Fool on the Street: DSW's Missing Piece

Here at The Motley Fool, we believe individual investors should have the same access to information that Wall Street has. In that spirit, we've listened in on some investment bank conferences with major companies and are giving you the rundown. We call this feature "Fool on the Street."

Did I miss a beautiful opportunity?

Shoe retailer DSW (NYSE: DSW  ) has been scooting along, rising 53% since June 2005. It's a spinoff from Retail Ventures (NYSE: RVI  ) , a classic special situation that Joel Greenblatt looks for. In their presentation during the CIBC World Markets conference, President Peter Horvath and Chief Financial Officer Doug Probst remained upbeat about getting more shoes to the feet that want them.

Despite all of the great things that are happening -- good sales growth, good earnings growth, and good strategy -- I remain perplexed. So I'll let you know what I found in the transcript of their presentation and then fill you in on the elephant in the room that nobody appears to acknowledge.

Solid strategy
"You've come a long way, baby" is a pretty fitting description for DSW. Once a close-out retailer that "bought [shoes] cheap and sold [them] for cheap," it now has much nicer stores with a very wide selection of brand-name shoes at value prices.

Selling brand-name merchandise in nice stores with helpful, consultative sales associates -- and good prices -- sure sounds like a winning strategy to me. That strong position helps the company compete very well against department stores Macy's (NYSE: M  ) and Nordstrom (NYSE: JWN  ) . As a result, Probst reminded conference attendees that DSW has a 2.5% market share in the very fragmented, "$39 billion adult footwear market." If we include stores that DSW runs inside Stein Mart (Nasdaq: SMRT  ) , Gordmans, and Filene's Basement, that share would grow to 3.5%. Clearly, the concept is widely accepted by customers, especially women, who make up 64% of sales, and more than 70% if you count the women who are buying athletic shoes.

According to Probst, the company has 233 stores and 365 leased locations. That's still far behind the 4,572 that Payless ShoeSource (NYSE: PSS  ) has around the world. So while Probst says the company would like to get to more than 400 stores, I really wonder if he's sandbagging a bit. He would know more than I, but 400 seems small.

Solid performance
Not only do customers love DSW stores, the company is generating great performance at the same time. According to Probst, "the operating income rate has improved substantially from 5.8% in 2004 to 7.9% in 2006." And he thinks the best is yet to come because management has "aspiration(s) to do at least 10% and go beyond there."

The investments made in changing the store's concept are starting to pay off. That's because, according to my calculations, returns on invested capital (adjusted for operating leases) have improved from 6.2% in fiscal 2004 to 10% last year. And should those margins continue to increase, returns should increase in tandem, creating more value as the company grows. That's about the best combination an investor can hope for!

What's not to like?
Now we come to the part of the story that bothers me a bit, that elephant in the middle of the room. It's not a really big elephant, but I've noticed it. And that's the lack of cash flow growth over the past few years.

Despite the impressive sales and earnings growth, operating cash flow has been declining, mainly due to increasing inventory. I realize the company must invest in inventory to keep growing, but inventory growth has started to outpace sales growth. That's a definite yellow flag to keep an eye on.

Is "chasing the new hot brand and making sure they are included in the assortment" causing a problem? It could be if you're always buying hot new products before you've sold all of the last ones. And while Horvath says the goal is to be "a 6 times [inventory] turn per year business," that's going to be a tough goal to meet. That's because it has been a four-turn business for quite a long time.

In addition, Horvath says that he wants to improve the sales productivity of stores, measured using sales per square foot. That would provide a big boost if management could move that number from about "$218 over the last couple of years" to more than $300 that the most productive stores are doing. Improving sales productivity, inventory turns, and margin improvements would turn a very good business into a great one.

The Foolish bottom line
So, as an investor, I face a conundrum. I am looking at a business with a solid strategy, good management, and solid performance. Yet, declining cash flow has pushed the price-to-free-cash-flow ratio up to 35, which indicates to me that the market is already pricing a lot of future success into today's price. As such, management must meet some high expectations. That, to me, is a risky situation. I would prefer a much cheaper stock price to benefit from an increase in performance rather than paying up to join the crowd.

Sorry, guys. I really love what you're doing at the company, but I have to give you the tag great company, not-so-great stock.

For more on the companies mentioned, check out:

While not all small companies turn into big ones, small companies can be great opportunities. At Motley Fool Hidden Gems, Tom Gardner and Bill Mann search for those underappreciated companies. And given their performance, they've found plenty. To learn more, take a free 30-day trial.

Retail editor David Meier is not married to a shoe girl. That may not be good for DSW, but it's good for his bank account. He does not own shares in any of the companies mentioned. The Motley Fool has a disclosure policy.


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