Has the Story Changed at DSW?

Mr. Market wasn't too pleased with footwear retailer DSW's latest financial report, judging by the company's subsequent stock price action. Is it time for bottom fishers to buy in?

Jun 25, 2014 at 3:50PM

Dsw

Source: DSW

Shareholders in footwear retailer DSW (NYSE:DSW) have been a happy lot over the past five years with the company's stock price up more than 400%, a consequence of a sharp rise in overall profitability.  DSW has benefited from better product pricing and consistent annual comparable-store sales growth, a trend that has also helped competitors like Brown Shoe (NYSE:BWS).

However, the company's overall positive trends are showing some signs of cracking. This was evidenced by a top-line decline and worse-than-expected profitability in its latest financial update, data points that received thumbs down from Mr. Market, judging by the negative subsequent stock-price action. So, after receiving a price haircut, is DSW a good bet?

What's the value?
DSW has built itself into one of the nation's largest sellers of footwear, operating a network of almost 400 company-owned stores as well as more than 350 shoe departments within a handful of regional department-store operators. The company runs its everyday-low-price strategy to great effect, creating consistent levels of operating profitability. The net result for DSW has been solid cash flow and ample funds to build out its store base, with a 29% increase in its company-owned store locations over the past four fiscal years.

In its latest fiscal year, it was another year of positive growth for DSW, highlighted by a 4.9% top-line gain that was primarily a function of a larger store network. While the company's operating profitability took a slight hit during the period, due to a failed and since abandoned luxury-footwear initiative, DSW still generated a double-digit operating margin, courtesy of a favorable product-pricing environment. More importantly, DSW generated a solid pickup in operating cash flow, allowing it to maintain a rock-solid balance sheet while investing in its growth initiatives, including a new, small-format store prototype.

Looking into the crystal ball
The question for investors is whether DSW can continue its profit-growth trajectory in the future as management tries to fulfill its goal of an eventual store base of 500 locations around the country. Unfortunately, things are looking a little mixed on that score, based on the company's latest fiscal quarter. DSW reported an increase in operating profit during the period, thanks to an increase in its gross margin, but it also posted a top-line decline, due to a decline in comparable-store sales that was ostensibly caused by reduced customer-traffic volumes.

Of course, DSW isn't alone in its growth challenges, as Brown Shoe seems to be having similar difficulties, evidenced by marginal top-line growth in its latest fiscal quarter compared to the prior-year period. Like DSW, Brown Shoe has benefited from better average product pricing as well as growth in its wholesale channel, which helped it to report a double-digit increase in adjusted operating profit during the period. However, the company's inability to attract increasing volumes of customers to its network of retail stores could spell trouble for the company in its quest to generate consistent comparable-store sales growth, a key ingredient in long-term profit growth.

A better way to go
Certainly, DSW is a better bet at its lower price, especially given management's willingness to use its strong balance sheet to try to recharge the company's top-line growth; this was highlighted by its recent purchase of a major stake in Town Shoes, one of Canada's largest footwear retailers. That being said, the adverse market reaction to the company's most recent financial update would indicate a lack of confidence in DSW's profit-growth story. As such, investors might find better returns with other players in the footwear-retailing sector, like Foot Locker (NYSE:FL).

Despite slightly pruning its overall store base over the past four fiscal years, Foot Locker has enjoyed consistent increases in its per-store productivity as well as a better gross margin, which has led to a big uptick in its operating profitability over that time period. More importantly, its business momentum has continued into 2014, unlike DSW, evidenced by a 14% top-line gain in its latest fiscal quarter that was partially a function of strong comparable-store sales growth, up 7.6%. The net result for Foot Locker has been strong operating profit and cash flow growth, fueling its growth initiatives including a larger presence in Europe through its recently acquired Runners Point Group brand.

The bottom line
On the surface, DSW looks like an intriguing bet with its stock price down more than 20% over the past 12 months, severely underperforming the market averages. However, there appears to be good reason for that performance, given the recent downdraft in the company's top-line growth trajectory, a trend that makes profit growth a more difficult result to achieve. As such, investors should probably wait for another financial update rather than trying to time the bottom with DSW.

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Robert Hanley owns shares of DSW, Brown Shoe Company, and Foot Locker. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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