Duluth Holdings Inc.
Q2 2021 Earnings Call Transcript

Published: 2 Sep 2021

[Operator:]

Good morning, everyone, and welcome to the Duluth Holdings Second Quarter 2021 Conference Call . At this time, I’d like to turn the conference call over to Donni Case, Investor Relations for Duluth Holdings. Please go ahead.

[Donni Case:]

Thank you, and welcome to today's call to discuss the Duluth Trading's second quarter financial results. Our earnings release, which we issued this morning, is available on our Investor Relations Web site at irduluthtrading.com under Press Releases. I am here today with Sam Sato, President and Chief Executive Officer; and Dave Loretta, Chief Financial Officer. On today's call, management will provide prepared remarks and then we will open the call to your questions. Before we begin, I would like to remind you that the comments on today's call will include forward-looking statements, which can be identified by the use of words such as estimate, anticipate, expect and similar phrases. Forward-looking statements, by their nature, involve estimates, projections, goals, forecasts and assumptions, and are subject to risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed in the forward-looking statements. Such risks and uncertainties include, but are not limited to, those that are described in our most recent annual report on Form 10-K and other SEC filings as applicable. These forward-looking statements speak only as of the date of this conference call and should not be relied upon as predictions of future events. And with that, I'll turn the call over to Sam Sato, President and Chief Executive Officer. Sam?

[Sam Sato:]

Thanks, Donni, and thank you all for joining today's call. My first 100 days were, of course, busy and productive, but incredibly energizing after meeting personally with most of our team members. I continue to be impressed with the level of talent, commitment and energy this team brings day in and day out, and I'm proud and excited to be part of team Duluth. Over the last 60 days or so together with our team leaders, we continued our comprehensive review of our current operations, logistics networks, our marketing and technology capabilities and our unique brands and products. This review provided the foundation to formulate our strategic plan, which we are referring to as our Big Dam Blueprint. Our blueprint, we believe, will set the foundation to unlock our company's full potential for long term sustainable growth and is driven in part by meaningful shifts in consumer behavior. The five pillars to our blueprint are

[Dave Loretta:]

