Price: £0.89
Market Cap: £851.5M
EPS (TTM): 0.13
P/E (TTM): 8.60
P/E (NTM): 10.07
Dividend Yield: 6.6%
Dec 31, 2023
Elevator Pitch:
I recommend longing Dr. Martens (LSE: DOCS), a UK footwear brand that currently trades at £0.89/10x forward PE ratio. The market seems overly pessimistic about the short-term earnings disappointment and neglects the long-term potential. Assume a terminal PE ratio of 14x (still lower than the average of its peer group) five years out, 35% target dividend payout ratio as planned and 10%+ EPS growth starting from FY2025 (high-single-digit organic growth+ opportunistic buyback), an investment in DOCS would bring in a 20%+ IRR.
Due to the richly priced IPO and the operating/temporary logistics issues in the US, the stock gets pummeled heavily and has depreciated by 80%+ since IPO in 2021. However, Dr. Martens has been constantly strengthening its brand by, for example, reducing the importance of wholesale and putting more emphasis on DTC channels in the past few years, which leads to brand elevation and higher margins. The company has a long runway on increasing penetration in existing core markets and breaking into new market, and boasts of a high-teen ROIC. In my opinion, the issues are mostly temporary, but the long-term potential of the brand remains intact. This leaves us a prime chance to buy a quality stock at depressed prices.
Company Background:
- Dr. Martens (DOCS) designs, markets and sells boots, shoes, sandals and accessories internationally.
- The core markets include UK, Germany, Italy, France, USA and Japan (low penetration, high growth).
- The sales of Originals, namely classic versions like 1460, 2976, and 1461, constitute ~46% of the total revenue.
Investment Thesis:
- The crux of Dr. Martens’ business is brand building. The management team has been paying careful attention to brand custodianship, and gradually shifting from wholesale channel to more differentiated DTC channel (52% DTC mix in FY2023, a ~10% increase over the past 5 years). As a result, the company has increased gross margin from 46.2% in FY2016 to 61.8% in FY2023, which is sustainable and higher than its footwear peer group. There is still more room to increase the DTC mix (management goal 60%+), leading to more direct control and better brand awareness.
- Dr. Martens is less susceptible to fashion risk and obsolescence compared with many of its peers. Most of its products are continuity products/black. Besides, the Originals are iconic and timeless to some degree, which have been in market for many years but still constitute almost half of the total sales.
- The situation is not as dire as many investors might think. The company fared well in core markets other than US in 2023. The DC issues in LA have been largely solved for the moment. The US leadership team was changed due to the marketing missteps, and the new team will put more emphasis on boots, which is the bread-and-butter for the business. The macro headwinds in the US resulted in less consumer spendings especially on discretionary expenditures. All those issues are temporary/correctible, causing no permanent impairment to the brand.
- The major short-term concerns at company level revolve around revenue decline and excessive inventory. 1) Revenue decline. In FY24 H1, total pairs sold down 9%, and revenue down 5% (3% constant currency). The decline is largely due to strategic decisions. 2) Inventory. The company suffers from a glut of inventory, especially in the US, over the past 18 months. The predicament in the US is caused by multiple factors: marketing missteps, macro headwinds and opportunistic inventory planning. However, the management will maintain pricing discipline and the risks of inventory markdown are minimal because 80% of the products are unchanging continuity products. The discounting of non-icon products may affect profitability for the short-term, but the rightsizing of inventory through FY2025 will free up more current asset into operating cash flow.
- The store counts increase by 48.7% over the past 18 months (from 158 to 235), and it takes 3-5 years for those new stores to attain maturity. Since the company uses brick-and-mortar stores to showcase the brand and product range, the spillover effect will also boost e-commerce revenue in those core markets outside of the UK.
- The innovation product 14xx and the launch of repair and resale in the UK are still in their very early innings.
Risks:
- Potential macro headwinds in the UK and EMEA core markets, which might cause another 5% fall in revenue under the worst-case scenario.
- Unsuccessful launch of ultra-modern 14xx products.
Valuation:
The management projected high single digit % decline for FY2024 revenue guidance, but the forward PE ratio is only 10x. If we look past the FY2024 obstacles, it is conservative to assume that revenue grows at ~7% (2-3% average selling prices increase+4-5% unit growth) after FY2024. In this case, EPS is projected to grow at 10%+ per annum (2% margin expansion+1-2% buyback yield after attaining 1x net debt/EBITDA). The management plans to maintain the current dividend payout until it reaches 35% dividend payout ratio. At £0.89, the dividend yield is already 6.6%.
Take a five-year investment horizon. Even if there is no multiple expansion five years out, we could still get an IRR in the mid-teens. Assume a 5-year terminal PE ratio of 14x, then we’ll get an IRR of 20%-25%. The downside risk is minimal for a quality brand at the current valuation.