Cabot Turnaround Letter Issue: September 27, 2023

Apparel Retailers: Everyone “Knows” They’re In Trouble

The economy seems to be slowing, rising interest rates and inflation are pressuring consumers’ budgets, the resumption of student loan repayments adds yet another reason why shoppers will stay away from stores, and mall-based retailers are doomed for extinction. Given all of this and other reasons, nearly everyone is fully convinced that most apparel retailers are doomed.

But as Mark Twain is reported to have said, “It ain’t what you don’t know that gets you in trouble, it’s what you know for sure that just ain’t so.” With that thought in mind, we found five out-of-favor stocks of retailers that have enduring customer franchises or are undertaking turnarounds backed by new leadership and strong balance sheets.

The Buckle (BKE) – This obscure retailer is a bit of a gem even as it is overlooked by most of Wall Street (only one firm appears to follow it). In many ways, this company would be a good fit for nearby Berkshire Hathaway if its long-running owner-operator management team, with a combined 40% stake, ever decides to sell.

The Buckle opened its first store in 1967 in the small town of Kearney, Nebraska, where it remains based today. Over the years, the company expanded organically to its current 441 locations across 42 states. It is highly regarded by customers for its wide yet well-curated selection of jeans (including its own popular brand) which produce about 40% of total sales. The Buckle also carries a broad but similarly well-curated assortment of high-quality, on-trend apparel, shoes and accessories. Unlike mass retailers, The Buckle has built a loyal following for its personalized attention to customer service, its menu of valuable related services and its up-to-date and well-designed stores. Another feature: While merchandising and pricing decisions are made at the central office, each store is given latitude to adjust its mix to suit its particular local customer base. Also unusual: New inventory is shipped daily to most stores, helping to maintain full shelves and fresh merchandise. Discounting is limited to slow-moving items, but the company does not hold store-wide off-price sales. These and many other practices help produce an under-appreciated and highly effective culture as well as a solidly profitable company. The Buckle carries $300 million in cash and is debt-free.

Despite these traits, its shares have fallen 45% from their all-time high and 40% from their 2021 peak. Valuation is low at 4.5x EBITDA and 7.3x per share earnings. The regular $0.35/share quarterly dividend produces a 4.3% yield. Boosting this return is the company’s practice of paying an annual special dividend, which has ranged between $2.00 and $5.65/share in the past three years. A repeat of last year’s $2.65/share special dividend would boost the total yield to over 12%.

Closing prices on September 22, 2023.
Earnings estimates based on fiscal years ending in January 2024, except for ZUMZ which uses January 2025.
Sources: Company releases, Sentieo, S&P Capital IQ, Nasdaq and Cabot Turnaround Letter analysis.

Chico’s FAS (CHS) – Founded in 1983 on Sanibel Island, Florida as Chico’s Folk Art Specialties, this company has had its ups and downs. We discussed Chico’s in our May 2023 letter and continue to find it attractive. The shares have ticked down about 13% since then, reflecting the roughly comparable decline in near-term estimated EBITDA. Chico’s continues to navigate rising marketing and operating expenses, but its revenues and gross margins are recovering. At the end of the most recent quarter, inventories remained in good shape, the balance sheet held $131 million in cash against $24 million in debt, and free cash flow was healthy. The relatively new CEO, Molly Langenstein (previously a rising star at Macy’s), as well as the new CFO, continue to execute a thoughtful turnaround plan. Chico’s shares trade at a remarkably low 2.7x EV/EBITDA and 6.4x per share earnings. Removing the cash balance and the related earnings, CHS shares trade at 4.5x earnings.

Foot Locker (FL) – Shares of this well-known retailer have tumbled more than 70% from their 2021 peak. The current price matches the 2020 pandemic low and is unchanged compared to the mid-2011 price. Two major structural shifts are behind the collapse in investor confidence. The first is related to the company’s relationship with Nike. In many ways, Foot Locker (along with a few other companies like Dick’s Sporting Goods, JD Sports and Sports Direct) was Nike’s retail arm. For decades, Nike relied on these retailers to reach the vast consumer market, primarily through mall-based stores. However, Nike is shifting away from this reliance, instead pushing for more sales directly to consumers through the Nike website and more Nike-branded stores. Nike is also expanding distribution to stores like Cabot Turnaround Letter-recommended Macy’s, adding incremental competition for Foot Locker’s stores. As 65% of Foot Locker’s merchandise are Nike products, this shift represents a major risk.

