Dr Martens (DOCS) does not look like the kind of private equity initial public offering that has been rightly criticised in recent years. Yes, the selling shareholders received a punchy price tag for their investment, but the business they were selling looks to have been well-managed, well-invested and is currently doing well.
There are good grounds for thinking that a decent chunk of value has been left on the table for new shareholders instead of getting them to massively overpay for a business that has already peaked.
Management has put together a strong investment case for the shares, but investors have to bear in mind that this is a fashion business and consumer tastes are fickle. There’s no guarantee that what they like today will be more popular in the future. This makes weighing up the shares and valuing them far from easy.
The company can trace its roots back to the start of the 20th century, but the story of its iconic boots began in 1945. A convalescing German soldier, Dr Klaus Martens, designed an air-cushioned sole and attached it to some leather uppers before showing it to a mechanical engineer friend. A couple of years later, the production of shoes started.
The story of the Dr Martens boot with its distinctive leather uppers, yellow stitching, eight lace holes and bouncy soles began in 1960 with the launch of the 1460 boot – the same boot that dominates the company’s sales today accounting for over 40 per cent of annual revenues.
The boots are a versatile product that developed a following amongst rebellious types such as punks and skinheads in the 1970s. They have come with a reputation for being durable and of good quality, but some question whether today’s offer is as good as it used to be.
Dr Martens is a brand with a broad and inclusive appeal across the social spectrum and age groups. Around half the new buyers of Dr Martens are aged under 35, but the company is still selling a lot of boots and shoes to the over 60s who have kept faith with the brand since their youth.
The boots are not cheap and sell for average prices of £109 to £189 but they are not super expensive either, which means lots of potential customers can afford them.
The 1460 boot is still the core of the business in its Originals category and accounted for 42 per cent of the company’s sales in 2020. A collection of boots and Airwair shoes make up the company’s Originals product line, which made up 60 per cent of sales in the year to March 2020.
Around a quarter of revenues come from its Fusion brand which takes the original boot design and modifies it by, for example, putting some extra height in the heels as it has with its very popular Chelsea boots.
The remainder of the company’s revenues comes from casual day-to-day shoes, kids’ boots, shoes and sandals, accessories such as bags, wallets and laces, as well as work and safety boots.
The business has been historically reliant on wholesale sales to other retailers, but has been making a big push to sell directly to consumers in order to boost profits but importantly engage with them and build the strength of the brand.
The company has been opening a lot of shops in key global cities over the past five years and now has 130 which are typically on short leases with a payback on in-store investment of two years or less. It has also granted a lot of concessions to franchisees in markets where it does not want to run its own stores.
In some markets, wholesaling is a faster route to market, but the company has been significantly reducing the number of its wholesale clients and is concentrating on best-in-class retailers who share its brand vision.
It has also launched websites in key markets and has significantly grown its internet sales. Six years ago they accounted for a very small proportion of sales but are now up to almost a quarter. Direct-to-consumer sales (internet and retail) continue to grow their share of the sales mix with the company targeting 60 per cent of total revenues over the medium term.
In recent years there has been significant investment in the supply chain to make it more efficient and provide the capacity for growth. Most of the boots and shoes are made in Asia, but the company has been reducing its dependency on China which used to make almost half its products and now makes around one-third. The production has shifted to countries such as Vietnam, Thailand, Laos and Bangladesh.
The company sold 11.8m pairs of boots and shoes in the year to September 2020 and is building a supply chain that can cope with demand for at least 20m pairs a year.
Dr Martens is a global business. Its key markets are the UK, US, France, Germany, Italy, Japan and China. The company feels that it is very under-represented in the Asia-Pacific region compared with its rivals and sees it as a key area to drive future growth.
Financial performance has improved significantly
Dr Martens has had its ups and downs over the years and was almost bankrupt in 2000. It is in a very healthy state now and has been on a great run since being bought by private equity company Permira in 2014.
The company only gave three years of financial information in its prospectus but its accounts can be found on the Companies’ House website, which allows an investor to build up a longer view of the business.