Thanks, Sam, and good morning. I'd like to start by thanking the Duluth Group for all their efforts this quarter. We're pleased with our strong second quarter results. We reported net sales of $149.1 million, up 8.6% compared to the prior year, largely driven by growth in our retail channel. Compared to two years ago, sales increased 22% and represents the third consecutive quarter where the sales growth rate has improved versus the comparable periods in 2019 or two years prior. Retail store sales were up 73.6% to $63.9 million, a significant increase over last year's second quarter when store traffic was adversely affected by the pandemic. For a more normalized comparison, retail store sales were up 3.5% compared to the second quarter of 2019. In addition, we are seeing meaningful improvements in retail level metrics, including average order size, units per transactions and conversion. Conversely, our direct channel was down 15% to $85.2 million compared to the second quarter last year when consumers were under stay-at-home orders and online shopping surged. Compared to Q2 of 2019, direct sales were up 42%. Sales in store markets from both retail and direct digital channels grew 20% over last year, outpacing nonstore markets, which were down 13%. This consistent performance to last year continue to prove out the value of having two channels to meet customer shopping preferences. For the balance of the year, we expect the retail channel will continue to outperform direct as we cycle past the period last year that was impacted by lower store foot traffic from COVID. Additionally, with a strategic decision to shift and increase advertising in the third and fourth quarters, we do expect direct channel sales growth to be flat to positive over last year in the back half of the year. During the quarter, average order value and sales per customer overall increased mid-teens due to the strength of our seasonal offering and being less promotional compared to last year. The higher customer sales productivity offset the decrease in new acquired buyers compared to last year when COVID shifted more consumers to online, and we invested deeper in digital prospecting. As we head into our third quarter, sales growth for the month of August was 13% in total. This included the direct channel sales being up 1.5% and retail up 32%. Compared to 2019, total sales growth in August was 31% with direct up 57% and retail up 7%. Our women's apparel business grew 10% compared to last year and represented 29% of total sales. Strong selling on seasonal fabrications, such as Dry on the Fly and Armachillo in our gardening collection helped women's outperformed in the quarter. Our men's apparel business was up 6.5% compared to last year and over 20% compared to 2019. Our men's apparel benefited from the expansion of lighter weight fabrications and a greater assortment of short sleeve, woven shirts, shorts and swim items. We delivered strong year-over-year profitability in our core underwear category as we strategically pulled back on deeper promotional pricing and digital prospecting compared to last year during the lockdowns. As we shared on our last call, we've expanded our test of selling men's Buck Naked underwear in Tractor Supply stores to an additional 100 stores just recently. As Sam mentioned, our fourth pillar, test and learn, will provide valuable insights regarding how we can engage with new customers and better understand the logistics and technological needs to support wholesale business. Our men's Alaskan Hardgear brand continued to grow, increasing 41% compared to last year and nearly tripling compared to 2019, and highlights the opportunity we have investing in brands that focus on outdoor activities and performance apparel. In addition, we will soon relaunch our Best Made brand with an assortment that reflects our own design and innovation. Under our new strategic framework, we'll continue to invest in new innovative products accompanied by a great storytelling to grow our Alaskan Hardgear and Best Made brands in both the men's and women's divisions. As I will share shortly we plan to increase the level of marketing investments to build brand awareness for these emerging brands and expect the top line benefits will accrue over time, but will likely deleverage advertising in the back half of the year. The investments we're making now in our emerging brands speak to our customers' different needs and will require subtle adjustments to our product development pipeline and marketing program. But ultimately, the goal of our digitally-led growth strategy is to capture new customers and expand business with existing customers to grow the Duluth Trading enterprise. Financially, we are well positioned today to make the investments necessary to drive profitable growth on our path to $1 billion in sales. Our balance sheet and cash flow generation are healthy and provide over $200 million and liquidity to support the growth of our core Duluth business, while investing in our multi-brand platform and to transform our business with the digital first mindset. digital-first mindset. Turning back to our second quarter results. Cleaner inventories led to improving gross profit margin in the second quarter, resulting in a 180 basis point increase to 54.6%. We entered the quarter with 25% less clearance inventory and ended the quarter down over 60% compared to last year. We've continued to see significant improvement in full price selling by strategically dialing back promotional offers. Healthier merchandise margins in both the men's and women's divisions are continuing into our third quarter and will be important for the balance of the year as we navigate the ongoing supply chain disruptions. As I shared on our last call, we are not immune to the numerous factors impacting our inventory flow. In response, we are taking action where we can to accelerate to accelerate inbound receipts and selectively expediting holiday and core inventory orders to ensure in-stock positions during our peak selling period. As such, we are planning to absorb an incremental $12 million and an expedited airfreight costs for key items, and expect this will mostly impact our fourth quarter gross profit rate. Absent the incremental freight costs, our gross profit percent in the back half of 2021 would likely be up as much as 250 basis points over prior year from the strong momentum in full price selling. But with the decision to protect in-stock positions on core items, we expect gross profit rate to be flat to last year in the back half. Turning to expenses. SG&A