Interactive Investor

Stockwatch: this FTSE 250 company is a buy again

1st August 2023 11:36

by Edmond Jackson from interactive investor

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Institutional and director share buying has reignited interest in this popular company, and analyst Edmond Jackson believes there’s good reason to follow suit.

Last weekend, a story broke that Sparta Capital – a two-year-old US hedge fund run by a former executive of activist investor Elliott Management – had accumulated a stake in mid-cap footwear group Dr. Martens (LSE:DOCS) and been engaging with management to improve underlying performance. 

It is unconfirmed by published information, but a £50 million holding would not pass the 3% disclosure threshold for a near £1.5 billion company. I imagine Sparta is intrigued by the prospect for turning around US sales given the 1 June annual results proclaimed: “Returning America to good growth is our number one operational priority” after recent mistakes such as a Los Angeles distribution centre. 

This is not isolated buying: Artemis Investment Management passed the 5% threshold on 7 July; implicitly buying at least 2% given it was below the 3% disclosure level. Obviously, it could have meant averaging down a loss-making stake. 

It at least offers encouragement to other holders while forecasts are uninspiring. Consensus expects a near 20% drop in earnings per share (EPS) this financial year to March 2024, with net profit down similarly to £104 million, then a circa 14% recovery to 2025. With the stock around 151p it implies a 12-month forward price/earnings (PE) ratio approaching 14 times, vaguely in line. 

Shifts in the dividend are pegged similarly, with 5.4p a share expected in 2025 actually below the 5.5p maiden dividend as a listed company for 2022. There’s a mid-3% yield.

Ironically, there was £158 million of balance sheet cash as of 31 March and a £50 million buyback programme started only last month. It could have nothing to do with boardroom incentives being geared to earnings per share? 

Dr. Martens - financial summary
Year-end 31 Mar

Turnover (£ million)3494546727739081,000
Operating margin (%)11.515.021.214.625.217.6
Operating profit (£m)40.268.0143113229176
Net profit (£m)-5.717.274.835.7181129
EPS - reported (p)-
EPS - normalised (p)-
Operating cashflow/share (p)4.65.612.
Capital expenditure/share (p)
Free cashflow/share (p)
Dividends per share (p)
Covered by earnings (x)
Return on total capital (%)10.317.627.122.532.621.3
Cash (£m)86.458.4117114228158
Net debt (£m)334332378253166294
Net assets (£m)-29.4-8.470.5151328404
Net assets per share (p)-2.9-

Source: prospectus and company accounts.

Directors have accumulated material equity  

Notably, the CEO bought £400,000 worth of Dr Martens shares at 129p on 14 July, which goes some way to being in the same boat as “outside” shareholders. 

Yet at end-June he was granted over 1.5 million performance shares, which will vest subject to achieving EPS (67% weighting) and shareholder return targets over three years; then subject to a further two-year holding period.  

Now we see a £50 million share buyback programme which will help achieve this remuneration scheme’s principal EPS target. 

One should not get too cynical otherwise one misses a pattern of belief in value existing here. 

Two non-executive directors also bought in June. One could be seen as meeting expectations to hold equity, picking up nearly £25,000 worth at 135p after being appointed in May. But another, appointed in January 2021, followed with a £5,000 purchase near 136p. 

Marketing is the crux in context of consumer demand  

Despite signs of encouragement from two institutions and three directors, I think the reception to Dr Martens’ sales pitch remains key. 

Its strategy is to sell boots, shoes and sandals, with original models at the core. Shoes and sandals enjoyed 51% and 54% revenue growth, respectively, in the last financial year to 31 March. They are seen as a long-term growth opportunity; hence ranges being improved. Boot sales fell 10%, blamed on the Los Angeles warehousing fiasco and marketing mistakes rather than lack of appeal. Ending shipments to a China distributor also affected boots revenue in Asia Pacific. 

Sales growth potential is placed on the use of softer leathers and wider colour ranges, and collaborations with various fashion outlets. Prices have increased by 6% on average to cover supply-chain cost inflation.  

Yet the question remains: what might be the effect of interest rate rises on footwear discretionary spending? Or are the alleged 30-something customers of Dr Martens largely living at home with parents, hence relatively immune to the cost-of-living crisis?  

Theme of mixed trading - wholesale versus consumer - persists 

While March 2023 annual revenue grew 10% to £1 billion, net profit plunged 29% to £129 million. US wholesale was disrupted at a Los Angeles distribution centre - said to be resolved at near-£15 million extra costs - although group operating expenses increased £57 million to £373 million. 

It was thus a tale of two sides, with wholesale easing 3% at constant currency due to warehousing issues, while the consumer-facing side saw retail up 25% (albeit e-commerce flat) and direct-to-consumer up 11%. 

Perhaps Sparta sees potential in 14 new stores opening in the US last year. The US represented 43% of last year’s group revenue and 41% of EBITDA despite a margin hit from warehousing. Europe, the Middle East & Africa dominated at 44% and 60% respectively. 

A 13 July AGM trading statement then cited lower US revenues, chiefly wholesale, while direct sales will take until the second half-year to show meaningful improvement. “Addressing our performance in this region remains our top priority,” the company said.

Overall like-for-like trading since March was cited “in line,” although the first quarter to end-June is the characteristically smallest in Dr Martens’ financial year. Direct-to-consumer sales showed “very good growth” in Asia-Pacific (driven by Japan) and Europe, Middle East & Africa. But wholesale revenue was lower, partly the effect of strategic decisions, and without seeing numbers it is impossible to say if they have largely offset growth. 

Near £300 million net debt implies 73% gearing  

I’m inclined to include leases given they are a cost but which does add to debt given retailers often rely on leases. 

The end-March balance sheet had £299 million of borrowings and £152 million such lease liabilities, mitigated by £158 million cash – resulting in a near £17 million net interest charge, which took 10% off £176 million operating profit.  

The bank debt was refinanced at end-January 2021 with an early-February 2026 maturity date. 

It therefore looks a manageable - if less-than-ideal - debt profile, for the new era of moderately higher debt costs.  

You would think a retailer’s cash generation should help debt reduction, although a need for higher inventory (said to improve availability) walloped last year’s operating cash generation from £208 million to £48 million. 

Reduction in forecasts but still a long-term ‘buy’ 

I drew attention to Dr Martens at 140p last January, suggesting mean-reversion had run too far (from a 515p high in early 2021) amid cynicism at yet another over-priced private equity flotation at 370p a share.  

The forward PE looked then to be around 10 times and the yield over 4% - seemingly low for a brand with proven appeal over decades – but forecasts look to have been worked down. 

The stock still rallied 21% to 170p despite an 11 April trading statement cautioning of 10% annual revenue growth slowing to 6% in the final quarter to 31 March, plus year-end cash plunging. I adjusted my stance to “hold” given a case to lock in short-term gains versus uncertain consumer prospects, but did not see a downgrade to “sell” as appropriate.  

Shares then fell to a 116p low in early July despite the 1 June final results maintaining guidance for March 2024 annual revenue of mid to high single -igit growth at constant currency – plus an improvement in the EBITDA margin.  

The company said: “In the medium term, we expect double-digit revenue growth and further margin expansion.” 

Somewhere along the way, numbers still got downgraded. I would not fixate on this nor chase the latest spike related to Sparta. But the message from recent share buying signals long-term value, hence I again conclude: Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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