Destination XL Is Resilient, Has A Growth Plan, And Is Cheap (Upgrade) (DXLG)

Destination XL (NASDAQ:DXLG) is an apparel retailer serving the big and tall men’s market.

I commended the company’s characteristics, strategy, and management in a recent article. I issued a Hold rating on macroeconomic uncertainty and a fair but not opportunistic price back then.

After releasing Q4 results, DXLG’s stock suffered a big setback. In addition, the company accumulated more cash, kept its operations stable, and announced a new growth plan for the future.

I believe that under new information and with a lower EV, the company’s stock has become an opportunity below $3.6 per share (corresponding to a $200 million market cap and $140 million EV), and I changed my rating to Buy.

Recapping

My latest article on DXLG is recent and has more detail on its operations, but here are the main points

DXLG serves exclusively the big and tall market and focuses on providing tailored fit, exclusive service, and broad assortment to this market. It has 280 stores in the US. DXLG sells several price points and occasions, but I speculate that it sells more on the high(er) end because of its high (60%) contribution margins.

The company struggled for many years pre-pandemic with a bad strategy. Since 2019, a new management team is executing. It has kept SG&A fixed despite 30% increases in labor costs, a $10 million increase in advertising, launching a website and apps, and remodeling stores. Thanks to eliminating most promotional activity, store productivity and contribution margins are much higher.

At the time, a break-even analysis showed that the company would be ok even with a 10% to 15% fall in revenue. The figure did not seem impossible.

Recent quarterly info

Q4 is the make-or-break quarter for retailers. It generally concentrates sales and, via higher store productivity, most of a retailer’s operating income. This is not the case for DXLG, whose sales are stronger around spring, summer, and Father’s Day.

Still, in this context, DXLG presenting relatively stable quarterly results is good news. The company’s sales fell 5% (10% on a comparable basis). However, last quarter sales were falling at an 8% rate. On the other hand, the company’s gross margin is 1 percentage point lower than last year, but that is actually not so bad news if comparable sales are 10% lower because it means the company is not deleveraging as much. The operating margin deleveraged two percentage points.

The company maintained its policy of lower discounts, meaning that most of the sales fall came from lower volumes and mix (mostly reflected on lower CoGS).

These results are not of growth but rather of a shrinking market. However, considering them in the macroeconomic context, especially considering how the fall in sales did not trickle down as much in margins (the main peril of retailers is operating leverage), they look more promising.

Management said lower sales were caused by lower store traffic and customers trading down to more entry-price products.

New growth plan

In the company’s earnings call, management also presented a new growth plan.

The first goal is brand building. The company hired an advertising agency (Barrett Hofherr and Media) and plans to launch TV and YouTube commercials that increase customer awareness. DXLG’s management believes that unaided awareness is too low (35%) across the big and tall population; therefore, many people simply don’t know about DXLG’s stores.

The second goal is to open more stores. The company did not open stores until 2023 when the new management team arrived in 2019 with three new stores. Management wants to ramp up the plan with eight stores in 2024 and fifteen from 2025 to 2027. Also, the remaining 30 stores belonging to the legacy Casual Male concept will be progressively converted to Destination XL. Management’s rationale is that some demand is untapped because the company does not have close or convenient stores.

Updating the model

This plan will need investing. Specifically, Destination plans to increase its advertising budget from 6% to 7/7.5% of sales. It also plans to raise capital expenditures from $17 million this year to potentially $25 million next year. Finally, with the store base growing close to 3% this year and 5% forward, SG&A will increase in line.

Management has guided for a decrease in EBITDA margins of 3 percentage points (from the current 10.5% to about 7/7.5%). This makes sense, considering at least one percentage point from higher advertising and higher SG&A without higher revenues (the company is guiding for flat to decreasing revenues for the year, with a guidance of $500/530 million compared to $530 million in FY23).

In my last article, I considered a fixed SG&A of $260 million, including rent expenses (which are included in gross margins in DXLG’s statements). If we update for the higher advertising ($8 million or 1.5% of $530 million) and the 3% higher SG&A ($8 million) from the store openings, we will arrive at fixed costs of about $276 million next year. We should add another $4 million from higher D&A non-cash, but included in accrual, as the company spent $17 million last year in CAPEX and plans to spend $25 million next year, but D&A is only $13 million. The final fixed cost figure comes at about $280 million.

