength in the second half. I think it is more likely than not that the first half of FY2025 will be affected by a weaker consumer, followed by a second half that will be relatively stronger. This leads me to believe that FY2025 gross margin will be similar to that of FY2017, and below current analyst estimates of 33.5%.

Final Thoughts

In this article I provided a history of Zumiez’s returns on invested capital and explained why this has led the stock to be relatively stagnant over the past few decades despite growing revenue and earnings in that time. In short, Zumiez’s store count has more than quadrupled since 2005 and this growth has necessitated high capital expenditures. These expenditures have not only provided volatile and dubious returns but have led to higher steady-state SG&A expenses. As management will continue to invest in stores going forward with similar returns, investors are not willing to pay a high multiple of earnings for the company’s stock.

This volatility of returns on invested capital means that Zumiez is not a buy-and-forget type of stock. Rather it is optimal to trade it when ROIC inflects up due to a confluence of factors relating to industry dynamics and the economy. While ROIC is currently low, I don’t think an inflection point will come early in FY2025 as investors seem to be expecting.

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