Value Play: DSW Inc. (NYSE: DSW)

If Imelda Marcos can have 3,000 pairs of shoes, the Roadrunner Value Portfolio is entitled to recommend two shoe companies. Back in January 2014, I recommended Weyco Group (WEYS), an upscale footwear retailer of brand names such as Florsheim Royal Imperial that sell for $300 a pair. The stock has made a little profit, but the company’s 24% exposure to foreign markets hurt the bottom line due to economic weakness in Asia.

My Value Front Runner this month – DSW Inc. (DSW) — avoids foreign economic and currency problems altogether since 100% of its annual revenues comes from the good old USA. DSW also performs better than Weyco in weak-to-modestly positive economic environments because its shoe price points on the lower end of the spectrum. Although its corporate acronym stands for “Designer Shoe Warehouse,” it could just as easily stand for “Discount Shoe Warehouse.” DSW is the “Costco of shoes” because it buys in bulk and passes on the volume-based discounts to customers.

Footwear is one of the few retail segments that remains bullet-proof to Internet poachers such as Amazon.com and zappos.com because people need to touch and feel shoes before they buy them. Nobody wants blisters on their feet and you simply can’t tell how a shoe will feel by looking at a picture on the Internet. Even showrooming doesn’t really threaten bricks-and-mortar shoe stores because different pairs of the “same” shoe are never identical and can feel different on the foot.

That said, DSW has a thriving online shoe business, which is successful precisely because of its close coordination with the bricks-and-mortar locations. Customers can try several different shoes on at a physical DSW store and then decide later which one to buy online. DSW operates 449 stores in 42 states, the District of Columbia and Puerto Rico (95% of sales), as well as 372 leased departments for other retailers (e.g., Stein Mart, Loehmann’s, and Gordmans) in the United States under the Affiliated Business Group (5% of sales). It also operates an e-commerce site, http://www.dsw.com, a mobile site, http://m.dsw.com, and owns a 46.3% ownership interest in Town Shoes, the largest branded footwear and accessories retailer in Canada. (page 7).

A majority of DSW sales are women’s shoes (61%), which makes sense to me because my wife buys all of her shoes there. On average, women own 21 pairs of shoes and spend about $10,000 on shoes by their mid-40s. As former DSW Marketing Chief Kelly Cook (now at Kmart) said in 2013: “shoes make people happy.”

The founder of DSW is 60-year-old Jay Schottenstein, a member of a family retailing empire headquartered in Columbus Ohio composed of DSW, American Eagle Outfitters (AEO), Value City Furniture, M/I Homes (MHO), and a partial interest in the Albertson’s-Safeway supermarket chain. Mr. Schottenstein owns a 25.7% ownership stake in DSW and an even-larger 48.3% voting interest (page 3) thanks to his almost-exclusive ownership of Class B shares entitled to eight votes per share. Corporate governance has improved thanks to a 2-for-1 stock split of the regular one-vote Class A shares in October 2013, which reduced Schotteinstein’s voting control from 65.3%, but his 48.3% voting power remains dominant. One could plausibly argue that Schotteinstein’s control has not hurt shareholders since DSW has outperformed the S&P 500 by 50% since going public in July 2005:

The reason that the stock has performed so well over the last decade is that its financial performance has been stellar. DSW has exhibited tremendously consistent profitability:

The one-time spike in earnings that occurred in 2011 was caused by DSW’s reverse merger with its corporate parent Retail Ventures that resulted in a temporary reduction in shares outstanding and tax expense due to the usage of Retail Ventures’ tax credits. Excluding these merger-related one-time benefits, DSW’s profitability has been a smooth and steady ride higher over the last six years.

Long-term, DSW is a big winner, but so far in 2015 the stock has significantly underperformed the S&P 500 (-24% vs. -5%). The underperformance is curious given that the company has, until the latest second-quarter report, routinely beaten analyst estimates of both earnings and revenues over the past year:

Such solid financial performance deserves to be rewarded, yet the stock has slumped. I view the disparity between financial performance and stock performance to present a buying opportunity, even taking into account the total revenue and same-store-sales (SSS) misses in the recently-completed second quarter. The reasons for the revenue and SSS misses were self-inflicted in that the company consciously chose to reduce discounted merchandise and focus on regularly-priced merchandise in order to boost profit margins. Increasing sales for little to no profit is not a smart long-term strategy and the company made the right decision to sell less but make a better profit on what it does sell.

The stock fell 9.1% on the revenue miss, but this selloff is a gross overreaction to what was in reality an excellent financial report. Second-quarter sales increased 6.8% year-over-year, SSS increased 1.8%, and earnings per share (EPS) from continuing operations increased double-digits by 13.5%. Importantly, the company reiterated its prior full-year EPS guidance of $1.80 to 1.90 per share. Profitability is what counts and that hasn’t changed for DSW. Furthermore, management remains confident about future growth as evidenced by both its 6.7% hike in its dividend earlier this year and its continued store expansion.