Second, a similar 65% of Foot Locker’s North American sales are generated through mall-based stores. The secular decline in mall traffic, outside of a handful of still-thriving upper-tier malls, further challenges the company’s prospects.

The result: Foot Locker’s same-store sales are likely to continue to slide 9-10% this year, inventory is bloated and costs are rising. These problems are dragging down the company’s operating margin to about 2-3% compared to the pre-pandemic 9-12% level. Two consecutive and huge guidance cuts, and a “pause” in the dividend, leave investors with little confidence in Foot Locker’s future.

However, the new CEO, Mary Dillon, who joined Foot Locker in September 2022, is bringing her impressively successful experience as well as new ideas to the company. Dillon previously led Ulta Beauty to strong growth in revenues and profits from 2013-2021. She also was an accomplished and rising executive at McDonald’s. A new CFO, chosen by Dillon, similarly brings strong retail industry experience.

The company’s problems are challenging but not intractable. The turnaround strategy will take time (measured in years, not quarters) to be fully outlined and implemented. But investors appear to be assuming that the company will never recover, as the shares are valued at a depressed multiple on depressed earnings. Foot Locker still generates positive free cash flow and its balance sheet carries $180 million in cash. Its modest $450 million in debt will likely be further reduced with strong cash flow during the upcoming holiday period. For patient investors, the current sell-off looks like a good time to start a small position, with incremental adds on further weakness.

Gap (GPS) – Gap was founded in San Francisco in 1969 as a store that sold only “Levi’s, Records & Tapes.” It expanded rapidly across the United States and internationally to become the go-to store for basics like jeans and t-shirts. Gap’s acquisitions of Banana Republic and Athleta and its launches of GapKids and Old Navy further cemented its place as a retailing legend. However, time, changing fashions, and competition, along with numerous missteps and management turnover, have left Gap as a shadow of its former self. The shares are trading near all-time lows and are down 83% from their all-time high of $59 set in 1992, over three decades ago. One indicator of the problem: This year’s sales of $15 billion are 5x their 1992 level while EBITDA has only doubled, to around $850 million. Today’s EBITDA margin of about 6% is sharply lower than the 15% margin decades ago.

However, despite the profit erosion and other problems, Gap’s balance sheet remains remarkably healthy. Its cash balance nearly fully offsets its debt, with the strong cash-generating holiday quarter ahead. Further, its inventory is in good shape, at a level 30% below a year ago. The migration toward franchising its stores, rather than owning them, seems to be improving Gap’s overall finances while not hurting its in-store performance. While the company won’t likely reach its goal of 10% operating margins (equal to an EBITDA margin of perhaps 13%), any meaningful progress would be viewed highly favorably by investors.

Fresh leadership is likely to make major improvements in Gap’s results. Richard Dickson, installed as CEO in August, is well-regarded for his operational expertise, which he put to good use in turning around Mattel’s formerly lackluster prospects. Prior to Mattel, Dickson reinvigorated the Jones Group’s Branded Businesses. He also brings valuable experience as a former executive at Bloomingdale’s.

Gap shares trade at an unchallenging 4.5x estimated EBITDA. The $0.15/share quarterly dividend looks reasonably sustainable and offers a 5.9% yield. While the near-term share price will fluctuate with the market’s economic outlook and the Gap’s quarterly results, and the hurdles to a successful turnaround are high, if the new leadership is up to the task, these long-neglected shares could drive significantly higher in the medium term and beyond.

