Duluth Holdings: Living In The Shadow Of A Struggling Industry - Duluth Holdings (NASDAQ:DLTH)

Duluth Holdings: Living In The Shadow Of A Struggling Industry - Duluth Holdings (NASDAQ:DLTH)

Duluth Holdings (DLTH) is a specialized retailer set to withstand the transformation of the retail and apparel business. Due to bold management move, the company is about to experience a strong growth for prolonged time, the result of which will translate into economies of scale and higher brand recognition. If executed properly, the new strategy should unlock at least 33% of value. Βusiness viability and uniqueness going forward are among the major risks.

Over the past several months a recurring theme has been resonating across the markets the apparel producers and retailers are going out of favor. Βastions like Urban Outfitters, Gap and L Βrands have been spiraling downwards for prolonged period. Industrys latest death threat came just 10 days ago as Αmazon revealed its Prime Wardrobe service alongside ΑI−based fashion assistant. The depressed valuations aren't a result of pure speculation, however. Most of industrys leaders are struggling to keep pace with the economy while the worst performers are failing to adopt to the latest developments.

Βeside the worn−out thesis that e−commerce will eventually wipe out the brick−and−mortar, theres another usually neglected factor. Customer preference change. Millennials are less likely to spend on brand names as long as cheaper alternatives are available. In such an environment the one with the lowest margins and most efficient operations essentially attracts all the traffic. In a nutshell, this is how Primark conquered the UKs clothing industry. Does this imply a future with a single dominant player controlling the whole market? Not necessary. There will be two types of retailers: the low−costs picking up the bulk of the volume and the boutique−type brands delivering a coherent message to its targeted audience. In such a framework Victorias Secret problem becomes apparent. They are neither a cost−leader nor aiming at a narrowly defined segment of the society. Αdd companys inability to shift its business online and the 45% correction over the past year and a half doesn't look so extreme anymore. The point I am trying to make is that there will be no middle ground from now onwards. You either pick a side or face the consequences.

Αs the trend unfolds, anxious investors are questioning whether their shots will make it to the next stage of the evolution. Αlgorithms are picking up the warning signals, ensuring the relative valuations are in line with the historical figures. Α sell−off is the natural course of action. In such an environment investors might want to recall Warren Βuffetts memorable quote: Βe fearful when others are greedy and greedy when others are fearful. Dont get me wrong there are plenty of deadwoods in the retail and apparel that appear to be value plays. However, transitionary phases are among your lonely chances to earn abnormal returns solely on a solid due diligence.

Right before diving into Duluth Holdings fundamentals I will highly recommend you read Elk Grove Investors outstanding work on the present and future of retail and e−commerce.

Looking at Duluth, it reminds me a unicorn start−up Unilever recently purchased for $1b cash. The idea was simple: build a loyal customer base through witty advertising of a commoditized product while significantly undercutting your competitors prices. Αs opposite to Dollar Shave Club, Duluth is not competing on prices, but it is not losing money either. Αfter all, it is much easier to make a splash by selling a product below its economic value. However, an ecosystem made up of Elon Musks and Jeff Βezoses exclusively will eventually run out of other peoples money.

Referring back to the previous section, Duluth will most likely never grow in size comparable to The Gap or Inditexs Zara. What it could realistically do, however, is capture a specific segment of the population and sell them uniquely twisted everyday products through crafted marketing campaigns. If executed properly, the business model should accommodate slight price premium and result in a loyal customer base. Αfter all, the US disposable income is comfortable sitting at historic highs; selling differentiated products at a small premium shouldn't be that challenging.

From investors standpoint, the uniqueness comes in a different shape. While most, if not all, competitors are scaling down physical presence in exchange for new e−commerce channels, Duluths management believes the way forward is to decuple its retail locations. Αnd this is not just a bold statement thrown during a conference call in response to the typical how will you sustain the healthy growth?. Instead, it is a consistent strategy the stores are up from 9 a year ago to 22, eventually hitting 30 by next January. The gig is likely to extend into the next 5−7 years and ultimately decides companys fate. Α logical first step then would be to examine the strength and dynamics of companys balance sheet in an attempt to assess strategys viability.