The lifeblood of any retailer is growth in store-count, more stores means more revenue and more profit, and DSW has announced the opening of 22 new stores during the August-November period. Three of those stores will be smaller format (half the regular 20,000 square footage), which cost loss to construct and operate and yet still offer the same potential sales volume as larger stores. In the August 25^th conference call, CEO Michael MacDonald explained the “omni-channel” concept based on Internet technology, data analytics, and centralized logistics:

We have turned all of our 449 stores into mini-distribution centers capable of fulfilling demand that’s originated elsewhere, we implemented a new algorithm that more intelligently routes digital orders for fulfillment based on weeks of supply and profitability, and we have initiated a 10-store test of technology-enabled self-service model that we call endless aisle. All of these new capabilities either improve our ability to satisfy our customers or improve profitability or both, and they’re beginning to pay dividends.

Omni-channel sales, which are demanded from one place but fulfilled from another, are trending to well over $100 million this year. Our omni-channel customers spend two to three times more than our single channel customers, with our mobile app playing an important role in converting single channel customers. Mobile traffic has grown rapidly over the last two years and now accounts for over 40% of online traffic. Our customer conversion rate in store is up 10% over the past two years. Our online conversion rate has accelerated since we upgraded our DSW.com platform earlier this year. And we’ve meaningfully increased our assortment choices with much more to come.

Bottom line: I see a company moving forward with revenue and earnings growth, store-count expansion, and technological innovation. I see substantial insider ownership and continued insider buying – the Schottenstein brothers Jay and Joseph collectively bought one million shares of stock in late August at an average price of $28.32 per share. All of this good news comes in a financially-strong and undervalued package, comprised of zero debt, an enterprise value-to-EBITDA ratio of only 6.2, and other valuation metrics below the company’s five-year average.

Lastly, any company that has Hall of Fame baseball slugger Hank Aaron on the board of directors is a winner.

DSW Inc. is a buy up to $33; I’m also adding the stock to my Value Portfolio.

Value Sell Alert

To make room for DSW Inc., Roadrunner is selling:

• Rayonier Advanced Materials (RYAM)

On August 19th, I issued a flash alert downgrading the cellulose manufacturer to a “hold” rating on news that it was mired in a contractural dispute with Eastman Chemical, its largest customer responsible for 31% of total sales.

I was hoping for a quick resolution of this litigation, and that it was just a “negotiating tactic” as suggested by RYAM CEO Paul Boynton, but the litigation continues to drag on with no sign of good news. 

Back in April, I recommended selling FutureFuel (FF) because one its largest customers (12.8% of sales) was terminating its relationship and I called the termination a “materially adverse event.” I feel the same way about RYAM possibly losing an even-larger customer, so it makes sense to sell RYAM now. Although there is a chance that RYAM could win the litigation and force Eastman Chemical to continue purchasing cellulose under the original contract terms, the very fact of litigation means that the 85-year customer relationship is now poisoned and Eastman Chemical will look to cancel its contract with RYAM at the soonest possible moment in the future.

Rayonier Advanced Materials is being sold from the Value Portfolio.

Momentum Buy:

Abiomed (Nasdaq: ABMD)

Abiomed  is a pioneer and global leader in developing ground-breaking technologies designed to assist or replace the life-sustaining pumping function of the failing heart. The company invented the world’s smallest heart pump and the first totally artificial heart. Simply put, the company’s heart devices save lives and earnings estimates continue to rise.

• Price gain between 12 months ago and two months ago = 198.15% (100th percentile)
• Price gain over the past two months = 37.73%
• Price gain over the past month = 7.23%
• Roadrunner Momentum Rating: 198.15 – (37.73) – (3*7.23) = 138.72

Abiomed is a buy up to $117; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alert

To make room for the new momentum stock, Roadrunner will be selling the following price laggard: 

• EQT Midstream Partners (EQM)

I sold NuStar GP Holdings last month and now its EQT Midstream Partners’ turn to be jettisoned. I’m just not feeling the love from energy master limited partnerships.

Energy stocks have gotten crushed thanks to the Chinese slowdown, the Iran nuclear deal, and the strengthening U.S. dollar. Energy master limited partnerships (MLPs) like EQM have not been immune to the carnage.  I still like EQM as a long-term value play, partly because insiders continue to buy the stock, but price momentum is totally gone and the company’s second-quarter financial report missed analyst estimates, so there is no evidence of a near-term turnaround. 

Let me stress that this sell call is based on momentum criteria only and that value investors may wish to hold on. Credit Suisse recently upgraded the entire MLP sector based on valuation and projects 40% total return potential. Similarly, Deutsche Bank says MLPs are at their most attractive since 2008. Talk is cheap, however, and the MLPs continue to underperform.

EQT Midstream Partners is being sold from the Momentum Portfolio.