Introduction
Duluth Trading (NASDAQ:DLTH) surprised a lot of investors with their results, sending the share price up nearly 20% following the release of their Q2 results. As evidenced by this reaction, the results were fundamentally positive with Duluth now experiencing positive trends across both the top line and bottom line, foreshadowing what I think should continue into the future. And with this in mind, despite the share price nearly 20% higher post-earnings, per the economics I think are achievable going forward, investors can still earn above-market returns at today’s high-$3 price.
Sales: Seeing Improved Demand
Duluth’s Q2 sales came in at $141.6M, up just shy of 2% from the $139.1M they posted in last year’s Q2, and this is also up materially from the $116.7M they posted in Q1 (sequentially), although this comparison is capturing the (material) benefits of seasonality. Within the year-over-year comp, their DTC sales grew 5.6% to $91.7M while their Retail – in-store – sales declined 4.4% to $49.9M. And if we reframe that Retail figure, since their store count of 65 stores – including 3 outlet stores – didn’t change versus last year, AUVs trended from ~$3.22M to ~$3.07M.
At a high level, relative to the sales decline of nearly 6% in Q1, the step up to 1.8% growth is a positive data point and with the magnitude of the sequential growth, reflects an uptick in demand (as opposed to a worsening comp). As I wrote last time when discussing their Q1 results, there seemed to be some stabilization happening and that does appear to be (roughly) the ase. However, the step up wasn’t across the board – Retail was down mid-single-digits in both Q1 and Q2, a reflection of lower traffic partially offset by higher conversions. So, there wasn’t much improvement being driven here. Instead, the improvement came on the DTC side with sales declining mid-single-digits in Q1 to growing mid-single-digits in Q2.
But let’s zoom out and evaluate them as a whole. We know that prices were a headwind in the quarter – they admit in the quarter that “[p]artially offsetting the improvement in product cost was a lower AUR driven by deeper promotions and a higher-than-planned mix of clearance sales this quarter.” And this makes sense too – while they called out limiting their discounting back in Q3 2023, they did admit to promoting more in late 2023 and then called out increased sales of discounted products and a likely higher year (2024) of promotional activity.
We don’t know how much retail prices declined, but we can potentially think about them being down low-single-digits thereabouts, I think – that sounds reasonable. If true, then we can really think about volumes up around 3%-ish on a consolidated basis. Now, if we break it out, the question is whether both Retail and DTC were similarly impacted by the price movement? It’s really hard to say, but if we think about the “deeper promotions” and increased “clearance mix” being the environmentally driven reality that it is, I don’t really see why there should be a material disconnect here – i.e., why DTC might see materially more impact than Retail. Maybe I’m wrong, but this isn’t, in my opinion, much of an explanation for the performance dichotomy.
Now, I don’t necessarily think the trade-off here was a net positive either – i.e., that the associated volume growth was greater than the decline in AURs. After all, they were seeing lower AURs from increased promotions and clearance, both of which are more so a reaction to lower demand. In other words, I don’t think – per their commentary – management was proactively discounting based on new insights into their demand curve – after all, the strategy is to shift away from discounting, not towards it. So, more than likely, once we contextualize the full impact of price, it had a negative impact even once we add in the volume benefits.
What that means then is that if we look at DTC, their mid-single-digits growth is going to have to be driven from something else. I suppose there could be some year-over-year comp dynamics that I’m missing here, but I don’t think so. If we go back to the first quarter, both DTC and Retail were down mid-single-digits, so the Q2 performance gap is a new trend. However, going back to 2023’s results, DTC was up 1.8% in Q2 and was up just over 2% in Q1 2023, so there’s not some visible degradation in Q2 2023’s results which might’ve made the comp a little easier today (or more normalized in Q1). So, admittedly, I don’t fully understand what’s behind the performance delta – perhaps one of you readers can kindly bridge the gap that I’m missing – although I’m not terribly too concerned with it at the moment.
