Duckwall-ALCO Stores: Finding Value in America's Heartland

| About: ALCO Stores, (ALCS)
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In a previous article, we noted Duckwall-ALCO's (DUCK) unique niche and how this protected it from competition. Unfortunately, this niche allowed the company to become uncompetitive and continue archaic operating procedures. In the last three years, however, Duckwall-ALCO has replaced two CEOs, brought in a new CFO, eliminated two positions on its executive team, permanently closed the smaller, unprofitable legacy Duckwall stores, changed its merchandising mix and upgraded its inventory control system. Today, the operations are more efficient and less expensive, the stores have been rebranded, many of the capital investments have already been made and management is focused on serving the diverse needs of ALCO shoppers. This situation presents investors with a great opportunity.

The current executive management team, along with the board of directors led by Royce L. Winsten, has been willing to make necessary investments in personnel, operations and logistics and merchandising. The new management team has been aggressively breaking down the company piece by piece, evaluating where weaknesses lie and rebuilding from the local store up to corporate headquarters.

Of all the changes made, perhaps the most import is the company's new commitment to organizational leadership development. Duckwall-ALCO has worked diligently to change its corporate culture. Store managers are now encouraged to be more engaged and focused on creating a clean, enjoyable shopping experience. Senior management is aiming to create a common shopping experience at ALCO stores for customers from Texas to Minnesota. To accomplish this goal, they are focusing on developing strong district managers and motivating local store managers. This, however, has costs. Store managers are being paid higher salaries with bonus potential of up to 20 percent of their base salary. Bonuses are weighted 50 percent towards revenue growth, 25 percent towards gross margin improvements and 25 percent towards shrink reduction. We believe this extra compensation is a great investment and over the long-run will increase shareholder value. Yet, the company continues to have a relatively high turnover in local managers and until senior leaders can retain talented store managers across all regions, the company will face headwinds. Shrink, for example, declines by approximately thirty percent when managers have two or more years of experience.

Local store managers are not the only individuals within the company rewarded for performance. Executive management's compensation is partially tied to return on equity. They can receive a cash bonus of 50 percent of salary if they achieve a return on equity (ROE) of 7.5 percent. Bonuses may reach 150 percent of base salary if ROE reaches 17.5 percent or higher. We would be happy to pay management a 50 percent cash bonus if they can provide us with a 7.5 percent return on equity. Based on the latest 10-Q, this would equate to $7.7 million in net income or $2.00 in earnings per share. We feel this aligns investor and senior management pecuniary interests.

The investments in operations have also been remarkable. Years of insulation from competition and entrenched leadership had created inefficiencies. For example, goods arriving at stores via direct store delivery, which accounts for 20 percent of costs of goods sold, were previously invoiced using pen and paper. This method undoubtedly exhausted morale, kept managers from focusing on growing top line revenues and improving gross margins and allowed for high levels of shrink. Today, Duckwall-ALCO has a fully integrated electronic invoice process. The company has also made significant IT investments to better track sales and help increase shelf productivity and product placement.

Duckwall-ALCO evaluated personnel requirements at stores, its corporate support center and its distribution center. It has reduced the head count at stores from approximately 17 employees per store in 2007 to nearly 14 in 2010. At the corporate support center, staff was reduced and redundant roles eliminated. These reductions alone will yield annual savings of $1.2 million. The distribution center has been changed from a traditional warehouse model to a flow through model. Now, instead of picking and packing items that sit on shelves waiting to be shipped, orders are centralized, sorted by delivery destination and often sent out the same day. This reduces the need for fixed assets and inventory and improves Duckwall-ALCO's ability to get goods to its stores in a timely manner. Furthermore, the company's new partnership with Associated Wholesale Grocers (AWG) reduces the need for workers at the distribution center, since AWG will now deliver many goods directly to ALCO stores. Management anticipates this will lead to $1.5 million in annual savings flowing directly to the bottom line at the distribution center.

As a result of our many conversations with senior management, it is clear that Duckwall-ALCO is focused on solving its theft/inventory loss problem. Last quarter shrink was 247 basis points (bps) versus an industry average of 150 bps. Consequently, senior leaders have established a three part plan. 1) Manager retention 2) Risk Assessment of high shrink stores 3) Improvement in operational compliance. We have discussed at length store manager retention. Investments in inventory control and IT will help make parts two and three successful. Last quarter, the company lowered shrink by 30 bps from a year earlier and management has set a 50 bp improvement goal for the current fiscal year. On sales of $465 million last fiscal year, a 50 bp improvement would increase net income $2.3 million or $0.61 per share. If the company had shrink margins comparable to the industry average of 150 bps, last year's net income would have been improved by approximately $5.9 million or $1.54 per share!

