Duluth Holdings Inc. Q4 FY2020 Earnings Call

Good morning and welcome to the Duluth's Holdings Fourth Quarter 2020 and Fiscal Year Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Donni Case, Investor Relations for Duluth Holdings. Please go ahead.

Thank you, and welcome to today's call to discuss Duluth Trading's fourth quarter and fiscal year financial results. Our earnings release, which we issued this morning, is available on our Investor Relations website at ir.duluthtrading.com under Press Releases. I am here today with Steve Schlecht, Chief Executive Officer, and Dave Loretta, Chief Financial Officer. On today's call, management will provide prepared remarks, and then we'll 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 Steve Schlecht, Chief Executive Officer of Duluth Trading. Steve?

Good morning and thank you, everyone, for joining today's call. It was one year ago almost to the date that we announced our first store closings primarily in the northeast due to COVID. At that time, we didn't know just how far-reaching the impact would be, but it was clear that our plans for 2020 were suddenly disrupted. I won't go into all the details of our COVID response as it was pretty much standard procedure for all responsible retailers: protect the staff and customers and protect the financial position. What I think is more important are the lessons we learned from operating in an altered retail reality. First lesson, you don't know if your business model is resilient until it's pressure tested. By the end of March, all 62 of our existing stores were closed due to the pandemic, and we had absolutely no idea when they could reopen. In the prior year, retail store sales accounted for 43% of total revenues, so this circumstance presented a giant mountain to climb to fill that revenue gap. Fortunately, we already had a strong omni direct channel in place that allowed customers who traditionally shopped in stores to shift their buying patterns online. When our stores closed, we also ramped up digital marketing and promotions to draw current and new customers to our website. And it worked. Direct sales closed the retail gap and ended the year accounting for 72% of total 2020 sales. The second lesson was that the currency of the Duluth Trading brand was validated in a difficult retail environment. When your entire organization is dedicated to creating innovative, solution-based, high-quality products and an outstanding customer experience, you have created a lifestyle brand that can prevail in challenging times. Our online activity soared as both established and new customers recognized that Duluth products are at the sweet spot of their new normal at home and outdoors. As customers found their way to the Duluth Trading brand, we saw a 17% increase in new buyers, the largest percentage gain in 3 years. Our third lesson: never stop investing to make your company stronger and more competitive. Were it not for the substantial investments made over the last 3 years in distribution facilities expansion and capabilities, and replatforming our e-commerce channel, and value-added services like BOPIS, we would never have been ready to handle the surge in direct business. Fourth lesson: believe in the power of newness. During the past year, we expanded our playbook to focus on new ways to delight customers. We made headway building out our family of brands platform that celebrates the can-do spirit of Duluth. We developed 40 Grit, a no-frill basic workwear line to appeal to a younger, more price-sensitive customer. We expanded our Alaskan Hardgear line with a new fishing collection and added the Best Made brand of premium hard goods and workwear to our family of brands. We continue to drive innovative product development with new lines like swimsuits for men and women, Dang Soft underwear, NoGA Naturale and additional pant sizes for men. For all these reasons and the challenges encountered in 2020, I'm very proud of what our team accomplished to deliver net sales of $639 million, up nearly 4% year-over-year; adjusted EBITDA of $55 million, up 7%; and free cash flow of $38.5 million. So what's ahead in 2021? As we discussed before, we have paused our retail store expansion until there's more clarity around consumer buying patterns post-pandemic. Right now, we have only one signed lease for 2021. Looking beyond this year, we'll be testing new store concepts to reflect the changing retail environment. We'll continue to focus on new product innovations and potential line extensions, including possibly adding a women's collection to 40 Grit, Alaskan Hardgear, and Best Made. We'll continue to make investments to expand digital capabilities that will provide more customized marketing and improve our localized assortments in stores. We are exploring the benefits of partnerships. In the beginning of March, we entered into a pilot test with Tractor Supply Company to have Duluth displays of Buck Naked underwear in 13 of their stores. Tractor Supply is not only one of the biggest successes in retail today, it is also closely aligned to the Duluth customer base. If the pilot is successful, the concept will be rolled out to other Tractor Supply locations. I think this type of partnership makes sense for Duluth. We see this as a great opportunity to expand our brand awareness with a top-tier partner. That said, it's way too early to count any chickens. In today's press release, we announced that Board member Dave Coolidge has decided to retire at the time of our upcoming annual shareholder meeting. Dave has been involved with Duluth for 20 years, having served on our earlier advisory board and then on our public board, providing invaluable advice and guidance to our company. Brett Paschke has been slated to replace Dave on our Board. Brett is a partner and Managing Director of William Blair's Equity Capital Markets and was instrumental in bringing Duluth public. His deep experience in the capital markets and public company directorships will be a complementary benefit to our Board. I also want to mention that we have engaged a search firm to identify our next Chief Executive Officer. When I reassumed the CEO role in September of 2019, I didn't expect to stay on this long. However, COVID made the continuity of leadership a deciding factor. Frankly, jumping back into day-to-day management gave me a greater appreciation for the talent and dedication of our team. I'm proud of the work we did together during the most trying of times, and I've more confidence than ever in the future of the company. Finally, Duluth Trading has always been committed to the principles of corporate social responsibility, and many of its principles are embedded in the values that shape our culture of striving for greater purpose, like treating customers, coworkers, and vendors like next-door neighbors, striving for growth, both personally and collectively, building lasting satisfaction into our products, and achieving a fair profit. I admit that we have been a laggard in communicating our commitment to CSR and ESG, but in 2021 we are going to do a better job. We have already formed an ESG Steering Committee and are adding ESG to the oversight responsibility of a nominating governance committee of our Board of Directors. We understand this is an important initiative for our many stakeholders, our customers, employees, vendors, investors, and the communities in which we have facilities. With that, I'll turn the call over to Dave Loretta to cover the details of our financial and operating results for the fourth quarter and full year. Dave?