Now, there is a subtle benefit they might be getting here in Q2. As I talked about last time, their Q1 results were impacted by a worse in-stock position that prevented many sales during the quarter. It’s hard to estimate the magnitude of this variable, but one could reasonably imagine that some of the lost sales in Q1 were deferred to Q2. Not all customers, of course, will simply wait until their inventory/stock returns, but as we could all imagine with ourselves, sometimes we do wait and thus, we need to think about some of their Q2 sales coming from deferred transactions. All that said, however, I don’t really think the impact of this to be huge.
Another contributing tailwind – as was called out on the call – is that Q2 contained a whole lot of “newness”, which was very likely a volume tailwind. To give some context, management undertook an initiative to reconfigure their supply chain to allow them to more rapidly respond to customer preferences by allowing them to get new products to market quicker/reducing lead times. As they measure it, their “level of newness sequentially improved in the second quarter and increased by more than 300 basis points when compared to last year.” They further expanded:
“We entered the third quarter with a strong lineup of newness such as Duluth Reserve, Bullpen 3D and Souped up Sweats and we expanded our Plus size assortment including our successful Adjustabust, a bonded zip-front bra with a sleek silhouette and criss-crossed back offering extra support and security.
…
In early August, we introduced Souped up Sweats, Duluth’s take on a better basic, which features a heftier 14-ounce brushed cotton for added softness and warmth. And later this month, we’re excited to launch 2 new Duluth footwear collections, founders and Ground Effect, which will expand our work and casual offerings. Looking ahead, we’re introducing several exciting collaborations and new prints. In the coming weeks, we will continue our beer underwear collaborations with the launch of Hamm’s, alongside a Pheasants Forever collab featuring a new on-brand underwear print.”
This increased level of newness should – in theory – be driving higher sales. And the way they discussed it, it sounds like it is indeed doing just that. I mean, we can really think about it in the same way a new store might add sales – by expanding their product selection into new territories or deepening their selection in an existing area, they’re essentially addressing incremental demand they weren’t previously. E.g., Previously, a customer might just be buying $X of clothes, but with the new selection out there today, that customer might instead now be spending $X + $Y.
So, this variable should’ve been a year-over-year tailwind and should be offsetting the net price headwind that I referenced earlier. And it’s possible that this is what ultimately drove the DTC growth year-over-year, although it’s still not an explanation for why DTC is outperforming Retail – both should have benefitted from such structural increase in the amount of “newness” offered.
One variable that is driving some of the performance dichotomy is a mix shift in their ad spend. On a consolidated basis, their ad spend in Q2 was actually lower than last year on a dollar basis, so when I contextualize Duluth as a whole, I don’t really contextualize there to be any huge benefit from this (although all ad spend is incremental in terms of awareness). However, DTC is seemingly getting more from their ad spend. I say this because DTC is disproportionately benefitting from the growth in mobile – as noted on the call, “70% of visits and 57% of sales came through a mobile device, reflecting increases of 100 basis points and 230 basis points, respectively, and “…conversion on mobile devices improved 10 basis points, and we saw a sales increase of nearly 10% in the quarter.” In other words, if we think about total sales from mobile growing from 54.7% to 57% year-over-year, this translates to a dollar amount of ~$76M in mobile sales to nearly $81M.
Thinking about this fact, based on their historical comments about prioritizing a slightly younger demographic and leaning more into digital advertising and less traditional spend (as well as redesigning their mobile platform), we can infer that versus last year, Duluth is likely shifting their ad spend that’s in turn causing more mobile sales and thus, more DTC sales. In fact, when they released their “Big Dam” Blueprint in 2021, tenet one was to lead “with a digital mindset,” and tenet 2 was to “intensify our efforts to optimize our own DTC channels.” It’s hard to quantify, but 2023 was a year in which they did just this, leaning more into email and social, and while not explicitly mentioned, they probably shifted the mix even more digital in 2024. This is clearly proven out by their new customer profile too:
“Our strategic shift towards targeting younger consumers continues to gain momentum. New consumers are 5 years younger than existing consumers with the average age trending younger for the past several years. Further, when looking at our active customer file for the quarter, the biggest gains in both customer count and sales growth came from customers below 50 years old and importantly, women’s buyers increase in penetration within our target customer.”
