Betting Lands’ Ends with Amazon

LE_KIDSLands’ End (LE) stock has taken a hit recently with the resignation of its CEO Federica Marchionni and I think this presents a new buying opportunity. My thesis still remains the same, but the leadership void does add risk.

I’m kind of flip-flopping on why I’m interested in this stock. In my original post Can Lands’ End Right Its Ship?, I was arguing to buy Lands’ End because it was under-valued and a potential acquisition just adds upside. I still believe that to be the case, but deep down, I’m really only interested in this company because of the potential “pop” from an acquisition. Rather, the market valuation is simply my “margin of safety,” not the reason I’m buying. So I’m buying it because I think there is a good chance that it does get acquired. Otherwise, I’m not interested in a straight value play because, while I think it does have its niche for the Midwestern classic styling, I’m not completely sold on the long-term growth prospects of the brand. If it’s not going to grow, then the long-term value is not there for me. Its unique business model makes it a truly interesting take out candidate, and that’s why I’m in the game on this one. Let me explain.

Not Much to Get Excited About on the Surface

On the surface, Lands’ End is not much to get excited about. It sells traditionally styled, casual clothing and accessories and it’s known for high quality and customer service and is backed by an unconditional guarantee. It was founded in 1963, so its been in business for over 50 years. So I don’t think it’s going away any time soon, which is a good thing. But at the same time, it doesn’t seem like its going upwards either. It’s not a popular, high-fashion business, but really a solid business selling classic and basic traditional and conservative clothing.

Here’s a snapshot of its financials over the past twelve months.

  • It’s $1.4 billion of annual revenue puts it in kind of a third tier of apparel companies that have sales in the $1-2 billion range. That’s below the first tier behemoths like Nike, Adidas, and the Gap with sales of $4-33 billion, and the second tier of companies like American Eagle, A&F, Burberry, and Guess with sales of $2-4 billion.
  • It’s topline has been declining at a rate of 3.6% over the past three years. The company grew from $1.57 billion in 2002, when Sears first acquired it, to a peak of $1.72 billion in 2011, from which it is now down to $1.37 billion. Definitely a negative.
  • But its gross margins of 45.7% are healthy and at the median for the comp set.
  • It is profitable on an EBITDA basis ($84 million) but had an overall net loss of $36.5 million.

Here’s my graphics on the Tableau Public site–click through the Fundamental story. I apologize that I did not embed it, but Tableau did not display very well within my blog site.

Its Uniqueness Makes it a Prime Acquisition Candidate

So what makes me excited about Lands’ End? I think that it is such a uniquely positioned business in the apparel space that it screams acquisition to me. Let me state my case.

First, while it is not even close to being the largest apparel company, it is, however, one of the largest apparel companies in terms of direct-to-consumer (DTC) sales. In fact, of the comps we looked at, Lands’ End had the second highest amount of DTC sales with $1.2 billion, which trailed only L Brands $1.9 billion of DTC sales. Lands’ End was bigger than Nike, Under Armour, Ralph Lauren and many, many more. So, from an acquisition standpoint, Lands’ End would provide immediate size and scale in the e-commerce space for another apparel retailer or wholesaler. Here’s my graphics on the Tableau Public site–click through the Acquisition story.

Second, Lands’ End’s DTC is so high because DTC makes up the vast majority of its sales–86% of its overall sales. The median percent of DTC sales for the comps was only a mere 15%. Since Lands’ End is almost entirely Direct-to-Consumer, there would be very little fallout and cannibalization if it were acquired by a larger retailer. The same cannot be said about the rest of the comps. How many retailers would stop carrying Polo if Amazon bought Ralph Lauren? This makes Lands’ End as much of a plug-and-play acquisition as you can get.

Third, Lands’ End has a very loyal customer base with very attractive demographics. Here’s an excerpt from their recent 10-K. “We believe that a principal factor in our success to date has been the development of our list of existing and prospective households, many of whom were identified by their responses to our marketing. We routinely update and refine our customer list prior to individual catalog and email mailings and monitor customer interest in our offerings as reflected by criteria such as the timing and frequency of purchases and the dollar amount of and types of products purchased. We believe that our customer base consists primarily of affluent, college-educated, professional and style-conscious women and men. In Fiscal 2015 , our customers had average annual household income of $106,000 and approximately 42% of our customers were within the 36-55 age group, according to an analysis of our customer file with data provided by our third-party consumer information provider using its proprietary demographic, behavioral, lifestyle, financial and home attribute databases.”