for the second quarter increased 9% to $68.3 million compared to $62.7 million last year. As a percentage of net sales, SG&A expense increased 45.8% compared to 45.6% last year. This included increases of $6.1 million in general and administrative expenses, $1.2 million in advertising and marketing expenses, offset by a decrease of $1.6 million of selling expenses. Selling expenses as a percentage of net sales decreased 230 basis points to 14% compared to 16.3% last year, driven by shipping cost leverage from retail comprising a greater percentage of the total business. In addition, the higher average order size in direct allowed for improved shipping expense leverage. On our last call, we discussed the challenges in hiring for distribution center staff and plans to increase our hourly wage rates. No surprise our retail stores are also experiencing wage pressure as brick-and-mortar retailers ramp up in advance of the holiday selling season. As such, we plan to address starting wage rates in our stores to remain competitive along with the DC workforce. The combined impact of the cost increases will pressure selling expense leverage in the back half but we still expect our selling expenses for the full year to be 50 to 100 basis points lower than last year on a percent of sales basis. Advertising and marketing costs as a percentage of net sales increased 20 basis points to 8.3% compared to 8.1% last year. We plan to shift our 2021 ad spend where it will make a greater impact on either driving sales or building brand awareness. Also investing deeper in the brand development of our emerging brands will likely offset the efficiencies we're gaining on core Duluth advertising. As a result, we expect to see deleverage on our advertising expense in Q3 of roughly 400 basis points but the full year will be an improvement to last year on a percent of sales basis. General and administrative expenses as a percentage of net sales increased 230 basis points to 23.5% compared to 21.2% last year due to the adding back of temporary expense reductions during the pandemic and the addition of fixed cost from the three stores opened in the back half of 2020 and one new store this fall. Right now, our current store count stands at 64% and we have one new store grand opening in Cherry Hill, New Jersey in November. Currently, we are conducting strategic research on market size and the optimal layout of our store of the future to better inform our decisions as we move forward. Over the next two quarters, we will incur personnel expense from the temporary reductions to leadership compensation last year as well as incremental workforce costs that will reflect new skills and talent to bolster our product development, merchandising, inventory, marketing and digital initiatives. As such, we don't expect to realize leverage on G&A expenses in the third and fourth quarters. Regarding operating margins, given the incremental supply chain costs, which we believe will be transitory and our plans to invest deeper in marketing as well as executing our Big Dam Blueprint, we do not expect to realize operating margin expansion in the second half of 2021. That said, our performance and progress year-to-date will translate into full year earnings growth and increased margins. Adjusted EBITDA for the second quarter was $21.6 million, a 29% increase over last year and 230 basis points of the EBITDA margin expansion. Our net income was $9 million or $0.27 per diluted share compared to net income of $5.9 million or $0.18 per diluted share reported in the second quarter last year. Moving on to the balance sheet. We ended the quarter with net working capital of $84 million, including $19 million in cash and zero outstanding on our line of credit. Compared to the same period last year, we had $80 million outstanding on the line. And as a reminder, with the renewal of our loan agreement in May, the facility is now an all revolver structure of $150 million plus an optional $50 million accordion feature if we need to expand for strategic growth opportunities. Our overall inventory position is in sync with our sales demand, which led to improved inventory turns and free cash flow generation of $11.1 million in Q2 and $21.5 million year-to-date. As I mentioned before, the strong positive cash flow and increased liquidity position will allow us to fund growth initiatives that Sam outlined in our Big Dam Blueprint, such as scaling our emerging brand platform, investing in technology to support our digital transformation and new product innovations, as well as investing in greater automation in our distribution center network. To summarize our outlook for the back half of 2021. We expect direct sales growth to be flat to up low single digits and retail sales growth of up roughly 30% over prior year. We expect gross profit margin to be flat to prior year with a strong product selling margins continuing into Q3 and lifting that quarter's gross margin up 100 basis points, but the incremental expedited freight costs will mostly impact Q4's margin and will be down 50 to 100 basis points. We plan to increase advertising expense by roughly $11 million in the back half of the year, which represents deeper brand awareness opportunities, but we'll deleverage sales by up to 150 basis points. With selling expenses, we expect the sales productivity gains from greater store traffic in the retail channel and ongoing process improvement gains we're making in our DC network will mostly offset the increased wage rates and realized flat selling expense percent of sales. Overhead expenses will increase over last year due to annualizing costs from new stores, technology and logistics projects that are now in service, and personnel expenses from the add back of temporary expense cuts last year as well as incremental resources and wage increases to support our new strategic direction. Our revised full year guidance on sales is $700 million to $715 million, EPS in the range of $0.71 to $0.76 and adjusted EBITDA of $70 million to $72 million. In addition, we expect capital expenditures for the full year to be roughly $18 million, free cash flow generation of $30 million to $40 million and zero outstanding balances on our line of credit at the end of the year. In closing, we delivered strong first half of the year results with healthy sales growth and product selling margins that we expect will continue. Sam and I are energized and excited to execute our Big Dam Blueprint and we look forward to sharing our progress on the next call. With that, I'll open the call for questions.