So, this could have potentially cannibalized some in-store (Retail) sales? I think so. From a qualitative perspective, you can imagine some prior in-store customers who are now starting to receive more personalized marketing/messaging make a purchase online that they wouldn’t have previously. On the other hand, however, I don’t contexualize the cannibalization to the that material – i.e., when I think about those incremental sales, it’s conceivable that the majority were perhaps new customers with only a smaller portion of that being cannibalized Retail customers.
This is where the analysis of Duluth can sort of get tricky and murky. Bringing this back to a high level, I think it’s reasonable to conclude that today’s sales – on a consolidated basis – are benefitting from product newness bringing in likely a mix of new customer and more spend per existing customer, new mobile customers driving higher DTC sales, and then some carry over from Q1’s worse in-stock position. However, that then doesn’t fully answer why Retail’s traffic is lower – to the tune of nearly high-single-digits lower – if one concludes that the DTC/mobile growth was more new customers than cannibalization.
To this end, I tend to think that their traffic declines do include some organic customer losses, however the tough part is explaining this. From a market (macro) perspective, the market tends be lower, it appears, although it’s not super clear. We can see that Columbia (COLM) posted a sales decline of 8% in Q2, The North Face (VFC) was down 3% – and notably, with higher DTC sales offset by lower Wholesale sales – and Under Armour (UAA) saw a 14% sales decline in North America. However, Levi’s (LEVI) was up 2% in the U.S. and TJX (TJX) saw a 5% same-store sales growth in their Marmaxx (U.S.) segment. So, there are some mixed results out there and we don’t have complete comp data – e.g., on Carhartt, Dickies, etc. – but I think by and large, it’s not inconceivable to me that some of Duluth’s traffic losses reflect some macro softness since last year.
However, I can’t fully rule out the argument that they might have been losing market share as well, which is something I argued last time. If we look at the data above, simply on a consolidated basis which I think is the more appropriate way to evaluate them, it’s not at clear that they’re losing share – i.e., Duluth is not dramatically underperforming the market. However, we know there have been times where they’ve been reluctant to fully price to the market – i.e., limit discounting – and we also know that they’re trying to shift their customer target. From a value proposition perspective, there’s no identifiable degradation that could explain any share loss, but as I talked about last time, there are some emerging and growing brands out there.
Broadly, however, I struggle believing that Duluth is a structurally declining business. Perhaps they’re indeed losing some market today, but on a structural basis, I don’t contextualize them to be long-term losers here. With that in mind, I think it’s reasonable to believe that Duluth can grow into a bigger business 3 years from now. For one, it’s evident that the consumer isn’t actively spending money like she would in a typical, more optimistic environment, so it’s possible that we see this pick up a little from today, which nonetheless appears to be stable. And then two, today’s pricing degradation which, by and large, seems to have roughly stabilized, should fade as well.
Additionally, while there’s only so much more “newness” they can add product-wise, they’ll nonetheless continue introducing products in new, unaddressed categories which’ll fundamentally drive increased sales. And furthermore, one thing we haven’t addressed is their Wholesale opportunity down the line – right now, they have a relatively small relationship with Tractor Supply, but it’s obvious that Duluth has a material number of areas they can eventually grow into.
And then finally, they actually plan on opening 2 new stores in the second half, which, at AUVs of ~$3-3.5M – was $3.5M in FY23 – we’re looking at $6M+ in additional annual sales in 2025 thereabouts – although the store can take time to mature – plus whatever benefit those store openings have on DTC sales, which is non-trivial per management’s comments. So, perhaps something like $10M is a better figure for the business overall in terms of the overall impact those additional store openings have on consolidated sales.
