Lands’ End (LE, Financial) is a high quality business as evidenced by its consistent high returns on capital that is selling at a discount to its intrinsic value. It had steadily grown its revenues at a respectable 7.2% a year from 1995 to 2001. Since being acquired by Sears in 2002, the business appears to have stagnated. This is likely due to the company “up-streaming” most of its cash flow to Sears and not reinvesting in its business. In April 2014, Sears completed a spinoff of Lands’ End. Now that the company is being operated independently it is free to reinvest in its business and be run with significantly less distraction from the issues at Sears. I believe this is purchasing a good business at approximately 75% to 80% of a conservative estimate of its enterprise value and approximately 60% of the average enterprise value/EBIT of comparable retailers.
Business Overview
Lands’ End was founded in 1963 by Gary Comer in Chicago and sells clothing and accessories via its print catalog and website. The company was publicly traded from 1986 until 2002 when it was acquired by Sears for $1.84 billion. In 2014, 85% of revenue was from Direct (website, catalog) and 15% was from retail stores within Sears locations. At the end of 2014 there were 236 stores within Sears with an average of 7,700 SF and 14 Inlet stores with an average of 9,300 SF. Of the total US consumer revenue, 80% was from the website. In 2002 only 20% was from the website. The typical LE customer is a college educated professional; 42% of customers are between 35 and 54.
Valuation
The Company’s enterprise value is currently 7.9x 2014 EBITDA – maintenance capex and 8x my normalized estimate for EBITDA - maintenance capex.This is significantly below the comparable companies average and median EV/EBIT ratio of 14.9X and 14.7X respectively (see supporting charts below). The company also trades at a low price to earnings ratio of 9.7X my projected normalized EPS. Assuming the company reaches my projected normalized results ($1,575MM in revenue, 46% gross margin, and 9.2% operating margin) an EBITDA - maintenance capex to enterprise value of 10x (significantly below the comps) would result in a stock price of $31, a 37% increase in the value of the company’s stock. I think the operating margin I’ve projected is also conservative considering the historical performance of Lands’ End (9% in 2014) and the average operating margin for the comps (9.9%).
Business Quality
LE appears to have an above average business as measured by return on capital which has typically been above 30% and has averaged 36% over the last 6 years. With 85% of sales coming from catalog and website, the company should be able to grow this portion of the business with only modest increases in capital expense. Furthermore, management has indicated that it will be exiting Sears retail stores once leases expire over the next 3 to 5 years. This portion of the business had a low EBITDA margin of 3% of sales versus 12% for the website/catalog portion of the business in 2014. Separating out the website/catalog business revels that its return on capital was actually 40% in 2014 versus 33% for the company overall. Once LE exits its relationship with Sears, the higher quality of the website/catalog business will be more readily apparent.
Durability of Business (Moat)
The sale of clothing does not lend itself well to “moats”. It is possible for some companies (like Burberry for example) to build a brand that does insulate them somewhat from price competition. This is more difficult for Lands’ End though because it doesn’t put a logo on its clothes and doesn’t market itself as a luxury retailer. It does try to differentiate itself with its customer service and high quality clothes and accessories at an affordable price. The quality of the company’s customer service was recently attested to by a third party report on retail companies performed by Prosper Analytics which ranked LE third in customer service (for the 2nd year in a row) behind only Amazon and L.L. Bean.
Financial Strength
- When Lands’ End was spun out of Sears it took on $515MM in debt and paid a $500MM dividend to Sears. The interest rate on the debt is 4.25% (Libor with a floor of 1% + 3.25% = 4.25%) which is about $22MM a year. In addition LE must make a 1% principal reduction each year or $5.15MM until the debt comes due in April 2021. Therefore, the total debt service is approximately $27.15MM annually. The company should have no problem servicing this debt. Over the last 6 years its EBITDA – estimated independent company costs of $10MM and maintenance capex of $15MM has ranged between $82,673M and $200,355M. In addition, the company currently has plenty of working capital with a current ratio of 2.8x and $178MM of cash on hand.
Catalysts
- One reason that has been noted for not purchasing this stock is the involvement of Eddie Lampert who owns 48% of LE and Sears. The theory is that he will exert control over the company to benefit Sears at the expense of Lands’ End. In reality, Lands’ End sales in Sears stores account for less than 15% of sales and only 4.5% of total EBITDA. The truth is the retail business is not a big factor in Lands’ End results and therefore I don’t expect it to have a significant effect on Lands’ End. In fact, I think that as Lands’ End’s leases with Sears expire over the next 3 to 5 years this could signal the end of the Sears relationship and the dissolution of this fear could be a positive catalyst for the company.
- LE was very small relative to Sears and therefore saw some selling from investors who were primarily interested in focusing on Sears. One such investor is Bruce Berkowitz (Trades, Portfolio) who has sold out his entire position of 7.41 million shares (23% of the total float) of Lands’ End. This near term selling wearing off and the sell-side firms beginning to follow the firm could both provide catalysts for price increases (currently only one analyst from a small brokerage firm is following the company).
Management Compensation
In January 2015 Federica Marchionni left her position as President of Dolce & Gabbana USA to become the new President & CEO of LE. Her compensation package included a base salary of $950M, an annual incentive bonus up to 100% of her salary, a long term incentive opportunity equal to 150% of her salary and 2,750M in stock that will vest over 3 years. So it appears that the majority of her pay will come from her salary and bonuses rather than stock performance which is disappointing.
Risks
Highly competitive nature of the clothing business without significant “moats” to keep out new competitors
Limited track record of current management
If ESL/Lampert begins selling its large stake it would put downward pressure on the stock
Supporting Charts
https://www.hightail.com/download/bXBieEVWUnJRYThYRHRVag
(Cutting and pasting this URL into your address bar will take you to a website where you can download the spreadsheets that were used in this analysis (Comparables analysis, break out of direct vrs. retail businesses, etc)