Thanks, Steve, and good morning, everyone. I'll begin today with a brief overview of our fiscal year results. Then I'll cover our fourth quarter performance and conclude with commentary on our outlook and guidance for 2021. As Steve mentioned in his comments, the Duluth team rose to the challenge and demonstrated agility and resourcefulness throughout a difficult year, the strength of our omnichannel model shining through as many customers shifted to online while retail stores were closed for up to 10 weeks during the early stages of the pandemic. We delivered net sales of $638.8 million, an increase of 3.8% over the prior year. Our direct fulfillment network, including the role our stores played in shipping orders and expediting BOPIS orders, handled the surge in online sales with minimal disruption as the direct business overall grew to represent 72% of full year sales compared to 57% in 2019. We entered fiscal year 2020 with plans that reflected an emphasis on growing our brand in new and existing markets, leveraging expenses, and expanding bottom-line results faster than top-line sales. While the pandemic altered our approach, the actions we took coming out of our first quarter to increase financial flexibility enabled us to generate cash flow from operations of roughly $84 million over the 3 quarters. In addition, we grew pretax earnings by close to 12% compared to net sales growth of just over 5% over that same 9-month period. In 2020, we opened only 4 new stores versus an annual pace of 15 store openings in prior years. While new stores have been an effective way to attract new customers, we were very successful in growing brand awareness and reaching new customers through digital channels. In fact, 2020 delivered our largest gain in customer acquisition in recent history, with a 17% increase in the number of new buyers. And we did this without losing sight of our existing customers, where we've seen improving rates of retention and reactivation all year long. Another year-long initiative was to rightsize our inventory levels and free up more open to buy for newness in the assortment. A year ago, we were sitting on inventory levels over 50% higher than the prior year. This expanded by the end of the first quarter to 68% higher over the comparable period. By adjusting our future order flow and being more aggressive in our clearance strategy throughout the year, we ended 2020 with inventories that were roughly flat to last year. Our gross margins were impacted by these aggressive actions, but we realized sequential improvement each quarter and a 20 basis point year-over-year improvement in Q4 gives us the confidence that we've now turned the corner on our inventory position. That being said, we are realizing some delays today in inventory receipts due to the current challenged state of inbound shipping channels and congestion caused by record-high imports and COVID-related labor shortages. I'll address the impact this is likely to have on our first and second quarter sales trends shortly. Overall for fiscal 2020, we delivered $55.5 million in adjusted EBITDA, an increase of 6.8% over the prior year. This reflects greater operational efficiencies and a focus on optimizing the investments we've made over the last 3 years in technology and infrastructure. These investments are boosting our capabilities to increase delivery speed, customer spend, and inventory efficiency; and we expect this will continue in 2021 and over the coming years. Finally, in 2020, we generated positive free cash flow of $38.5 million compared with a cash burn of $22.4 million in 2019. As a result, we ended 2020 with a much stronger balance sheet and cash flow to fund our next phase of growth initiatives. Turning now to the fourth quarter. We reported net sales of $256 million, down 1.4% compared to the prior year. As we mentioned on our Q3 call in December, the holiday season began earlier this year. Peak sales volumes were pulled forward several weeks as many retailers encouraged early holiday shopping to avoid the strain on delivery networks. Our direct business continued its positive growth trend, up 15% in the fourth quarter, although down sequentially from third quarter's plus 40% growth rate. This reflected the early holiday shopping and the