Translating all of this into a precise number is a little hard from a predictive perspective. They’re guiding for $640M in FY24 sales, which amounts to $382M in sales in the back half – by comparison, this would be roughly flat with the $384M they posted in the back half of FY23, so no material improvement or degradation guided post-Q2. This, of course, doesn’t contemplate any addition of new stores, so when we think about FY25 and into the future years, if they’re able to eke out low-single-digit growth per annum, I’m looking at $680-690M in sales in FY26 – call it, $685M.
The biggest thing here is not so much a specific number, but a general direction. Right now, sales are marginally up and they’re expecting flattish sales in the back half, but we still know that this is probably still the case of DTC carrying Retail. I tend to contextualize some of the headwinds being more temporal in nature, and when I think about the additional variables in terms of product selection growth, advertising targeting improvements, new stores, and Wholesale growth down the line, I struggle thinking that this isn’t a business that could grow over time.
Margins: More Growth To Come
Duluth’s EBITDA margins came in at 7.5% in Q2. This is a material increase of ~135 bps from the 6.15% they posted in last year’s Q2, and it’s a massive jump from the 1.6% margins they posted in Q1 2024. Although, the sequential period isn’t the best period to infer trends from given the seasonality of sales and the material impact that has on margins.
Unpacking this year-over-year trend, there are a couple of angles we need to contemplate when it comes to product margins. First, AURs were lower like I noted earlier, which is thus a headwind to product margins. Now, of course it could have been the case that input costs declined along with AURs such that margins were actually consistent, but we know this was not the case – i.e., the reason for the AURs stemmed from an increase in promotional activity and clearance sales. So, this was a clear headwind margin-wise.
There are product margin offsets – tailwinds – however. First, they make a reference to the benefits they’re receiving from their “sourcing initiatives”, one of which refers to them now sourcing more of their clothes/material directly from factories. This is allowing them to cut out some margin they were previously paying. Then secondly, they’ve been flowing through higher cost inventory over the past few quarters, something they called out back in Q1. And concurrently – on the same coin – they should be capturing a tailwind for product margins from the increased amount of newness they’re selling. Admittedly, I don’t know this to be a general fact because management’s never confirmed, but my sense suggests so, although it’s likely immaterial anyways.
Furthermore, as I wrote about in my last write-up, Duluth has been capturing growing benefits from their new fulfillment center in Adairsville. As a reminder, this facility is much more automated, consisting of various new technologies that allows them to materially reduce labor and thus, save on such costs (although yes, depreciation increases, but so long as the facility lasts long enough, total costs should be lower over a decade long period).
To this end though, as they’ve been converting over volumes from older, higher-cost facilities to their Adairsville facility, their costs have been declining per unit of volume. Indeed, management claims that Adairsville’s variable cost per unit (CPU) is ~65% less than their older facilities, reflecting such labor savings. However, with all of these cost savings in mind between the facilities, I must admit that the year-over-year savings here aren’t likely all that much. They didn’t explicitly admit to it, but we can more or less infer that processed volumes were between 50% and 60% in Q2 2023. In Q2 2024, however, they tell us that processed volumes were 58%, so it’s not like there’s been a huge amount of growth to drive huge savings versus last year and thus, were likely immaterial to the year-over-year margin changes.
A similar dynamic applies to their fixed cost leverage. It’s not complicated to see that this is a relatively high fixed cost business given their footprint of 65 stores. Obviously, they’re going to carry material labor and occupancy expenses – as well as lease expenses for various equipment – to support this profile, which can’t be scaled up and down with sales. This is inherently why when sales go from ~$116M in Q1 2024 to just over $140M in Q2, EBITDA grows from ~$2M to ~$10M (~30% incremental margins thereabouts). But all that said, similar to the processing volume changes, the year-over-year change in sales was minimal, so the impact of fixed cost leverage was also minimal.