[Operator:]

Our first question today comes from Jonathan Komp from Robert W. Baird.

[Jonathan Komp:]

I wanted to start more of a near term focus question as we look at the updated guidance and it looks like sort of low to mid-teens revenue growth in the back half comparing against 2019. Could you maybe just talk more about the assumptions you've embedded from a top line perspective, especially since it sounds like August is tracking quite a bit ahead of that? So just any more color on what you've embedded first here in the second half.

[Dave Loretta:]

We are seeing the early trends in August in the third quarter, positive and encouraging. But we're still tracking to 2019’s growth rate and the assumptions, as you said, roughly mid-teens to mid to high teens is really our assumption compared to 2019 as the aspect that we're really looking at is what channel those revenues are going to be coming into between direct and retail. As we noted in our second quarter direct was still down relative to last year, in particular 2020, given the high level of discounting and promotional activity we had. So shifting back to more full price selling, adding more marketing to support that is what gives us confidence in that back half of the year sales. And I think there's upside related to that additional marketing. But I'll say that when we compare our marketing spend to 2019 in the back half, we're going to be spending about the same amount we did and we're going to be expecting a pretty healthy increase over 2019 back half. So that's why we're sort of leveling at the forecast that we're at.

[Jonathan Komp:]

And maybe one more related question, but could you just share more perspective on your supply chain, just the current exposure roughly if you're willing across the major geographies? And is there any risk that at some point, you don't have enough product to sell, given some of the challenges at the factory level in Vietnam right now?

[Dave Loretta:]

We are working as best we can to have visibility there, but it is a risk. We do have production coming out of Vietnam, both in the northern part of the country and the southern. And northern is where most of our production has been and the factory impacts haven't been as great there. So haven't seen a lot of delays coming out of the production. But it's the supply chain, once it's on the water and it gets through and even in more local terminals, there just is a delay. So we're about three to four weeks on average behind on our expected delivery time frame and that's another element that just gives us a little pause for being cautious on that outlook. I'll say our inventory position today, though, is very healthy where we're down in our inventory levels is really in the spring/summer collection, which is exactly where we need to be. We actually today have more fall/winter inventory than we had last year at this time, but we still have a lot that we need to bring inbound to support the Q4 business. So that's where we're at right now.

[Jonathan Komp:]

And last one for me going to the new blueprint. When you think about getting to $1 billion of sales at least by 2025, curious how we should think about really two different aspects that the mix when you think about the Duluth Trading brand versus some of the others you mentioned and maybe new ones as well. Just how should we think about the the mix of sales across the brand portfolio? And then how should we think about how the channel mix might develop as well, understanding it's an area you expect to test and learn on the store footprint side? But how should we think about those two aspects?

[Sam Sato:]

So on the mix question, we're working through that longer range plan, suffice it to say, the Duluth and Buck Naked brands today, as I said in my prepared remarks, represent about 90% of the total. And so at a high level, the plan is to aggressively grow the smaller brands but continue to grow Duluth as well, just maybe at a slower pace given its maturity. And so we think the continued growth of Duluth and Buck Naked as well as then a much more aggressive growth in the other brands leads to a better opportunity for us longer term.

[Operator:]

Our next question comes from Jim Duffy from Stifel.

