Cheap Stocks Wall Street Loves: Lands' End, Inc.

Wall Street rates Lands' End (LE 3.05%) a "buy," while investor enthusiasm remains relatively tepid. The stock of the apparel, accessories, footwear, and home products retailer is up 30% since the company was spun off from Sears Holdings in April, thanks to two solid quarterly earnings reports. However, it still only sports a price/earning-to-growth ratio, or PEG, of 0.84. A PEG of less than 1 generally indicates that a company is undervalued -- or "cheap" -- based on analysts' estimates for long-term growth. 

Let's look to see what's up, and whether Lands' End appears to be a potentially solid investment. First, I'll explain what I believe to be a big factor, and then we'll get into the financials.

Source: Lands' End.

The Sears effect: an anchor on investor enthusiasm
Surely, one main reason for investors' lukewarm feelings toward Lands' End stems from what I'll call the "Sears effect."

There are two related parts to this: the financial and the brand image. Sears has been struggling financially for years, so it's likely a spinoff wouldn't look too appealing to some investors. In fact, Sears' spin-off history has been dismal: Shares of Sears Hometown and Outlet Stores are down 52% since the company was cut loose in 2012, while the 2011 spin-off of Orchard Supply Hardware filed for bankruptcy last year. 

Then there's the brand association, which is likely fairly strong, especially among those who weren't familiar with Lands' End before Sears bought the company 12 years ago. While Sears has long been known to offer solid, quality tools and other hard goods at fair prices, it seems safe to say it's not known for its high-quality or stylish apparel. Conversely, Lands' End has long been recognized for offering high-quality, classic clothes. 

One main reason a company such as Sears acquires a company such as Lands' End is in hopes that some of the higher-status brand's pixie dust will rub off on its overall image. This rarely works, and the parent company often puts little effort into nurturing the acquisition and milks it for its cash flow, resulting in the acquired company suffering damage to its financials and reputation. Then the parent company usually divests the now-weakened acquired company at a lower price than what it paid. Case in point: Sears acquired Lands' End in 2002 for $1.9 billion, while Lands' End's market cap was less than $1 billion when Sears spun if off. Even with the $500 million dividend Sears extracted from Lands' End as its cost of freedom, Sears still lost money on the deal.  

So, Lands' End surely needs some TLC to regain whatever quality and customer service image it lost under Sears' ownership, and has some work to do to sever the Sears association. 

Smooth early sailing, but the Sears' seas are choppy
Investors were originally wary of Lands' End's stock, sending shares down more than 20% soon after the company sailed onto the public market seas. However, thanks to better than expected results in both quarters since it was spun off, the stock headed strongly into positive territory.  

LE data by YCharts.

For the first quarter of fiscal 2014, Lands' End's revenue increased 3.6% and comparable-store sales rose 3.4%. While these increases are modest, they still represent growth, and were viewed positively as Lands' End's revenue had been on a slight downward trajectory. More notably, the company's earnings per share jumped 48% to $0.34, driven by a slightly widening gross margin and reined-in costs. 

Lands' End followed up with a solid second quarter. Revenue rose 5.4% and comparable-store sales increased 2.8%. Net income increased 4.9% to $11.8 million, while EPS rose 5.7% to $0.37. These results were better than the headline numbers would suggest. One main reason is that expenses included $2.9 million of stand-alone costs related to becoming a public company. The gross margin reflects the true picture: it rose 3.1 percentage points to 48.5%. 

There's an additional factor at play with the year-over-year comparison, and this one could make for somewhat rough seas ahead. Net income was adversely affected by $6.2 million in interest expense, which is due to the $500 million in debt Lands' End took on to pay Sears a dividend prior to the spinoff. The company has a fairly hefty debt load, with a 1.4 debt-to-equity ratio; by comparison, Gap's D/E is 0.5.

However, Lands' End has a strong free cash flow -- more than double its trailing-12-month earnings -- which can support this level of debt. Of course, the debt load could become troublesome if free cash flow was adversely affected, which could impair the company's ability to invest in growth.

Source: Finviz.com.

While the debt load is a legitimate concern, I don't find it as worrisome as some others do, because of Lands' End's business structure. Lands' End is heavily a direct sales business, with 84% of its revenue in the most recent quarter derived from online and catalog sales, and only 16% generated from its relatively small brick-and-mortar presence. Not only is Lands' End traditionally a direct sales merchant, but more consumers are moving toward online shopping, and direct selling is more cost-effective than selling via physical stores. Given these facts, it seems highly unlikely that Lands' End's near-term goals are to aggressively build out its physical retail presence, which would, indeed, be costly. 

Lands' End is priced at a discount based on its PEG, but even more so based on its free cash flow. A P/FCF of 7.5 for a stock that is expected to average 20% growth over the next five years is a downright value. However, it's important to note that only one analyst follows this stock, so that 20% growth projection isn't a "consensus" figure. Additionally, surely a big reason the stock is selling at a discount is that Lands' End's fortunes are still tied to Sears in the following ways:

• 16% of its revenue is derived from its physical stores, most of which are shops located within Sears stores. If more Sears stores close, the number of Lands' End locations will shrink. 
• 48% of its shares are controlled by Sears CEO/billionaire hedge fund manager Eddie Lampert, which means he is still largely running the show. 
• In addition to Lands' End CEO Edgar Huber, who joined Sears and Lands' End in 2011, three of the six members of the board of directors have ties to Sears.

The takeaway
Lands' End stock offers a compelling value, but only for those who believe the company can achieve the projected long-term average annual earnings growth and not have its fortunes too negatively affected by its ties to Sears. As a long-term Lands' End customer myself, I'm fairly confident of the former; however, the Sears' connection is a wild card. As such, Lands' End stock is best suited for those who have higher risk tolerances. Additionally, potential investors might wait to see how the company performs in the ever-important holiday season quarter.