Zumiez (ZUMZ) – This company is not well known in the investor community even though it has been publicly traded since 2005. Founded in 1978, Zumiez is a Seattle-based retailer of “apparel, footwear, accessories and hardgoods for young men and women who want to express their individuality through the fashion, music, art and culture of action sports, streetwear and other unique lifestyles.” The company operates 608 stores in the United States and 150 in Canada, Europe and Australia, which are complemented by a robust online presence. Zumiez’s shares have been remarkably volatile: Since the IPO, the share price has cycled between 16 and 40 at least four times with no net progress (the current price is fractionally below the 18 IPO price). Slowing spending by its core customer base, more aggressive promotions by competitors, and a fading of the current fashion cycle are pressuring sales and margins. Nevertheless, the company appears to have a resilient franchise among its primary demographic, which has allowed it to recover from each previous downcycle. Zumiez remains debt-free and carries $140 million in cash, despite the increase in working capital typical in this pre-holiday period. Trading at 5.3x estimated fiscal 2025 EBITDA, the shares discount an overly pessimistic future for this enduring franchise.

Thoughts on the Dow Jones Industrial Average

While the S&P 500 Index gets all of the media attention, with its healthy +13% year-to-date performance and the powerhouse returns of the Magnificent Seven¹ mega-cap tech stocks, the old-fashioned Dow Jones Industrial Average (Dow, or DJIA) has a useful story of its own to tell.

Unlike the S&P 500, stocks in the DJIA are weighted by their share price – the higher the price, the larger the weight. Currently, the largest weighting is UnitedHealth Group (UNH). Its $506 share price grants it nearly a 10% weighting in the Dow. The next three largest stocks in terms of weight are Goldman Sachs (6.4% weight), Microsoft (6.2%) and Home Depot (5.9%). Apple holds only a 3.4% weight, while Salesforce has a modest 4% weight. This structure makes the Dow a very different index from the S&P 500 and more representative of the broad market. And, it explains why the Dow’s year-to-date return is a lackluster 4.1%.

Getting deeper into the weeds, one way to see this is to dissect the components of the Dow’s returns. The five best-performing Dow stocks include Salesforce (+56% year-to-date return), Apple (+35%), Microsoft (+32%), Intel (+29%) and Walmart (+15). These carry a combined weight of about 27%, close to the weight in the S&P 500 held by the Magnificent Seven. But all of the remaining 25 Dow stocks have lost 4% on average. And the two heaviest-weighted Dow stocks, UnitedHealth and Goldman Sachs, have both lost 5%. The wonky details of index construction strongly support the idea that the Dow is better suited to measure the performance of a typical large-cap stock.

So, if the typical large-cap stock has had lackluster returns, is there a contrarian strategy in buying the laggards of the Dow, using a “Dogs of the Dow” strategy? For reasons we describe below, we see little current appeal, with one exception, in this approach.

Nike (NKE), the #2 worst stock in the Dow so far this year, is off 22%, partly due to inventory problems, weak China results and cost issues. But the decline is also partly due to a return to normalcy following a remarkable surge during the pandemic. For value-oriented investors, Nike’s valuation at 18x EV/EBITDA and 25x per-share earnings is unappetizing. The shares may have some bounce potential after their sharp slide since July, but as a turnaround stock, Nike shares offer little appeal.

3M Company (MMM), the third-worst performing Dow stock, down 19%, is suffering from lackluster demand, uninspiring innovation and bloated costs, significantly worsened by unwieldy litigation claims for everything from faulty hearing protectors to “forever chemicals.” Despite progress on these issues, a potentially interesting spin-off of its healthcare business, and respectable valuation at 8x EV/EBITDA and 11x earnings, 3M shares still carry immense risk. And the otherwise hefty dividend, which produces a 6.2% yield, isn’t assured.

Structurally challenged industry economics have caught up to Verizon (VZ), the #4 worst-performing Dow stock (-16%). The telecom company, and its competitors, have a perpetual need to invest heavily in new technology, spectrum and service capabilities, even as the industry is mature, which eventually could threaten the otherwise attractive $0.66½ quarterly dividend. Cabot Turnaround Letter recommended Vodafone (VOD) faces many of the same issues but can exit from several marginally profitable countries and tighten its operations to boost its value to shareholders, unlike Verizon which doesn’t have much in the way of these options. Despite the share price slide, the valuation remains fair at best, at 6.7x EV/EBITDA. Verizon shares may have some bounce potential following a favorable earnings report, but a full-on turnaround is highly unlikely.

Shares of #5 worst-performer Honeywell (HON), down 11%, offer little value-oriented appeal, as they trade near their all-time high and are valued at a generous 14.8x EV/EBITDA and 21x per-share earnings.