[Jim Duffy:]

Couple of questions for me, I wanted to start on the digital first mindset objective. I'm curious, do you have the tools in place to navigate through this transition and if not, what are some of the key incremental systems investments you'll need to support that strategy?

[Sam Sato:]

Yes, I mean, that's a really important question as we transform the organization. So as we think about our priorities of capital, the use of capital investment into digital enablement, a big part of our work currently is really assessing where we are relative to that and then the needs. And then importantly, sequencing the investments and the deployment in the appropriate order. And so we're really looking at technical infrastructure and the logistics network in particular. And it's likely that we will start to ramp up and prioritize our logistics network as a priority as well as some of the digital tools that we’ll need to operate the business like a more streamlined and flexible order management system, planning and allocation tool as an example, as well as we've identified some needs to help improve and grow our product development and design capabilities. And so there's a whole long list of areas that we're looking at and we're going through now the assessment of those areas and then the priorities.

[Jim Duffy:]

Dave, I wanted to ask with that context and thinking about the 2025 objective of $1 billion in sales and high single digit, low double digit EBIT margin. It pencils to about $130 million or more of EBITDA. I'm trying to understand the cash generation capacity over that period. Do you have any thoughts on the CapEx requirements to support that digital first transformation or any sort of side lines you want to provide to cash generation between now and the 2025 window?

[Dave Loretta:]

Yes, I mean, at a really high level, Jim, over the next five year period, it certainly could be in the neighborhood of $180 million to $200 million of capital spend, which we can see that that our business can generate the cash flow to support that kind of capital given the systems that we'll have in place to manage inventory flow more efficiently and where that capital is going that supports the whole organization versus in our past four to five years, so much of our capital was going into our store base. We see that the capital can fairly easily be supported by the cash from operations. So on top of that, free cash flow in excess of the capital spend is what we're going to keep as a priority through this period of time to maintain the balance sheet health.

[Jim Duffy:]

And Dave, does the high level you just provided, does that contemplate investment in incremental stores?

[Dave Loretta:]

It does contemplate some incremental amount but it's not to the degree that we've been in the past. And really, we're going to start with some remodel of existing sites to understand store opportunity before we really on any new stores. We don't have anything planned for next year on a new storefront and really, it's focusing on our direct channel as the primary place that the investments will go to support that.

[Operator:]

Our next question comes from Dylan Carden from William Blair.

[Dylan Carden:]

I had a separate question, but I wanted to sort of confirm. Dave, did you say the CapEx number over the next four years is going to be a cumulative 280, did I hear that right?

[Dave Loretta:]

No, what I said was $180 million to $200 million, possibly at the high end.

[Dylan Carden:]

So that's a good bit more than, I guess, we were anticipating. With things like sort of some of the margin pressures you're seeing now, that higher level of spending maybe some marketing increase to support these newer brands. I mean the margin flight path here, would it make sense that you're going to see more pressure in the more immediate term as it relates to some of that spending and some of those layered in costs, particularly in the front part of the four year outlook?

[Dave Loretta:]

The margin pressure that you picked up on for back half of the year is really related to the supply chain challenges that we think our transitory will relieve over the next 12 to 18 months, because underlying that is a healthy gross margin improvement in product sell throughs and efficiency in our selling costs. And then you mentioned marketing, we don't believe that the marketing spend needs to increase relative to what we're going to spend this year on a percent of sales. I think we've narrowed down to an efficiency level that will just continue to improve. But we don't think as a percent of sales that advertising will need to suddenly increase in the future years. It's really just getting back to a level that we should have been at last year if we weren't during a period of this pandemic and uncertainty related to that.

[Dylan Carden:]

So it should be relative -- I mean I'm not going to hold you at any sort of given flight path, but it shouldn't necessarily be a dip down in a dip out, it could be relatively straightforward linear progression in margins to 2025…

[Dave Loretta:]

That is what we're planning for. Yes.