shifting of key sale events from November into October to avoid the elections. As we progressed through the peak holiday period, customer traffic to our stores was impacted by reemerging concerns with COVID lockdowns. For the quarter, our retail store sales were down 29% and reversed the improving trend we saw from the third quarter. Our omnichannel initiatives helped to offset the soft traffic, with our stores fulfilling 22% of all direct demand in Q4. Also evident of the shifting buying patterns, our direct sales in store markets increased 20% compared to an increase of 13% in non-store markets in Q4. Store traffic trends improved in January and continued into February, giving us confidence that 2021 will see a significant rebound in the store sales channels, as the vaccines rollout continues and more customers return to stores. With industry-wide constraints on shipping deliveries in the fourth quarter, pulling some peak holiday sales forward did help alleviate delivery delays. However, competitive pricing and free shipping offers weighed on our shipping fee revenues, which were down $1.9 million in the fourth quarter. Additionally, as mentioned last quarter, we expected higher costs associated with strains on the last-mile network and heavier staffing needed to fulfill direct orders. Overall roughly $2 million of incremental costs related to UPS shipping surcharges and COVID pay premiums were incurred in Q4. Turning to our product update for the fourth quarter. Overall our men's apparel was down 2% compared to last year, and women's apparel was down 3.5%. Softness in our button down woven tops and core men's outerwear fell below last year. However, in both men's and women's, our core bottoms, outdoor active, and workwear collections had strong performance. Comfortable basics remain in high demand, including underwear, No-Yanks, and the NoGA collection. In men's, holiday-themed underwear, DuluthFlex, Fire Hose pants, and flannels contributed to men's volume. A bright spot was Alaskan Hardgear products, which increased 9% from last year. In women's, we had a strong response to seasonal goods like outerwear and sweaters and flannel. The plus business is holding strong at 11% of the total apparel business and is responding well to outerwear and bottoms. Additionally, we added 2 new collections to our brand lineup in the fourth quarter, 40 Grit and Best Made. 40 Grit saw increased momentum in the fourth quarter, representing our latest introduction for entry-level workwear at an everyday low price. Best Made launched on our platform in October as our new digitally native premium men's brand, and we quickly sold out our best-selling colors and styles within the first few months. We are excited about the potential of these 2 brands under the Duluth Trading umbrella. We believe the new brand structure, including Alaskan Hardgear and our core men's and women's Duluth brands, establishes Duluth as a destination for like-minded outdoor and workwear lifestyles. These emerging high-growth brands speak more directly to targeted customers based on their needs and wants, and they will benefit from our scale and infrastructure platform in a way they couldn't achieve on their own. Turning to expenses. SG&A for the fourth quarter increased 1% to $105 million compared to $104 million last year. This included increases of $4.4 million in general and administrative expenses and $4 million in selling expenses, offset by a $7.2 million decrease in advertising and marketing expenses. As a percentage of sales, SG&A expense increased 110 basis points to 41.1% compared to 40% last year. This increase was largely due to the incremental costs incurred to meet customer expectations in a unique holiday shopping environment and the higher mix of direct sales as a percentage of the total. Selling expenses as a percentage of net sales increased 170 basis points to 16.7% compared to 15% last year. The carrier surcharges and heavier use of stores for direct order fulfillment pressured our cost per unit metrics and increased delivery expenses. On the advertising front, our continued investment in digital prospecting drove growth in mobile traffic, conversion and sales rates, although at a slower pace than the third quarter. Planned cuts to TV ads mainly during