We see interesting value only in the shares of the worst-performing DJIA stock, Walgreens Boots Alliance (WBA). This company, well-known to Cabot Turnaround Letter subscribers as one of our worst-performing recommendations, has seen its share price slide 43% year to date.

For the most appealing turnaround stocks, we are finding considerably more value outside of the Dow. This month’s Buy recommendation highlights one of these opportunities.

1. The “Magnificent Seven” stocks are the largest seven names in the S&P 500 (excluding Berkshire Hathaway (BRK/B), which recently moved up to #6 from #8) as measured by market cap. These seven stocks are all mega-cap technology stocks whose shares have surged this year, including Apple (AAPL), Microsoft (MSFT), Alphabet (GOOG), Amazon (AMZN), Nvidia (NVDA), Tesla (TSLA) and Meta Platforms (META).

Disclosure note: The chief analyst personally owns shares of Walgreens Boots Alliance (WBA).

RECOMMENDATIONS

Purchase Recommendation: Ammo, Inc. (POWW)

Ammo, Inc. 7681 E Gray Road Scottsdale, AZ 85260 www.ammoinc.com

Symbol POWW Market Cap $240 million Category Small Cap Business Ammunition Revenues (FY2024e) $143 million Earnings (FY2024e) $(2) million 9/22/23 Price $1.99 52-Week Range: 1.56-3.99 Dividend Yield: 0% Price target: $3.50

Background:

Ammo, Inc. produces rifle and pistol ammunition for sport, law enforcement and military uses (about 60% of revenues). These products are sold through big-box retailers like Dick’s Sporting Goods and Bass Pro Shops, manufacturers, local gun shops and shooting range operators, as well as through the company’s website. Ammo, Inc. also owns Gunbroker.com, the world’s largest online marketplace where third parties sell firearms and accessories, which generates about 40% of revenues. Based in Scottsdale, Arizona, the company was founded in 2016 by a now 82-year-old entrepreneur, Fred Wagenhals. This old-school “American success story” previously built from scratch an industry-leading maker of NASCAR toys, which became an NYSE-listed company that he sold for over $245 million in 2005 (NASCAR legend Rusty Wallace is on Ammo’s board of directors). Wagenhals also has earned several high-reputation academic and professional accolades. Ammo, Inc. expanded essentially from scratch to generating $175 million in ammunition sales by 2022, supported by organic growth and the acquisitions of Jagemann Stamping Company (for $27 million) and SW Kenetics (for $6 million). In 2021, the company acquired Gunbroker.com for $245 million in cash, shares and assumed debt. Ammo, Inc. has been a public company since its debut in 2017 via a SPAC merger.

The company’s ammunition revenues nearly tripled and profits surged during the pandemic, helping drive its share price to an all-time high of nearly 10. However, the subsequent fall-off in demand, combined with inflation and other pressures on its customer base, has weighed on revenues, while higher input and operating costs squeezed profits. The share price has tumbled 80%.

Worries about these “typical” problems, as well as atypical problems like a pending lawsuit by the former Gunbroker.com owner, the company’s inherent risk as a small/micro-cap business and the controversial and potentially legal liability-intensive nature of producing ammunition and selling guns, have led investors to abandon Ammo, Inc’s shares.

Analysis:

Ammo, Inc. may appear to be a purely cyclical company undergoing threatening external challenges. But the reality may be very different. We see a young organization working aggressively to become an established, well-run, profitable and shareholder-friendly company. The Jagemann deal provided the then-upstart Ammo with key and high-quality ammunition production capabilities. The SW Kenetics purchase gave it valuable patents for specialized military ammunition and thus a potentially new and attractive market. Its acquisition of Gunbroker.com provided both a highly attractive new market opportunity along with an additional outlet for Ammo’s ammunition products, in essence creating a vertically integrated producer.

More recently, the aging founder, chairman and 6% shareholder has handed over the reins to a capable new CEO. Jared Smith, 45, was hired in January 2023 as president and chief operating officer and promoted to the top executive role in July. Smith has over 17 years of ammunition industry experience and was previously a rising star and general manager of Fiocchi of America, a global and highly respected Italy-based producer of premium ammunition for competition, hunting, and military applications. He brings considerable leadership, P&L, supply chain, manufacturing and strategy experience, including overseeing strong growth and three acquisitions.