The number of apparel companies positioned this way are very, very few. That list includes Lands’ End, L.L. Bean, and to a lesser extent Eddie Bauer and J. Crew, who all have roots in mail-order catalogs. However, the latter two have significant investments in physical stores.

Amazon_Prime_logoWhat Makes it Prime for Amazon?

In the prior section, I gave reasons why Lands’ End would be an attractive acquisition candidate in general. But there are additional reasons specific to Amazon why it would be appealing.

First, Amazon has targeted the fashion and apparel segment as a key strategic growth area. “In order to be a $200 billion company, we’ve got to learn how to sell clothes and food,” CEO and founder Jeff Bezos has reportedly said, according to Brad Stone’s 2013 book about the company, The Everything Store. It has had fashion on its radar since 2002 and has grown its presence mainly through its Marketplace. Amazon’s apparel sales in 2015 was estimated to be $16.3 billion with some forecasting it to grow to $27.8 billion in 2017 (sold by Amazon and third parties). Amazon has built a platform, but now it has to fill it out. As I mentioned in my previous post Stranger Things in Store for Lands’ End and the Man in the High Castle, my thesis is that Amazon will want exclusive (only sold here) apparel brands to fill out its store. This will be akin to its original content strategy for its Prime Video business (same strategy as Netflix and HBO). Lands’ End is a brand that is sold direct and effectively has no multi-retailer conflicts. So its $1.4 billion of sales could be easily brought over to Amazon with little fall off and immediately add 8.5% to the size of its business.

Second, an all cash acquisition of Lands’ End would not dilute earnings. Unlike other traditional businesses that have to generate real earnings today, Amazon does not and is pretty much a break-even business with projections to become enormously profitable in the future. Since it doesn’t have to worry about earnings, Amazon can make acquisitions for growth. Amazon has over $16 billion in cash and generates another $7 billion of operating cashflow less capex annually, so it can easily afford to buyout Lands’ End in an all cash offer. Plus, right now with low and negative interest rates, cash is cheap–that’s why you are seeing lots of acquisitions happening. Okay. That’s not so exciting, but wait for it…

Third, Amazon can generate immediate returns from cross-selling and up-selling products from the rest of Amazon’s store. “Way back in 2006, Amazon reported that 35% of it’s revenues were as a direct result of it’s cross sales and upselling efforts.” (Source and other article citing same figures). This is just adding outside revenues to the Amazon engine so that the Amazon engine can produce another 35% more dollars. On $1.4 billion of Lands’ End revenue, that’s $490 million in additional cross-selling revenue. Multiplying that by Amazon’ 2015 gross margin of roughly 33% generates incremental profit of $160 million per year. Even if it’s just half of that number, that’s still an additional $80 million of profit to the bottom line. And that’s not counting any cost savings, synergies, or growth that could be had from the acquisition.

The Market is Mis-valuing Lands’ End

I think there are two groups of apparel companies: Brands (usually wholesalers) and Retailers. Apparel Brands are more ubiquitous and sold non-exclusively to retailers. Apparel Retailers operate storefronts and sell their usually internally sourced products and labels. Apparel Brands have a much higher valuations than Apparel Retailers. From our comps, the median price-to-sales multiple (P/S) for Brands was 1.33x, whereas the P/S for Retailers was only 0.55x. On a price-to-EBITDA basis, the median Brands was 9.9x and Retailers was only 4.7x. Lands’ End is firmly viewed by the market to be in the Retailer camp with a P/S of 0.34x and price-to-EBITDA of 5.55x. I believe that it is. Here’s my graphics on the Tableau Public site–click through the Valuations storybook.

I think that, because it is a direct-to-consumer company, Lands’s End is better classified as an Apparel Brand. Right now, Lands’ End is being penalized by the stigma of declining foot-traffic at brick-and-mortar stores. Lands’ End doesn’t own many stores and the retail segment of its business is a small, small portion of its overall sales (<14%). So, there is an opportunity for an expansion in its multiple based on being more appropriately classified with other Apparel Brands rather than Apparel Retailers.