live sports in October and November impacted site traffic and brand search in subsequent months. Our brand search and website traffic were up 9% compared with 30% in Q3 and 2% in the fourth quarter of last year. Despite the slowdown in holiday traffic, we realized significant advertising leverage in Q4. Advertising and marketing costs as a percentage of net sales decreased 260 basis points to 10.6% compared to 13.2% last year, primarily due to reduced catalog and TV advertising spend as well as cutting billboards in local store markets, partially offset by higher digital advertising. General and administrative expenses as a percentage of net sales increased 200 basis points to 13.8% compared to 11.8% last year, largely due to higher depreciation and amortization on new technology investments. Our store count remains stable at 65 stores during the fourth quarter. We are on hold at this time for adding new stores while we observe customer shopping behavior and the economy begins to return to normal. Adjusted EBITDA for the fourth quarter was $38.7 million, a decrease of $1.3 million versus the comparable period. We reported net income of $21.8 million or $0.67 per diluted share compared to $24.4 million or $0.75 per diluted share reported in the fourth quarter last year. Moving on to the balance sheet. We ended the quarter with net working capital of $115 million, including $47 million in cash and $48.3 million outstanding on our term line of credit. Clearing through the elevated inventory levels from earlier in the year and reduced capital spend relative to prior years helped generate positive free cash flow of $38.5 million in 2020. Cash flow will fund future growth, will lessen our reliance on the credit facility, and support the exploration of new third-party distribution channels, as Steve articulated before. As we begin the new year, we're focused on improving profitability through increased sales in the stores, cleaner inventory management, and greater automation in our distribution center network. In addition, the initiatives to support our emerging brand platform are on track. Our new customer data warehouse and analytic tools are ramping up to enable deeper customer segmentation and personalization. All together, we are very optimistic about what the future holds at Duluth. That being said, given the continued uncertainty with respect to COVID-19, we remain prepared for a range of scenarios to ensure we can sustain growth and continue to accelerate our operating efficiencies. Based on the assumption that our stores will remain open over the course of the year and vaccination rates will continue to improve, we expect to deliver sales growth in the range of 6% to 10% overall for the business. This includes one new store opening in Cherry Hills, New Jersey currently slated for a November 2021 opening, and the closure of our Mall of America test concept store next month. The quarterly mix of sales by channel will shift dramatically in 2021 given the easing effects of the pandemic. We do expect some near-term pressure in the first half of the year due to the delays in inventory receipts. Our best estimate at this time is that sales growth will be at the lower end of that sales range in the first half of the year and at the higher end of the range in the second half of the year. With cleaner inventory levels, we expect to realize gross profit percent improvement of 50 to 100 basis points. This will drive operating margin improvement of at least 100 basis points for the full year as we realize leverage in selling expenses and stores contribute up to 35% of company sales. We are entering the year with a number of key investments in place that have added to our overall depreciation and amortization estimate of $31 million to $32 million for 2021. The adjusted EBITDA is expected to be $66 million to $70 million this year, which represents growth of roughly 25% over 2020. In addition to this healthy growth in earnings, with only one new store in the pipeline, capital expenditures including software hosting implementation costs will be down slightly year-over-year to about $15 million. As a result, we are expecting to generate positive free cash flow of at least $20 million in 2021. And with that, I'll open the call for questions.