Smith’s plans, now underway, include three priorities that look likely to further build the company’s foundation and profits. First, he is shifting the ammunition segment away from low-margin commodity products and toward higher-margin casings and proprietary ammunition. Its new 185,000-square-foot manufacturing facility in Wisconsin provides the modern tools and the capacity necessary to make this transition successful in terms of both higher revenues and higher margins. In addition, Smith is upgrading the firm’s account management, branding and packaging, pricing integrity, and basic operating efficiency. Once these practices and systems are firmly in place, the next steps will include new products as well as more emphasis on international, law enforcement and military sales.

Second, the new CEO is upgrading the Gunbroker.com operations. This business has long operated in a highly compliant manner and appears to be well-designed to limit the risks involved with gun and ammunition sales. One example is that it uses only federally licensed firearms dealers (those that hold a Federal Firearms License, or FFL) as transfer agents. Gunbroker.com essentially arranges a sale online, takes a small fee, then has the products shipped directly to the licensed agent. Gunbroker.com currently has 7.8 million registered users and generates over $1 billion in annual gross merchandise sales volume. Despite these strengths, the segment needs to professionalize and innovate. One potentially significant improvement is to create a shopping cart to allow the purchase of multiple products at one time. Currently, the site allows only a single item per purchase – a significant impediment to revenue growth. In addition, Smith is focusing on improving the customer experience, building more brand awareness and developing new sources of revenue. Similar to the changes in the ammunition segment, Smith is upgrading overall efficiency and productivity at Gunbroker.com.

The third strategic priority is to bring professional management to Ammo. This includes more effective and transparent communications with investors, alignment of management’s incentives with profitability and shareholder value, greater accountability throughout the organization, and tighter compliance, controls and governance. While these initiatives require incremental spending, they will make the organization more resilient and greatly reduce the risk of potentially costly problems. Ammo is also aggressively looking to upgrade its engineering, research and development, sales and administrative teams.

Ammo is committed to maintaining a sturdy balance sheet that will provide a solid financial foundation for its turnaround. Currently, the company holds $48 million in cash against $11 million in debt. Its inventory and other working capital items appear to be in good shape.

Potential investors should be aware of the many risks this company faces. Near-term results will likely be pressured by weak industry conditions and could further sour investor sentiment. Ammo faces a wide array of potential legal, regulatory, social and other gun-centric risks, in addition to more common risks that exist in all small companies. One unusual risk comes from the Steven Urvan lawsuit. Urvan founded and then sold Gunbroker.com to Ammo, but alleged in an April 2023 lawsuit that he was “fraudulently induced to sell Gunbroker.com” to Ammo. Urvan is seeking a partial recission of the sale, along with monetary damages and other relief. Adding to the complexity of this situation, Urvan holds a 17% equity stake in Ammo and, with two allies, holds three of the company’s nine board seats. The company holds the claim as meritless, and based on our outsider’s view we agree. But, this battle could stretch for an extended period, with an unknown outcome, and Ammo is incurring legal fees to defend itself.

While this small-cap turnaround carries considerable risk, there appears to also be immense potential return.

Ammo shares trade at a very reasonable 7.8x estimated fiscal 2024 EBITDA. This multiple, however, may meaningfully undervalue the Gunbroker.com segment. This segment could readily be worth at least 2x sales (a conservative multiple compared to peers), or nearly $360 million. Based on this value, Ammo would be worth $3.40/share as is, even if the ammunition segment had zero value. Given the broad organizational upgrade underway, and a world that seems likely to need ever-higher volumes of ammunition, Ammo, Inc. shares look highly appealing.

We recommend the purchase of Ammo, Inc. (POWW) shares with a $3.50 price target.

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations.

Large Cap¹ (over $10 billion) Current Recommendations

Mid Cap¹ ($1 billion - $10 billion) Current Recommendations

Small Cap¹ (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:
1. Based on market capitalization on the Recommendation date.
2. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNRE return includes spin-off value of BAM shares.
*** GE total return includes spin-off value of GEHC shares at January 6, 2023 closing price to reflect our sale.

The next Cabot Turnaround Letter will be published on October 25, 2023.