Duluth Trading ($DLTH): Approaching The Inflection Point
Duluth Trading (DLTH) is a casual wear, workwear and accessories company, known for offering quality and durable products, with a loyal and satisfied customer base, and a widely recognized brand.
The Company started in 1989 as a catalog business and morphed into an omnichannel platform, adding first a website and opening later on its first store in 2010. Since then they have expanded their retail presence and as of today DLTH operates 65 stores (that represent approximately 36% of its net sales vs. 6% in 2013).
Why This Opportunity Exists?
DLTH is the perfect example of a successful company carrying out a messy and hurried geographic expansion. As commented, in 2010 the Company opened its first store and it was gradually expanding its store base, adding 1 to 3 stores per year between 2011 and 2015. However, in 2016 DLTH decided to accelerate the pace with the opening of 7 new stores, and even more in 2017, 2018 and 2019, with the opening of 15 new stores each year, to reach 65 stores spread across 33 states by 2020.
The problem is that DLTH’s infrastructure and technology were not ready for this rapid and wide expansion, and the Company relied excessively on (costly) third-party logistics centers. This situation caused the Company to increase their expenses more than proportionally compare to their revenue. The increase in freight costs related with the transportation of inventory to retail stores across the country and in SG&A expenses due to retail growth made the Company to rapidly deteriorate its margins:
DLTH started to work seriously on these issues in 2018 but by the end of 2019 decided to slow down the pace of store openings and finally in 2020 to temporarily stop its geographic expansion (also as a consequence of the COVID situation). Since then the Company has been investing in the infrastructure needed to support its growth, but the problem right now is that, being those strategic investments the right decision, they have put the Company in a short-term challenging situation: those strategic initiatives have increased DLTH expenses at a time when macroeconomic factors are pressuring its customer base and so cannot offset those expenses and much less to enjoy any operational leverage. In other words, while DLTH’s top line remains under pressure, the increase in fixed costs (i.e. depreciation and personnel expenses) is deteriorating its margins even more and even making DLTH incur losses. This situation has led DLTH stock to trade close to its all-time low.
What Makes Me Optimistic?
As commented, since the interruption of its expansion the Company has been investing in the infrastructure needed to support its growth, spending approximately $90M (more than 50% of its current market cap) in logistics and fulfillment infrastructure and technology investments (all of them funded with operating cash flows). DLTH ended its third-party logistics contracts and has recently opened two new distribution/fulfillment centers: one in Salt Lake City (Utah) to service the West Coast (in Q3 2021) and the other in Adairsville (Georgia) to take care of the Southeast region (in Q3 2023). With these investments DLTH has finished the lion's share of its investment cycle and it is ready to operate with a much more effective and cost-efficient structure, and to grow again (indeed the Company is planning to resume the expansion of its store base). The Company expects meaningful cost savings, with a direct impact in both gross and operating margins.
Additionally in September 2019 the former CEO left the Company and Stephen L. Schlecht (the Chairman and founder) took temporarily the helm until April 2021, when Sam Sato, the current CEO, was appointed. The new CEO has more than 30 years of retail industry experience and is taking care of the main issue with DLTH, its unprofitable growth, and preparing the Company for the future before resuming the growth.
Besides the Company is still loved by their customers, demand is still there. Channel checks indicate that men love DLTH’s pants and underwear and women’s business is gaining traction. Customers praise the good quality, durability and comfortability of DLTH’s products, being at the same time not excessively expensive. There is no doubt that consumer discretionary is suffering and the Company has had to adapt to this challenging environment and increase its promotional activities. However DLTH has been investing in sourcing and product innovation, it is fostering different revenue initiatives (i.e. women’s business, wholesale, sub-brands as AKHG, etc.), and enjoys a loyal and satisfied customer base. It seems just a matter of time for DLTH to recover its luster, surpass its maximum activity levels (especially if they finally make the decision to resume its geographic expansion) and do it profitably.
In that sense, by September 2021 the new management established its 2025 targets: at least $1 billion in sales, 9%-10% operating margins, 14%-15% EBITDA margins, at least $2 in EPS, positive FCF and low balance sheet leverage. DLTH has suggested that those targets are currently under review but the most likely scenario is that they move the 2025 date one or two years, but keeping the financial targets unchanged.
Should finally the Company is able to reach its targets, we would be in front of a company with an expected EBITDA of $140M-$150M and an EV of $360M (including leases). In other words, DLTH would be trading at a 2x EV/(fwd)EBITDA multiple vs. its historical average of around 10x. But even if the Company just achieves 2019 pre-pandemic levels of ~$50M EBITDA (in one of the most challenging years in the Company’s history) the multiple would be well below its historical average (7x vs 10x).
All in all DLTH is a company turning around its business (which is always risky) but taking steps in the right direction. Many of the necessary investments have already been made and implemented; its renovated structure should start to unveil is positive impact in terms of profitability; and it seems just a matter of the macroeconomic environment to start changing for the Company to improve and potentially recover its historical luster.
I do understand that for many people this is not an actionable idea as DLTH is still pending to reach the “inflection point” of its turnaround process, but it could become a really interesting investment opportunity in the (near) future. For others, the trough of the cycle is really the best time to acquire cyclical companies. You can only make that decision.
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