The first question comes from Jonathan Komp of Baird.

Dave, maybe first, just wanted to get your thoughts on the near-term environment. It sounds like you've had a good start to the first quarter. And you're about to cycle, if not already, pretty significant disruption last year. So how are you thinking about the current trajectory and maybe the balance of Q1, Q2? Any thoughts on how that might play out by channel would be appreciated.

Yes, we are currently experiencing significant changes compared to last year, particularly since we had to close our stores around this time last year. As a result, the comparisons will differ from what we have seen recently, but overall trends in the business are very promising. For February, our total business was up 13%. This included a direct channel increase of over 40%, while the retail channel, though still negative, improved slightly compared to the fourth quarter, with a decline of about 20-24%. In the first two weeks of March, we continued to see this improvement, with overall trends in the mid- to slight high teens. Recently, we've started to see our stores perform positively compared to last year as traffic decreased and then stores began closing. Looking at our first quarter, we expect overall business growth to be in the mid-teens. However, we anticipate direct sales will be slightly down from current levels because last year we were very active in promotions and clearance events at the end of March and into April. Conversely, we expect retail sales to significantly increase, by 60% to 70% compared to last year, leading to a mid-teens outlook for Q1.

Okay. Great. And maybe on margin, the full year gross margin expansion as well, it looks like a little bit of implied G&A leverage for the year. Could you maybe just differentiate some of the drivers for both of those pieces, to the extent you're willing?

Yes, certainly. We do expect that gross margin will see some improvement. Last year we had a significant hit to our gross margin. So we'll see some improvement in the first quarter, likely a little over 100 basis points, and for the full year 50 basis points to 100 basis points improvement in gross margin based on our promotional plans right now. But yes, our leverage is coming from selling costs and overhead. The big component of overhead is simply having our stores open and being able to leverage the occupancy and the fixed costs in that channel. But in terms of ad spend, we're expecting to be relatively flat in terms of our percent of sales. We held some back last year, and we're going to shift it around. We'll have significant leverage in the first quarter, but we're just moving dollars into more of the back half of the year. So full year guidance that we provided on earnings growth is sort of what those components will get us to.

Okay, excellent. Just last one on the new pilot selling and Tractor Supply, the handful of stores so far, just any broader thoughts on how to shape the strategy, how it's evolving around where you may be willing to sell Duluth product? I know it's very early, but just given the current margin profile of the business of selling in your own channels, if you did decide to ever meaningfully increase that portion that you might be willing to sell in other channels, any kind of broad-stroke thoughts on what that might mean from a margin contribution standpoint? Understanding it's early, any thoughts there would be helpful.

Yes, it is very early. The product we chose for this test is our most reliable and well-known product, which also has some of our best margins. Therefore, we anticipate that we will see an overall increase in margins from this activity if it performs as we expect. We don’t necessarily need to allocate the same level of advertising spending for this effort, which provides some additional benefits. Furthermore, the partnership is between two established companies, and we currently have no plans to significantly expand a wholesale division or increase internal costs to manage growth in that area. This was simply our initial effort to see how our product performs in different retail environments that could enhance customer awareness and attract new customers.

The next question is from Jim Duffy of Stifel.

Overall, it has been a good year with significant progress on inventory. After experiencing growth in both the second and third quarters, the revenue decline in the fourth quarter came as a surprise. Given the new customers we've gained, advancements in technology, and new product offerings, we expected the direct business to perform better. Was the decline in direct business more than you anticipated in the fourth quarter? Do you think you possibly reduced advertising expenses too much during that time? Also, Dave, I'm interested in what you foresee for the direct business in the full-year outlook.

Let me start with our outlook. For the full year, we don't expect our direct business to generate much growth compared to last year. From April to November, direct was experiencing significant growth. The slowdown in the fourth quarter primarily occurred during some key weeks in December, and our decision to reduce ad spending likely impacted this. Given the changes in consumer shopping behavior, we were worried that increasing our efforts during that time could lead to disappointing our customers with late deliveries, which we wanted to avoid. This is partly why we observed some deceleration. However, things picked up again in January, so I have no concerns about any issues with our direct channel. I estimate that for 2021, most of our growth will come from retail, rather than direct.

Okay. With respect to the direct business, you've greatly tightened up the inventories. It's your intent to be less promotional. There's some inherent tension there between promotion and supporting that direct business. Are you confident that you can stabilize the direct business while being less promotional? Or do you view that less promotional stance as being a headwind we should consider in estimating?