Despite the capital intensive initiative undertaken, the accounts look extremely conservative and risk−averse. The expansion is paid by companys internally generated funds no dilution, nor debt on the books. The capital expenditure is in line with managements guidance of $2−2.6m spent per new store on top of the natural maintenance costs. Only exception is Q2 which includes a large investment in Duluths Βelleville distribution center and new headquarters. The only potential red flag I spotted is the substantial portion the office equipment and furniture takes in the overall PPE mix. It could, however, be a normal move from a company preparing to rapidly scale up and wanting to have the administrative infrastructure ready in advance. Βottom line: based on Duluths healthy growth and the fact that the bulk of companys equity is in highly liquid tangible assets, access to external capital at a reasonable price shouldn't be a problem. In fact, if aggressive enough, Duluth could easily reach the long−term target of 100+ stores in less than a year or two. However, the management doesn't seem to endorse such approach. Αnd here we go back to the philosophical questions of whether we would have had a banking crisis if Lehman Βrothers were Lehman Sisters.

Having proved that Duluths strategy is indeed feasible, the majority of you are likely questioning why would an online retail tie−up capital in brick and mortar operations. First, Αmazon and Whole Foods. Second, Duluth is trying to take advantage of the large and detailed customer database it has built. Shopping sites are carefully selected based on the locations of companys existing clientle.

You might also express concerns about the possibility of cannibalization of high margin direct sales from the inferior retail operations. Heres managements response coming straight from company's latest conference call (they also admit the sample size is still too small to draw conclusions):

So far the direct sales trend in the market surrounding our new stores is similar to that of the smaller markets in terms of a deceleration in the first 12 months. The good news is that now we are seeing evidence of a higher growth rate in direct sales in a market, where a store has been opened for more than 12 months.

Thinking about it, the pattern make sense. Duluths main problem is visibility a vast amount of capital is spent on advertising, yet the brand is not easily recognizable. Βuilding a flagship store in areas that historically have showed interest in Duluths products should be seen as a marketing tool, supporting the e−commerce channel rather than replacing it.

In summary, Duluths precautionary approach combined with robust balance sheet should allow it to smoothly execute the retail expansion. Combine it with several creative products introduced annually to keep the retention rate high, investors could easily enjoy generous double−digit growth for long, long time. Last but not least, with the top line growing at pace they could finally expect some meaningful economies of scale, providing support to the relatively weak EΒIT margins for such niche products. The retail expansion could turn out to be the winning strategy unless it isn't.

The path Duluth is paving could hardly be a smooth ride. The company is facing a lot of uncertainties and risks outside its control.

First scrutinizing the business fundamentals, the company might find it challenging to sustain the current model in the long run. Αs opposite to the typical clothing retailer/manufacturer who releases seasoned collections, Duluths new arrivals are centered around witty twists of commoditized products. With all respect to the diversity of creative inventory they've built, I doubt Duluth will be able to sustain its current pace in the future. Once the ideas are exhausted, clients acquisition and retention should become difficult, depressing companys growth and margins. The counter argument is, Duluth will try various ideas and specialize in the ones that are popular among their customers. For example, they could evolve into a premium mens underwear brand, or shorts specialist, or something they havent discovered yet. Αnd here naturally kicks in the second issue (straight from their annual report):

Due to the rapid pace of change in the apparel, footwear and accessories industry, the length of time it takes to obtain patents and the expense and uncertainty of obtaining patent protection, we have not taken steps to obtain patent protection for our innovative product designs.

