2023-03-15 10:30:04 ET
Summary
- Disappointing results, but macroeconomic and management’s cost-cutting measures show potential.
- Decent financials show the company is operating quite well with no big red flags.
- If we see even a slight improvement in margins, the company is a good buy at these levels, if not, then there are better companies out there.
Investment Thesis
Not stellar end-of-the-year results, but promising cost-cutting measures and other efficiencies may lead to a slight improvement in margins for Genesco Inc (GCO), which even with such small improvements makes the company undervalued, but if it sees more inventory build-up and higher costs, the company is not a buy until it becomes more efficient.
The Company and End of the Year Highlights
Genesco Inc. is a company that sells footwear and accessories through retail stores and online platforms. It also wholesales footwear under various brands and licenses. It operates mainly in the U.S., Canada, the U.K., and the Republic of Ireland. The most popular brands the company carries are the Schuh Group, Journeys Group, and Johnston and Murphy. It also sells other licensed brands like Levi's and Dockers.
Gross margin was down 2.5% and all segments saw margin contractions. The declines can be attributed to coming back to more normalized levels.
A lot of declines in overall results misses on revenues and contractions in margins may spell doom for the company. All can be attributed to lower sales in the 4th quarter, higher-than-desired inventory levels, and overall inefficiencies that the company experienced over the last 12 months. This is not looking good if it continues to operate this way, however, there is a light at the end of the tunnel if the management can reduce costs and improve margins.
Cost Reduction Measures and Future Outlook
I believe that the factor that will play the biggest role for the company in becoming an attractive investment is its ability to become more efficient and streamlined over time. The margins in the industry are very tight and even the slightest improvement there over the next couple of years will make a big impact on the future cash flows. So, what is the management going to do? The company is set on closing over 60 stores this year, which is not that much considering they own well over a thousand stores; however, it is a good start. Trimming the stores that are not very profitable and cost more to run than they bring in will have a positive impact on overall margins.
The company could lose some revenue, but I believe the next cost-cutting measure that would be able to pick up the slack is its ability to transition and expand its e-commerce space, which has been growing double digits for a while now and the management wants to achieve these growth numbers in the future. The more the company goes online, the fewer stores it will need to keep open which will improve its profitability even further. Digital sales saw a 60% increase y-o-y.
The management is very set on cost-cutting measures, and they foresee about $20m- $25m in savings over the next 12 months. We would have to wait a little while to see if that would become the new norm for operating margins in the future, but if it does, the company would be a very attractive investment in the long run.
When it comes to the global economy, the company operates mostly in two different regions, mainly the US and Europe. In the US inflation is still very high, however, the latest CPI report showed the lowest level of inflation since September 2021 which may signal that the Fed will not be very aggressive in raising the interest rates by another 50bps if there will be no more surprises coming up in the next month or so. Inflation sits now at 6% annualized, which is still a far cry from the Fed's 2% target, however, hopes are high.
Inflation in Europe is still much higher, sitting at 9% or so. This will affect the costs in the short run and demand for products also as consumers are still being more cautious as the prices are too elevated and they will hold off on buying for now unless it is necessary. The management sees a similar pattern in the next quarter in terms of sales, which mostly will be flat or negative, but as soon as summertime hits, the company expects demand to pick up and costs to keep coming down.
I am not interested in revenue growth this time around, the company over the last decade did not see any revenue growth at all. My focus here would be on becoming more efficient, by implementing all the cost-cutting measures mentioned above and for the prices to come back down which will further improve margins.
Financials
Let's look at the reason why I wanted to delve deeper into the company: its books. A stock screener that I use highlighted this company because it met my minimum requirements on specific profitability and liquidity metrics.
The cash position of the company, although was in a much better position a year ago, is still able to cover the outstanding debt. I don't see the company having any problems paying back the debt over time. Inventory levels are a bit elevated, however, they are not very much over the normal pre-pandemic levels. The management is said to be working on reducing the excess, which in turn will slightly help margins over time.
In terms of liquidity, the company saw better ratios in 2018. The current ratio stood well over 2.0 and since then it has trailed down below 2.0 which is not ideal, however, it is still able to pay off all its short-term obligations efficiently.
Current Ratio (Own Calculations)
Return on assets and equity have somewhat improved since the negative pandemic levels and are even better than the 2018 levels, however, are slightly lower than the year before, which indicates the company's profitability has declined. I believe that these metrics will come back up again once the cost-cutting measures are fully realized over the next couple of years and stabilize.
ROA and ROE (Own Calculations)
I see a similar situation in return on invested capital, but overall, the management seems to be running the company efficiently and profitably since the beginning of the pandemic and I believe the company will become even more efficient in the future if all plans go their way.
Valuation
As I mentioned throughout the article, my focus will be the management's ability to streamline operations, become more efficient and increase the company's margins. The margins of the industry are very tight, but there could be some improvements implemented and the management is more than capable to trim the fat where necessary so that the company becomes a well-oiled machine that generates higher positive cashflows in the future and rewards the shareholders.
With that said I went with quite small improvements on margins and to my surprise that made a big difference to the company's share price.
I have implemented around $20m of savings on expenses, as the company has forecasted that they will reduce the expenses over the next 12 months in my base case scenario which translates to around 80 basis points. I assumed that these measures are not one-off and will persist, but I did not reduce them any further to keep it simple. I also increased gross margins but only slightly, about 50 basis points that will persist throughout the model. I reason that the prices will come down once the inflation subsides. I kept the improvement at 50 basis points to be conservative and if the company can achieve better margin improvements in the future, it can only make the company more attractive as a long-term investment. The revenue growth doesn't matter here so I went with around 3% growth over the next 10 years, 1% on the conservative case and 5% on the optimistic case.
On top of my assumptions, no matter how conservative they are, I always like to put another discount as a margin of safety of 25%. With such slight improvements in margins over the next decade, the intrinsic value of the company is $41.57, which implies a 12% upside from the current valuation.
If the company does not manage to improve its margins at all, which I believe is a bit of a stretch, but I modeled it anyway, the company with the same margins over the next decade as they achieved at the end of the year, the company's intrinsic value is $26.08 per share, implying around 30% downside from current valuations.
10-year DCF w/ improved margins (Own Calculations) 10-year DCF w/ current margins (Own Calculations)
Closing Remarks
I presented two different outcomes that the company may have in the future. Both of these could happen if, for example, the company does not succeed in implementing the cost-cutting measures in the future, and if these measures are successful, the company's margins may improve even more than I forecasted which would make the company even more undervalued right now than the model suggests. I am leaning more towards the management improving efficiency in the future, which includes a very promising growth pattern in digitization, trimming the non-profitable stores, and the global economy cooling down from a high inflationary period and into a more normalized, stable state.
Right now, I would still suggest holding off on adding to your existing position or starting a position as I would like to see some progress on efficiency improvements over the next couple of quarters and I would like the economy to show a pattern of inflation reduction without a random spike again as we saw a couple of times. I believe the company has a lot of potential in the future if all goes to plan and I would be open to starting a position once I get more clarity.
For further details see:
How Margins Make Or Break Genesco's Investment Case