We are seeing growth in direct sales during times when we are less promotional. You mentioned the customer file, which has indeed expanded significantly. Therefore, during periods when we launch new products that align well with the season, we expect to gain positive momentum in direct sales. However, it may be challenging to compare this to last year. This doesn't imply that we are moving backward in that area.

Okay. Last one for me, and I'll let someone else jump in. Just point of clarification on the guidance, Dave, is the Tractor Supply rollout reflected in your commentary about mid-teens growth quarter-to-date? Are you embedding any assumptions about a wholesale revenue contribution in your 2021 outlook?

No, it's not contemplated in the outlook. The tests that we're in right now involve 13 stores of Tractor Supply. It's just our Buck Naked SKU across a few colors and sizes. So it's fairly small and not material at this point. But if things progress well and we expand it to other stores, then we'll obviously refresh our outlook to contemplate that, but it's not in there today.

The next question comes from Dylan Carden of William Blair.

Just curious, you had mentioned kind of the outperformance of hardgear, and it sounds like Best Made Co. is off to a good start. Could you kind of just break down the contribution at this point between kind of plus hardgear, some of these newer categories and brands, as they stand now or maybe as you anticipate them to stand for 2021?

Yes, Alaskan Hardgear is certainly much larger than Best Made and 40 Grit. It's about 5% of our business, but growing at a faster pace. So that's probably more of a meaningful sub-brand that's going to move the needle when it does well. Best Made and 40 Grit today are less than 2% in what they're planned, but we're going to see significant growth in those channels in those brands in 2021; but still relatively small compared to our core men's and women's, which are driving most of this volume for us right now.

Great. And then kind of when you talk about sort of this next phase of growth, maybe talking about sort of why CapEx hasn't stepped down a little bit more this year with only one store coming online and kind of what you're putting capital towards now that stores aren't kind of the primary growth engine, is debt pay down anticipated in uses of cash going forward? Anything there would be helpful.

Okay, yes. Certainly, CapEx is a function of the stores. With one store, then we'll see less spend there. But the other areas that we've got teed up and that we're working on right now include a software implementation, our merchandise lifecycle management tool, that will provide us with tools to allow for assortment planning, forecasting, and replenishment. These are basic infrastructure that retail organizations have. We've gotten by with a patchwork of systems and manual procedures, but it's really due time to have this initiative. So that's going to be several million dollars, $3 million or so million dollars of CapEx to get that initiative stood up. The other big spend is going to be in our logistics area. We are going to add some efficiency capabilities in our Belleville warehouse. But more importantly, we're adding a third distribution center in Salt Lake City that will have several million of implementation and fixed costs to get it up and running. That capacity will give us further confidence during the fourth quarter to step on the gas, like I articulated, and really be confident that we can deliver and meet our customers' expectations. These are capital spends that are infrastructure-related and necessary, but we'll get benefits from for the foreseeable future, 3 to 5 years at least. That's kind of the big pieces.

I want to get a better understanding of your guidance. You seem to be starting at a mid-teens growth rate. It appears that the total revenue could improve as you move past closures. However, for your annual sales outlook of 6% to 10%, it seems like the first half will be closer to the lower end of that range, while the second half may reach the higher end. There may be some fluctuations between quarters, and stores are expected to account for 35% of the total annual revenue. Can you explain how this plays out in the first half compared to the second half, Dave?

Yes. Certainly, the first half, we're going to see direct going against some significant volumes at the end of the first quarter and in the second quarter. We're not anticipating that for channel growth will see any growth. It will likely be down to the prior year in the mid-single digit, but that's going to be offset with retail. That could be up as much as 50%. So that's the rough math to get you to the low end of our sales guidance range for the full year. Then in the back half of the year, we will expect direct to start to grow, especially in the fourth quarter. For the full back half of the year, it will probably be mid-single-digit. Retail will be closer to 20% to 30% growth as we're going against periods where the stores have been opened, but traffic wasn't as strong last year with the pandemic concern. We think the back half of the year can combine those 2 to be higher to the high end of that range, the 10% growth.

There are no other questions at this time. This concludes the question-and-answer session and today's conference. Thank you for attending the presentation. You may now disconnect.