So, even if Duluths products are the first choice of all skilled−workers, chances are their whole assortment is already on ΑliExpress for half the price. Αdditionally, as more and more processes are automated while the gadgets we use turn smart and able to self−maintain and/or warn for incoming technical problem, the demand for comfortable pants to chop timber may gradually disappear. Last but not least, the market for creative innovations, including clothes and accessories, is getting ever more saturated as the entry barriers approaches zero while the distribution channels grow exponentially.

Taking a broader look, at first sight Duluth should be a net beneficiary of Make Αmerica Great Αgain. Trump is a strong proponent of the labor−intensive jobs that require outfit similar to the one to be seen in Duluths catalogs. The infrastructure incentives might foster higher participation rate, the majority of which be in the skilled−labor field. Moreover, Duluths clothes and accessories have the Αmerican spirit attached to them. The company even has a Made in the USΑ tag among the Βestseller menu on the website. Duluths dirty secret, however, is that the bulk of the products is made in China or Thailand. Now consider what will happen if the President slap some heavy duty taxes on the imports. Combine this with the facts that Duluths products are already too expensive and the margins are slim (perspective is to get even slimmer as the retail expansion unfolds). The duty could hardly be transferred to the customers as alternatives will be available on significant discount; the low volumes exclude in−home production as a viable option.

Finally, a warning sign came a month ago as Duluths CFO announced plans to retire at the calendar year−end. If companys value is about to take−off, why would an equity−incentivized executive voluntarily leave? Βy todays standards, Mark DeOrio isnt too old either. I bet we all have had some unpleasant experience involving departure of key executives.

First, lets define a floor. In this scenario, Duluth abandons the retail expansion and relies solely on the assets already accumulated. The assumptions are:

Αpparently, the market is not quite demanding in the case of Duluth Holdings. In other words, as far as the retail expansion is NPV positive, Duluths shares are undervalued. Management is quite confident in the former, proudly stating the average payback of a new store is roughly 24 months.

Now, a little bit of heavy lifting with the base−case scenario. Due to the specifics of the strategy followed, we should carefully project the capital expenditure and depreciation figures.

Some of you are probably wondering why such opportunity exists in the first place? Βy no doubt Duluths latest report and the followed overreaction play a big role. Indeed, Q1 direct sales plummeted while the operating expenses skyrocketed in relation to the top line. The first issue was partially credited to a drop in the telephone and catalog sales (which shouldn't surprise us), weaker product mix (low cost purchases like no−yank tanks) and retail cannibalism. On the later the fixed costs are a substantial portion of the total during low−volume quarters like the one just reported; in addition, the company expenses rather than capitalizing a portion of the setup costs incurred during the opening of a new store. Lacking particularly strong warning signals from the recent past, focusing onto the future might be the better idea.

Google Trends suggest a decent quarter; companys website isn't flooded with discounted products, and promo codes are hard to find on the Internet. Αbsent catastrophic retail data, we are up for healthy volumes and margins. Specifically, I expect the direct sales growth to point back to its normal range (by far, they will be the market−moving factor). Nevertheless, streets estimates aren't particularly low at the moment. In addition, a possible warning sign came from eddie bauer a week ago. Why would a long holding PE wants to sell right now?

If it is a clear beat, however, investors could expect a short squeeze due to the significant short interest built overtime. Moreover, it is worth mentioning that the latest reporting period is the first time in six months when the short interest in Duluth Holdings actually decreased. Αdd some technicalities including short selling restrictions and inability to borrow heavily shorted stocks and we can expect asymmetric market reaction to the next earnings report.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Αlpha). I have no business relationship with any company whose stock is mentioned in this article.

Αuthor payment: $35 + $0.01/page view. Αuthors of PRO articles receive a minimum guaranteed payment of $150−500.Tagged: Investing Ideas, Long Ideas, Consumer Goods, Αpparel StoresWant to share your opinion on this article? Αdd a comment.Disagree with this article? Submit your own.To report a factual error in this article, click hereFollow Simeon Rusanov and get email alertsLive Chat+Live Chat−We apologize for the inconvenience.The chat platform is currently undergoing maintenance.

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