The investments in personnel and infrastructure will be for nothing if Duckwall-ALCO fails to provide the right merchandising mix. We have been encouraged by new store layouts and new product offerings. Prior to the management shake-up, Duckwall-ALCO had dedicated prime store real estate to home décor and crafts — two slow moving items — and had relegated consumables, such as cleaning products, plastic storage and kitchenware, to low traffic areas. In an effort to increase foot traffic, consumables were brought forward and placed in a new dollar store format at the front of the store. The company's partnership with AWG provides ALCO stores with two nationally recognized private label brands, Best Choice and Always Save. These brands typically sell at 25-30 percent less than similar nationally branded products. The amount of space given to home décor and slower moving items has been rationalized and more popular items added to the store — such as, Gloria Vanderbilt jeans for women, Wrangler and Lee jeans for the family, Keurig one cup coffemakers, Samsung (OTC:SSNLF) TVs, Acer notebook computers, Kitchenaid small appliances and Crew, Biolage, and Bedhead hair care products. Like shoppers in larger urban markets, rural customers desire these nationally branded items. Management found that most of their customers were driving 60 miles round trip on weekends to buy these products at larger broad line retailers. We think the new store layout and merchandising mix are critically important and represent a catalytic shift in strategy. The company now delivers greater value and a convenient shopping experience [ALCO stores average around 23,000 square feet versus 186,000 square feet for a Super Wal-Mart (NYSE:WMT)], but at the same time aims to deliver higher quality, price point and margin items. Management believes customers are responding positively to this new layout and initial results are encouraging.

With the new dollar stores in the front and higher margin goods throughout the remainder of the store, the company faces the two opposing challenges of raising inventory turnover and increasing gross margins. The company has relatively low inventory turnover compared to the industry, but in order to be profitable needs gross margins to be above 30 percent. The dollar store and AWG products increase foot traffic and inventory turnover. These products, however, have lower margins, meaning the rest of the store will need to have higher margins to maintain profitability. Assuming that food and consumables continue to account for 20 percent of sales and have gross margins of roughly 22 percent, the rest of goods sold will have to have 33.25 percent gross margins in order to achieve an overall store gross margin of 31 percent. Management acknowledges this challenge, but with the right product mix believes an overall gross margin in the low 30 percent range is achievable. The company aims for inventory turns above 2.5. Our calculations indicate that achieving turns of 2.5 would unlock nearly $20 million in capital from current inventory that could be used for store expansion and other capital improvements. The company also has $58.9 million outstanding on its $110 million revolving loan credit facility, leaving ample liquidity for current operations and future expansion.

With the current management team in place and many critical investments having been made it is evident that management is leveraging the company's fixed assets and personnel to increase shareholder value. In addition to the improvements in merchandising strategy and the achievements made in controlling costs, which will drive shareholder value through same store sales growth and margin expansion, Duckwall-ALCO plans to drive value through the addition of new stores. Senior management believes there are hundreds of markets within the company's current distribution network ripe for new ALCO stores. Additionally, they believe Duckwall-ALCO can sustain substantial growth without straining its current asset base. CEO Rich Wilson indicated the company could add 50 stores without making new investments in the distribution center. Likewise, he said the company could add 100 stores without having to make large investments in capital or labor at the corporate support center. The other big cost that affects value is store expense. Senior management believes they can increase same store sales by 15 to 20 percent and would have to add to the current average worker count by only one or two individuals. This is a hugely valuable business model with significant upside potential at this time.

Looking at the income statement on a pro-forma basis illustrates the operating and profitability potential of Duckwall-ALCO. The company averaged approximately $2.17million in sales and approximately $0.46 million in expenses at ALCO stores for fiscal year ended January 31, 2011. With 214 stores and gross margins of 31 percent, cash-flow to corporate would have been approximately $46.8 million. Deducting last fiscal year's corporate support center and distribution center costs, as well as depreciation expense of $10 million, earnings before interest and taxes would have been $5.95million. Assuming a slightly higher interest expense of $5 million, due to higher borrowings drawn on the revolving line of credit, we are left with earnings before taxes of $0.95million. Assuming a 34 percent tax rate produces a net income of just $0.63 million or just $0.16 per share. If, however, we take into account $2.7 million in overhead savings and assume a 50 basis point improvement in shrink, net income increases to $3.9 or $1.03 per share. Furthermore, assuming 50 new ALCO stores are added, then under the forecasted cost structure, net income jumps to $11 million, or $2.85per share. Additionally, if the company is able to lever its current store assets and generate an average of $2.5 million in sales per store (an increase of 15 percent) while adding only one additional worker, net income would increase to approximately $22.7 million or $5.91 a share. Admittedly, these are optimistic assumptions. We don't expect the company to add fifty stores in the next year or instantaneously add 15 percent to same store sales. However, in the next three to five years, we think the company is capable of achieving similar operational results and growth targets.

Given the significant investments in infrastructure that have been made and management's focused commitment on building a top tier team, we believe Duckwall-ALCO's shares are greatly undervalued. ALCO stores have a unique economic opportunity and using large operating leverage can produce substantially higher earnings per share. With CEO Richard Wilson leading a very talented executive management team, including CFO Wayne Peterson, CIO Ted Beaith and Tom Canfield, Jr. in logistics and administration, the future at Duckwall-ALCO looks very promising.

Disclaimer: The security described in this article is owned by the contributor and clients of Milwaukee Private Wealth Management, Inc., an investment management firm owned by the contributor. Thus, the contributor has a financial interest in any future price increase of the security.

Disclosure: I am long DUCK.