Source: Investor presentation, page 7
Here we go again
Shares of Duluth Holdings (DLTH) have been on a wild ride in the past couple of years. After spending a lot of time bouncing between the high-teens and low-20s, Duluth rocketed to nearly $36 very briefly last summer. However, things haven’t been so rosy since then.
I’ve been a Duluth bull and bear at different times, depending upon the valuation at any given point. The way the stock has moved has created situations of great overvaluation and strong buying opportunities alike. Today, after the selloff from the Q4 earnings report, Duluth looks like it is a buy once more.
An imperfect Q4
Duluth’s Q4 report certainly wasn’t perfect, but investors that have sold the stock, in my view, are missing the point on long-term growth potential. That potential has been there all along, but the stock has, at times, built in some of that growth well in front of when it would actually occur. However, with the stock very near the lowest levels it has seen in the past two years, I think there is some value in Duluth despite relatively weak guidance for this year.
Total sales in 2018 rose 20.5% to $568 million, including a $7.7 million increase from an additional operating week. Duluth continues to not only grow its core direct-to-consumer, or DTC, channel, but open new stores as well. The company boosted its physical retail footprint by 50% in 2018, adding 15 stores. Duluth reckons it will open another 15 stores this year, and in fact, just opened its 50th store in support of that goal. Duluth continues to see mid-single-digit gains in the DTC channel, while retail sales grow at ~40% rates, thanks to new store openings. Importantly, Duluth is seeing growth from both its men’s and women’s lines, the latter of which is still in its relative infancy but gaining momentum.
Gross margins have been a sore point for Duluth in recent reporting periods and in 2018, this was once again the case. Gross margin declined 80bps to 54.6%, from 55.4% in 2017. The decline in gross margins was due to the continued loss of shipping revenue, which Duluth has been dealing with for some time. Its current shipping policy is no charge for any order over $75, but given the prices of the items it sells, that is a fairly easy threshold for consumers to reach.
That’s a good thing, but it does result in ever-declining shipping revenue, which means the relative cost of shipping for Duluth rises. In addition, the expansion of the company’s store network has caused shipping costs to rise meaningfully, which is something Duluth cannot avoid. This is part of building a retail network, and the company will have to adapt. Keep in mind the decline in gross margins isn’t huge by any means, but it is something Duluth is working on with improvements to its distribution processes in the hopes that some of that lost margin will be recouped.
Operating margins in 2018 fell, to no one’s surprise, from 7.9% of sales in 2017 to just 6.6% of sales. The decline was due in part to the gross margin loss, and also because SG&A costs continue to rise. Duluth still spends ~15% of its revenue on advertising and marketing as it works to build brand awareness across the markets where it is present. That’s declining from even higher levels in years past, but this is an enormous expense for Duluth.
Selling expenses are increasing as well, but this is to be expected, given that Duluth is rapidly expanding its store network. Store labor, customer service costs, and distribution expense all rise as a retailer builds out its network, and that is what Duluth is experiencing. While this is painful, the good news is that, over time, as the network is built out, many of these costs should be leveraged down via higher revenue. Duluth certainly isn’t there yet, but the lower margins we’ve seen of late should be a temporary problem while it grows.
Long-term growth is intact
While I don’t dispute that Duluth has some near-term issues to work out, these issues are common for rapidly-expanding retailers. As a result, I don’t think anything is necessarily wrong; I just think Duluth is experiencing the same growing pains a number of other retailers have before.
From a long-term perspective, there is an attractive path to growth in front of Duluth that I think is being largely ignored today.
Source: Investor presentation, page 10
Duluth has currently identified 100 potential store locations throughout the US, which is exactly double where it is today. The company’s stores have very attractive unit economics, given that they ramp up quickly and pay the company back on its investment in less than two years. It can do this because Duluth’s stores have high levels of margin when support costs are stripped out. This matters because the more stores the company has, the more its support costs are leveraged down, and operating margins for the whole company will expand. Given that the store base can still double from here, and potentially more over time, I’m not particularly concerned by near-term margin issues.
The other long-term tailwind the company has is that when it introduces a store to a market, the DTC channel benefits as well. The store, it seems, boosts brand awareness significantly, driving not only physical retail growth but via the DTC channel as well.
Source: Investor presentation, page 11
Given the company still has dozens of new markets to enter, this is also long-term bullish for not only revenue but also margins as that high level of revenue leverages down support costs. In short, I think the revenue outlook for Duluth is bright and that, with this higher revenue, higher margins should follow.
Weak guidance creates the opportunity
Duluth guided for below-consensus revenue and EPS for this year in the Q4 release, and the stock was hammered for it. Shares trade for 22 times the midpoint of guidance at $0.77 for this year, so it isn’t necessarily cheap on an absolute basis. However, it has routinely traded at valuations in excess of 30 times earnings in its relatively short history as a public company.
In addition, analysts have Duluth growing earnings in excess of 20% annually in the coming years, which is a reasonable expectation. The company’s store network expansion will continue to drive mid-teens or better sales gains, while leverage on support costs should help drive margins higher. In this context, Duluth doesn’t seem very expensive at all, and that is why I think now is the time to buy.
Duluth has its issues to work out, but they are no different than many other retailers that have worked in the past to build out their store networks. Duluth has a distinctive brand with memorable marketing that clearly works. It is still in the early stages of expansion, so writing off the stock due to some margin pain is imprudent. I think that $17 is a wonderful opportunity for investors that want to own the stock to do so, and I rate Duluth a buy as a result.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DLTH over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.