Designer Brands: Not Worth The Risk (NYSE:DBI)

Designer Brands (DBI) had a terrible second quarter. The company was not only heavily impacted by the closing of their retail stores due to COVID, but they were also caught off guard by a change in consumer taste towards athleisure apparel and athletic footwear, as people were looking for comfort. DBI’s low assortment of such products negatively impacted their top line and caused them to lose market share to competitors. Having the wrong inventory also caused DBI to report e-commerce growth of 27% at DSW (its banner retail store), which is low compared to other retailers showing digital growth in the triple digits for the quarter ended.

When we first wrote about DBI, we believed the market was being too pessimistic. Back then, the market was valuing DBI at a discount to peers based on book value and EV/Sales. We believed the value gap would close once the company completed the integration of Camuto, which would give them vertical integration and private brand penetration, levering the brick-and-mortar presence of DSW for increased synergies. We thought better control of the supply chain plus a higher mix of private brands would lift margins from their cycle low.

However, the impact of COVID changed our main investment thesis, and if trends persist, Camuto could be written-off. You see, Camuto is a preeminent dress and seasonal footwear house. Decreased product demand from those two main categories could persist if people continue with their work-from-home routine. Camuto also does a small percentage of business (5%) with wholesale partners; however, the wholesale side of the business remains substantially challenged, as department store customers adjust their inventory position to match current trends.

Can we recommend DBI as an attractive investment now? We don’t think so. Risks are higher now due to the changing landscape and continued uncertainty due to the pandemic. The company faces an uphill battle as they try to win back the market share lost during the quarter. It could take DBI a couple of quarters to match their inventory with current trends, but by then, consumer taste could turn again. We believe there are better risk/reward opportunities in the market, therefore we have a neutral view on DBI.

DBI was caught off-guard

DBI reported second-quarter sales of $489M, down 42.8% on a year-over-year basis, and missing expectations by $106M. The company also reported non-GAAP EPS of minus $1.28, missing the consensus by $0.43. The company saw a decline in comparable sales of 43% during the quarter, compared to down 0.6% in Q2 of 2019.

The worse-than-expected results were the consequence of store closures and a change in consumer taste that caught the company off guard. With people staying at home, there was a clear shift in consumer behavior by way of increased demand for athleisure products. In response, the company started adjusting its product mix during the quarter to match current demand, ending the quarter with athletic inventory representing 24% of their product mix, compared to just 17% in Q2 of 2019, and with Dress and Seasonal accounting for 40% compared to 47% in the prior-year period. For comparison, Caleres (CAL), which we believe is its closest competitor, has 90% of its product mix towards Casual and Athletic.

Management noted sequential weekly improvement once stores reopened, but there was a pause in that trend by mid-June. Currently, store traffic is comping between negative 30% and 40%, with management stating that store traffic has remained consistent at those levels. On the other hand, DBI’s digital business grew 25% during the quarter compared to its prior-year period. That said, we see their growth in e-commerce as rather weak if compared to other retailers. For example, Caleres saw its e-commerce channel grow by 50% sequentially from Q1 and 150% on a year-over-year basis. Management acknowledges their weak product assortment as the reason for underperforming the market:

“And I would tell you, if we would have had — if we’d have known a pandemic was going to hit and could have invested in athleisure inventory the way that some of our competitors are positioned already in advance, right, I’d tell you, we would have done a hell of a lot more business in dot-com, I mean a lot more business because we did not promote dot-com for an athletic standpoint.” – Q2 call

What’s next for DBI

The company drove a very aggressive and promotional campaign during Q2 to drive sales and liquidate their Dress and Seasonal inventories. As a result, DBI ended the quarter with inventory levels down 37% compared to their prior-year period. Their markdown efforts cleared unwanted categories and positions the company to begin the fall season with a clean slate:

“Moving forward, we have significantly decreased future inventory receipts and refocused our orders on currently trending categories. The health of our inventory position allows us to chase into trends as they emerge, and this flexibility is a significant strategic differentiator for DBI.” – Q2 call

There are other initiatives that could add a few basis points to operating margins moving forward. For example, management initiated an internal reorganization and implemented a meaningful reduction in its workforce. Both actions are expected to generate annual cost savings of approximately $40M. The company is also in negotiations with landlords to find better lease terms that would better match with current demand and traffic trends.

What we don’t like

While the company is reducing fixed costs, we believe it’s going to be offset by higher marketing expenses moving forward. It is no secret that many retailers are seeing strength in athleisure. That means, competitors are flooding into that category to chase market share. With DBI starting at a disadvantage, we expect the company to start a big marketing campaign to lure customers into their stores. Another point to keep in mind is customer retention. Competition is going to intensify as companies invest in retaining new customers. That could lead into a heavy promotional holiday season, pressuring operating margins.

Then there is the issue with Camuto. When we first looked at DBI, we believed the acquisition of Camuto made sense from a strategic point of view. By acquiring and integrating Camuto, the company was becoming a vertically integrated retailer with the opportunity to expand its private label brands by leveraging the strong brick-and-mortar footprint of DSW. However, COVID has put the brakes on the increased penetration of their private brands as their product assortment is off-trend with current demand:

“Second and most importantly, the primary reason that we purchased Camuto was to support U.S. retail and exclusive brands and the strong sales synergies with their national brands. However, given that these products have traditionally focused on dress and seasonal products, the business is particularly challenged at the moment. With strong aversion to public gatherings and shelter-in-place mindsets, we have seen the dress and seasonal categories significantly slow, leading to weakness within Camuto.” – Q2 call

As a result, management has reduced future production levels by 73% for the balance of the year. Since the facts have changed, we believe Camuto has added a layer of risk to DBI that wasn’t there before the pandemic. It has also changed our view on the attractiveness of DBI as an investment.

The Bottom line

There were not many positives to take home from DBI’s second-quarter results. We believe the company is going to remain challenged for at least a few more quarters as they adjust their business to current trends.

If trends in athleisure continue, then there is the risk of a permanent impairment in Camuto, adding more pressure to the stock price.

We are changing our bullish stance to neutral.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

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