I explained in the last article that gross margins adjusted for lease expenses (what I call contribution margins) are closer to 60% today for DXLG, a reality that has not changed with the last quarter’s results.

Also, the company has substantial NOLs ($40 million federal, $50 million state), which means it will not pay taxes for some years.

I also updated my model by calculating sales instead of revenues. The difference is that instead of revenues falling, what falls is CoGS, meaning fewer volume purchases. Then, we speculate on different gross margins, and from there, we derive revenues and gross profits, remove fixed costs, and arrive at a profitability metric (NOPAT).

I believe this system is better because different factors can cause falling revenues. For example, one is falling margins via higher promotions, and another is via lower volume sales, as people do not purchase as much as before.

The table provides a good understanding of what can happen next year.

The first important information is that the worst scenarios come with lower contribution margins. This is why I like the company’s policy of not doing promotions. The company is better off losing 15% of sales at the current 60% margins than maintaining the same level of sales at 55% margins.

The company has guided for flat gross margins and 5% lower sales (considering the lower end of their guidance). The table shows that the company could resist even a 10% fall in sales without going into the red, again, as long as margins are maintained, which I believe management is committed to.

The consensus is for an improvement or flat conditions in 2024, with less pessimism than in late 2022 and 2023. Even during 2022, DXLG continued growing, and in 2023, comparables are worse off (10% lower), but the company’s revenues fell only 4% from the peak, thanks to conversions and opening. This year, the company will expand its store base by 3% and increase its advertising budget, which should help sales slightly.

With $60 million in cash and short-term investments, the company could sustain a couple of years of even 20% lower sales (GFC level crisis) at consistent margins.

Valuation

For the last portion, we reapproach the valuation. Currently, DXLG trades for an EV of $140 million. This is less than a 10x EV/NOPAT under the company’s guidance scenario of 5% lower revenues next year at flat margins.

But by extending the valuation a little, we can invert the process and ask what expectations are needed to obtain a specific return from DXLG, say 10%. In the table below, I calculate the IRR of an investment with a negative cashflow equal to the company’s EV at time 0, plus an original NOPAT of $15 million (a 3% operating margin on $500 million sales), and that after five years, the stock can be sold at an EV/NOPAT multiple of 10x.

The table shows that under the assumptions above, the return is close to 10% even if the company’s operating income falls to $15 million next year (from the current $45 million) and then keeps falling 5% for two years to remain flat.

Of course, this is an assumption exercise with potential flaws, like considering an exit price of 10x EV/NOPAT. By changing the exit multiple to 7x, the return is only 4%. However, the table makes relatively conservative assumptions, too, including falling sales, operating income decreasing by two-thirds this year, and then shrinking more, and the stock still generates a positive return.

This is what I consider a margin of safety. That is, a lot can go wrong, and the stock still has the potential to result in a positive (albeit low) return. On top of that, we get the positive characteristics I like about DXLG, meaning operationally efficient, conservative, and sincere management, a relatively premium-priced position in the market, and a niche focus that other retailers are not pursuing.

I believe DXLG is a buy at these prices.

Risks

We have already touched on breakeven scenarios and the company’s strong financials. One last risk I want to talk about is stock price risk.

The company has guided for a challenging first half of the year. Comparable sales will continue to fall at 10%, implying 5% consolidated, and the company will start seeing the cost of higher investments (advertising, signing lease contracts, hiring people, higher depreciation) without so much of a return.

This means the results in Q1 and Q2 could be bad comparatively. I do not expect operating losses because the first half is stronger for store productivity at DXLG. However, sales and margins will come lower than next year, potentially having operating profits. Starting from last year’s 1H $265 million sales to this year’s $251 million at 60% contribution and $140 million fixed expenses leads to operating profits of $11 million compared to $20 million for 1H23.

Management has warned about this, which may have caused the fall in price after the earnings announcement. However, markets can forget, and the comparables will not be pleasant. This means the investor in DXLG should expect more volatility in 1H24. Further, the plan will take time to yield results, generating depressed margins. On the other hand, if the stock dips in 1H24, it could become an additional opportunity to buy a cheap stake in the company, so the investor may prefer a patient approach to buying DXLG’s stock.

My opinion is that below $3.6, or a market cap of $200 million, EV of $140 million, DXLG is a Buy.