In addition, Lands’ End is being penalized because of its association with Sears and its pedigree as a spin-off from Sears. I completely agree with the market’s poor valuation of Sears Canada (SRSC) and Sears Hometown and Outlet Stores (SHOS). Both of these spin-offs are just alternative forms of the broken Sears Holdings (SHLD) business model. Sears Canada is just Sears, but north of the border. SHOS is just a smaller version of Sears that focuses on appliance, lawn, garden and hardware. Actually, it sounds similar to Orchard Supply Hardware, another Sears spin-off that went bankrupt before being acquired by Lowes.

However, I would argue that this comparison is not fair for Land’s End because it is not anything like Sears, nor is it a traditional merchandiser or retailer for that matter. Its core has been in direct-to-consumer sales, not brick-and-mortar sales. So it is really more of a brand, in my opinion. Lands’ End does have a limited footprint via shops within Sears stores, but that’s more of a legacy arrangement that will eventually be going away either from Sears going bankrupt or when the business leases end. According to the master lease agreement with Sears, the last stores leases are scheduled to expire on January 31, 2020. This relationship with Sears was never really a good fit, so the sooner the arrangement ends, the better. For 2015, Retail Segment contributed $205 million in sales and $86 million in gross profit (gross margin of 42% versus 46.7% for Direct Segment). That contribution will drop off over the next four years, which is a negative headwind, but better for the brand over the long-run.

What Would a Buyout Be Worth?

Here’ are some rough buyout prices to create a range:

  • Back in 2002, Sears bought Lands’ End for $1.9 billion, which was 1.2x its Sales of $1.57 billion. Assuming a similar price today, Lands’ End’s equity would be worth about $1.65 billion (Price-to-Sales) or $51 per share.
  • If they purchased it on an enterprise value basis (EV-to-Sales) at 1.2x, we’d subtract out the debt on its books of $491 million. The equity would be worth $1.16 billion or around $36 per share.
  • If Amazon bought Lands’ End at a 1x Price-to-Sales multiple, the equity would be worth $1.37 billion or $42 per share.

If they do get acquired close to the 1x sales price, then we have a nice pop to our trade with a selling price in the range of $36-51 per share. Here are some of the M&A comps that I had in my prior posts supporting the 1x Sales figure.

I don’t know if or when an acquisition would happen, but my best guess would be within 1-2 years. I say that because I think Amazon would like to see how much traction and cross-selling Lands’ End actually brings to its site. I think they should know over the course of a year as their new selling arrangement begins its roll out now.

Key Risks

As mentioned in my original posts, the biggest risk factor is Eddie Lampert. He’s the largest shareholder and controls the company and there’s always issues with that. So that’s a wild card. The new risk is the new leadership void.

Summary

I like the fact that Lands’ End has a truly unique model. It is neither a wholesaler that sells its goods to all retailers, nor is it an apparel retailer with its own large and expensive physical store footprint. It is a direct-to-consumer apparel brand. If you think about it, the mail order catalog model was the pre-internet form of e-commerce. Lands’ End is its own self-contained brand that can be easily ported over into another apparel company’s portfolio with essentially no cannibalization of store sales. If you want immediate online scale, that entire billion dollars worth of sales gets you there immediately. They have shipping logistics and warehousing already set up since everything is sold online or, God forbid, over the phone.

I’m not interested in Lands’ End as part of my core portfolio. This trade is in the portion of my portfolio (10-20%) where I’m looking for higher risk higher reward returns. So I’m not interested in Lands’ End if it was just a pure value play. The only reason I’m really interested in it is that I do feel like it is a great acquisition candidate. Being that it is undervalued, in my opinion, provides the margin of safety, but it does not provide a strong reason for me to invest. The big upside from an acquisition is that reason.

Anyways, I think Lands’ End has value as an ongoing entity, so I don’t think there is that much risk in holding it for the next couple years to see if I can more than double my money. If nothing happens (which is the most likely case), then I’ve mostly lost the opportunity cost of investing my money elsewhere. That’s the rationale for my trade.

 

Disclosure: The author is long LE. Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation. The views expressed in the article are the author and the author’s alone.

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