However, they are still getting increased fixed cost leverage, just not from an increase in sales. That is, a few items have resulted in cost savings since last year, allowing them to do more sales on fewer costs and thus, drive margin. First, ad expenses are lower versus last year, which is a materially positive data point and potentially reflects their growing efficiency here as they continue to shift to more digital channels and selective locations. But then secondly, as they discussed, in the middle of April, they recontracted at more favorable shipping/freight rates – seemingly by contracting with other low-cost providers – which ultimately lowered their outbound freight costs. As such, while sales may be up just marginally year-over-year, they were able to capture some savings here to keep SG&A roughly flat (once you adjust for the sales tax accrual).
From a mix perspective, this is something I’ve also written about previously, but I don’t contextualize there to be any huge impact from this variable either. DTC sales grew a decent amount while their Retail sales declined – resulting in DTC sales to total sales going from ~62% last year to ~65% today – but it’s seemingly the case that margins across both channels are roughly the same. At the gross margin level, the sales mix change was positive as DTC carries higher gross margin given the avoidance of outbound freight costs (to the stores). But when it comes down to the operating level, the margins tend to end up comparable as DTC carries more ad spend.
And also, when we think about mix from a mens and womens perspective, it’s the same. Womens grew more than mens year-over-year, but with the margins being comparable per my conversations with management, I’m not contextualizing there to be any material impact here. And so that’s what I’m concluding for mix entirely.
Putting it together then, we can see that margins grew as a result of increased product margins notwithstanding lower AURs driving increased gross margin. Looking ahead, there are a few things to consider, but first, with respect to today’s margins, now that we’re past the benefits of new freight contracts, inventory flowing through, the structural increase in new products which I don’t contextualize to grow materially more from here, and the fact that the promotional/discounting environment has largely stabilized it seems, I tend to think we’re at a fairly normalized point today.
However, we should see some further benefits. As they discussed on the call, following the end of the quarter, they entered into an agreement to accelerate the termination of a fulfillment center lease they were under as part of their footprint rationalization. As a result, they helpfully lay out the financial impact, noting that once this is behind them, they’ll see a $1.2M reduction in quarterly expenses by Q4 amounting to $5M annually. There is a cost though – they’re telling investors they’ll see cash restructuring costs of $4.4M, but this is one-time. Structurally, this materially improves their cost profile.
So, with this in mind, the way I’m thinking about margins going forward is that if they do $640M in sales or ~$160M quarterly, we can probably think about them doing nearly 8% EBITDA margins on that sales base given the additional operating leverage relative to Q2. That would be ~$12.8M in EBITDA on $160M in sales, or incremental margins of around 20% from their Q2 profile. Layering on top of that an additional benefit of $1.2M post-Q4 and we can think about normalized margins post-lease termination being ~8.75%. And then, from this base, should they grow to $685M in sales by FY26, they could be doing ~9% once we add in the tailwinds of operating leverage. For conservative sake, however, I’m just going to keep it at 8.75%.
As a cross-reference, they’re guiding for $26.5M of EBITDA on $382M in sales in H2, or ~7% margins, so it appears that they’re being rather conservative. In other words, unless there’s a mix shift they’re not telling us about or unless they’re thinking product margins will decline for more discounting, they really shouldn’t be doing sub-7% EBITDA margins on $382M in sales. So, I’m okay using the 8.75% figure.
Valuation: Attractive
Let’s talk capital allocation. Right now, they have around $10M in cash with no bank debt, but they do have just over $34M in finance leases that carry interest expense. But they’re not in any critical situation and do have some flexibility. Their inventory is in a good spot – 90% of inventory consists of current seasons’ inventory – so we’re not looking at huge near-term cash needs here. Although, they are going to spend just shy of $5M to get out of those leases, which I discussed earlier.