[Dylan Carden:]

And then the question I actually did have is, I'm curious, the brand portfolio strategy and the rethinking of the DTC model here. I'm just curious kind of what the opportunity is as it relates to brand integration, the crossover that you have as far as the customer profile in some of these brands, yielding them up across different brands themselves, marketing efficiencies. And then on stores, how you're thinking about how you reimagine? It sounds like there's a retrofit as opposed to sort of reimagining the store itself. Kind of can you just give a little bit more about what that looks like and what that looks like, particularly from a branded portfolio? Is it going to be all four brands in one location, is there going to be sort of different facades? Just anything there to kind of paint the picture would be helpful.

[Sam Sato:]

Let me start with your first question around brands. So by focusing our brand positions by customer occasion, we believe in totality, we can increase our share of wallet and really creating these unique positions will allow us to reduce, and in many cases, eliminate duplication and so really have a purposeful position by brand. And then longer term, what's important to understand is that our infrastructure and logistics investments are also meant to not only enable the current brands that we have in our portfolio but allow us to develop and integrate new brands into the portfolio with relative ease and efficiencies, and really start to target a broader audience of consumers. So that's really important to us from a longer term strategic perspective. And then in terms of stores, two things I would say. One is yes, we are going to take some of the learnings that we're gathering around what we're calling the store of the future, what it should look and feel like. Importantly, the role that it will play within the omnichannel experience, consumer experience. And so we're looking at the way it's designed, site lines, creating hero vignettes for certain categories and also brands across both men's and women's. And then the second thing I would say is we have purposely decided to pause new store openings beyond the one that we've already got planned for this fall. And largely so that we can learn more about what the consumers value as well as our market opportunities when you couple new stores with our digital proposition, where we have the best opportunity to succeed, grow sales and profits on a sustainable basis. And so we're pausing for those reasons and importantly, because we're going to prioritize our capital investments in technology and logistics. And we think that that's the appropriate path to take in terms of sequencing our investments to enable the enterprise to scale and to continue to grow sales and top line and bottom line.

[Dylan Carden:]

And just on that last point, the sort of the fulfillment infrastructure, just the infrastructure more broadly. I mean you guys have been sort of going in and spending in these categories already. What kind of -- just if you can give me any sense of what gets layered on incrementally as opposed to sort of what you already have that would be helpful.

[Sam Sato:]

So we're really, what I would call, at the beginning stages of automation, there's so much more we can do there that will improve the efficiency of our inventories in terms of movement and usage. It starts to reduce our dependency on these big peaks of hiring people to move products around in our warehouses as our direct business becomes our key priority, the fulfillment through our warehouses. We're getting to a point where it's getting a bit strained. And so automation in that regard improves time, click-to-door as an example, but accuracy and efficiencies. And so the automation piece around logistics, given what the customers expect today, has to be something that is top of mind for us and a priority in order for us to continue to scale the business to the extent that we have been over the last handful of years.

[Operator:]

Our next question is a follow-up from Jonathan Komp from Robert W. Baird.

[Jonathan Komp:]

I just wanted to follow up on the full year guidance raise here for 2021, when you look at the EPS raise. Is there any way you could help us the incremental cost pressure that you're including in the second half? How much that's worth in terms of EPS and more importantly, trying to think through what's temporary or what you might be able to recapture after this year?

[Dave Loretta:]

John, I'd say the EPS impact that we think can be recaptured is certainly in the neighborhood of in the $0.25. When you think about the decision to expedite some key items and holiday goods into bringing them into our warehouse in time because the fear is if we just don't have those goods in hand by the key selling season, we miss out, we disappoint customers. So that's a short term decision that will cost us. But heading into next year, we expect to not be faced with that same decision.

[Operator:]

And ladies and gentlemen, with that, we'll be concluding today's question-and-answer session as well as today's conference call. We do thank you for attending today's presentation. You may now disconnect your lines.