We can see that the company has made huge progress since Permira bought it. Many private-equity-owned businesses are accused of starving businesses of cash and underinvesting. This is definitely not the case here.
There has been big investment in rolling out stores and concessions as well as in internet sales channels and an improved supply chain. The results have been impressive. Revenues have more than tripled since 2015, with operating profits increasing from £38.7m to £171.2m based on the 12 months to September 2020.
The shift away from wholesaling to direct-to-consumer means that the company has been giving away less of its profit to other retailers and this can be seen in the big improvement in gross profit margins, which has fed through to much higher operating margins.
|Dr Martens: Key financials|
Free cash flow
Debt to FCF
Net debt to FCF
|Source: Prospectus. Companies House. Investors’ Chronicle|
Based on its latest financial performance its return on capital employed (ROCE) is a very impressive 28.2 per cent, which takes into account its rented stores. Free cash flow performance has been patchy, but has been very strong more recently as profits have boomed.
The growth in profits and free cash flow has seen a reduction in financial gearing even though absolute levels of debt (including store leases) has increased. Based on its current free cash flow, it could pay off all its debt in less than four years if it chose to. This is not a business that has been sold on with crippling amounts of debt.
An important point to note about this business is the seasonality in its sales. Its peak selling period is from September to December, which leads to a big stock build in August and September which sees a big drop in its cash balances and an increase in its financial debt to the tune of 0.5 times net debt/Ebitda.
As it stands now, this is a business with many of the hallmarks of a high-quality business. If it is capable of sustainable profits growth while maintaining its high margins and returns on capital then it could prove to be a very successful long-term investment from the current share price.
How will it keep on growing?
There are good grounds to think that profits can keep on growing. The brand, as seen by its recent revenue performance, clearly has a lot of momentum behind it, which the company intends to reinforce by upping its marketing spend by 0.5 percentage points from 3.9 per cent of revenues currently.
The store roll-out is expected to continue at 20-25 new stores per year. With fresh revenue and profit contribution from these, the maturing of stores opened in the past couple of years and decent like-for-like performances from its existing estate revenues could still grow significantly.
The reasons for thinking this is the potential to improve brand recognition and sales, particularly in Asian and Chinese markets. Dr Martens currently sells 31 pairs of its boots and shoes in the UK per 1,000 of population, in the US 12 and China just 1. If brand penetration shifts up in Asia and Europe, then the directors have estimated £6bn of potential annual sales which looks very bullish.
Getting there will not be easy and will of course take a good few years if it does. That said, I am inclined to agree that there is scope to grow significantly from its current revenue base.
Whether it is successful depends on the brand staying relevant with consumers in a fiercely competitive market. Perceptions of brand quality are also crucial. Expensive boots made in cheap manufacturing countries makes this a risk, but is no different to what most of the world’s leading fashion brands are doing.
There are plenty of Dr Martens imitations out there, but the general consensus seems to be that the boots are still a good buy.
As well as revenue growth, there is also a lot of self-help on offer, which can boost the company’s profits. The continued shift towards direct-to-consumer sales still has some way to go and offers hope the profit margins can still improve. Cost savings from supply chain investment are also helpful in this regard.
The replacement of very expensive preference shares with new loans in January this year should also see a significant reduction in the company’s interest charge and boost profits to shareholders and free cash flow.
The company has guided to a very bullish outlook over the next couple of years. It expects significant volume growth to drive sales – 14 to 15 per cent sales growth in the year to March 2021 and high teens revenue growth in 2022. Margins are expected to improve with profits growing faster than revenues and debt levels coming down.
Free cash flow
Permira still retains a stake of over 40 per cent in the business and remains highly incentivised to maximise the value of its investments.
At a share price of 457p, the shares trade on a PE of 30 times 2022F earnings per share (EPS). This compares with global athleisure powerhouses Nike and Adidas on 34 times and 26 times, respectively.
This is a punchy valuation from which it is very easy to construct a bear case. The sustainability of the current enthusiasm for the brand is a valid concern, but if management is only vaguely right about the future potential of the business then the shares could turn out to be a very good buy from here. It does not look like a business that has been fattened up for sale.