From a capex perspective, we’re starting to see a more normalized level flow through, something I’ve written about in prior write-ups. For the first six months, they’ve spent $3.2M on capex, down materially from the $31.5M they spent in the first six months of 2023. As a reminder of the context, in 2023, they were spending a good amount of money on constructing their Adairsville fulfillment center – and their other fulfillment centers too – and buying all of the related equipment. As we can see, that’s behind us now and looking ahead, without any reason to build another fulfillment center like this and no adjacent projects, today’s run rate of ~$6-7M is now reflective of annual “maintenance” capex. (There’s a great slide in their deck on slide 13 showing historical spend and qualitative context per year.)
Now, ~$7M is probably a little too low – I don’t actually think this is a structural, normalized run rate. The way I think about it is that a lot of these investments are necessary for competitive reasons – they just don’t happen per year. So, while capex may be much lighter this year – in the single-digit million range – it’ll likely be heavier in future years. Said differently, if they spend around $80M every 10 years on similar tech and physical infrastructure, we’re really looking at normalized capex in the $15M range per annum, not $7M. Now, that’s a little aggressive – there’s no need to construct new fulfillment centers, for instance, instead of just upgrading the existing infrastructure – but I think it’s at least reasonably conservative to assume that capex is normalized around $13M thereabouts.
On top of that, however, 2024 may end up higher because they may be opening 2 new stores in the second half. Per the Q2 call, they “recently signed 2 LOIs and are targeting new store openings in the second half of next year.” Economically, this doesn’t materially concern me – I think the returns will be fine – but from a capex perspective, this’ll likely add something like $4M thereabouts to capex spend as I estimate each store costs ~$2M or so. I’ll model this in, however, when they do eventually open up these stores.
With all of this in mind, we can now think about their valuation. At today’s price of $3.8/share with 35.035M basic S/O, that’s a ~$133M market cap. Net of $9.8M of cash and $0M of total debt, that’s an EV of ~$160M.
What I’ve postulated earlier was that in the upcoming years – by FY26 – Duluth could be doing something like $685M in sales and $60M in EBITDA (8.75% margins). If we then back out D&A at ~5% (~$36M) – which is lower than the ~6% they’re running today as sales should grow without a concurrent increase in D&A – SBC at 1% of sales ($6.8M), interest expense of $4M – which includes finance lease interest expenses – taxes at 25%, and a normalized capex level of $15M, they’d be posting net income of ~$10M and free-cash-flow of ~$31M. If I’m wrong on margins, however, and they end up structurally earning something closer to 7%, free-cash-flow would come out to ~$22M.
Per what I wrote earlier, this is not a business that’s structurally losing market share nor are there any signs that that will happen or that the market will take a negative turn demand-wise. Thus, considering that and considering the fact that they can probably still open more stores beyond this point – on top of further expanding their selection – I don’t see why something like 14x free-cash-flow is an unreasonable multiple. Ascribing at 14x multiple, that gets me to a market cap of $420M in FY26 on $30M in free-cash-flow. Adding in interim cash flow generation of, just call it, $40M and discounting back to today gets me to a per share present value of $10, materially higher than the $3.8 they’re trading at today.
Economically, the key here is that they’re able to grow their margins and sales like I’m modeling. But even if we assumed this was a structurally flat business at today’s economics – $640M in sales at 7% margins – they’re still looking at high-teens free cash flow, which, at a 10x multiple, amounts to a high-$100M/low-$200M market cap. So, it’s less about the numbers precisely and more about Duluth proving their competitiveness.
Conclusion
Retail’s hard, and I think Duluth will continue encountering more unforeseen struggles in the future – they won’t get every season right or operate in an uncompetitive environment at all times. But structurally, they continue to improve their earnings power internally as evidenced by their margin growth today and with capex now coming down to a more normalized level, Duluth should see higher free-cash-flow levels flow through. As this begins to take hold, I expect the market to appropriately value them.
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