Retailer Shoe Zone (SHOE; 240p) recently delivered a remarkable trading update, saying that both June and July had been exceptionally strong trading months, in the light of which brokers upgraded for the second time in as many months - this time eps forecast is upgraded by 29%.
Unusually, the company says the surge in sales has come outside the back-to-school season and has instead been driven by shoppers opting to trade down. Although Shoe Zone sells some branded shoes (including the grunge shoes made by Dr. Martens), most of the stuff it sells is its own private label, primarily made of plastic, and with the majority priced at an affordable £10.
Shoe Zone was covered at 67p in the March ‘21 issue of SCSW and has climbed vertically to 240p since. But shares in Dr. Martens, the subject of this article, which has been listed since 2021, have been going in the other direction, down from a high of 503p to a low of 113p after encountering issues when consignments arrived too early at its Los Angeles distribution centre causing temporary issues and triggering three profit warnings in five months. But this is a high grade business and I think now is the time for shareholders to grab the shares with both hands.
Both Direct To Consumer specialists
As I have previously described, what had attracted me to Shoe Zone was that whilst manufacturing of its shoes is directly outsourced to factories in China, it has a direct to consumer (DTC) strategy of selling via its own network of stores and website, eliminating dependency on traditional wholesale distribution. By selling shoes in this way, the company gets to keep more of the margin: in spite of its low price point, Shoe Zone has a respectable gross margin of 24% and its pretax margin is expected to have increased to c.8.2% in the latest year, thanks to the increased volumes generated by its successful value-driven approach.
Dr. Martens’ strategy is similar and it too has embraced DTC. However its customers are clearly deep pocketed with the shoes in the £99-£199 range versus £10 for Shoe Zone. But it’s interesting to note that the company makes 2x-4x the profit per pair of boots/shoes sold direct rather than selling the same item via wholesale. Unlike Shoe Zone, it has also expanded internationally, driving sales past £1bn, with a strong focus on EMEA and the Americas, while also identifying APAC as a crucial long-term growth driver. Even despite suffering a blip last year, strongly driven by those bigger volumes and price points, its gross profit margin still sizzled at 61.8% with ebitda of 24.5%, putting those at Shoe Zone somewhat in the shade.
CEO buys 310,000 shares
The warehouse issues I refered to are a temporary headwind. The year to March 22 had seen the company battle with the doubling of shipping times from the Far East to the US but FY23 saw management have the ignominy of having to tell shareholders that too many containers containing shoes had landed at once, overstuffing its newly opened warehouse in LA, impacting wholesale shipments and forcing it to open three temporary US warehouses. The costs of rectifying the US problems alongside slower than hoped for sales growth led to a 26% tumble in pretax profit to £159m in the year to 31 March. Inventory ballooned by £123m to £257m.
But I think the problem will soon be ancient history. CEO Kenny Wilson, who gives analysts presentations wearing jeans and a casual shirt (and presumably DMs under the desk), told shareholders at the company’s AGM this month that strong DTC sales means the business is on track to hit its profit guidance for the year, in particular helped by “very good growth” in DTC across both EMEA and APAC.
By the second half of this year, Wilson thinks things will also be humming in the Americas because the excess inventory in America is predominantly best-selling, “continuity,” black boots and shoes and he sees minimal markdown risk. And he has followed up by putting his money where his mouth is by buying 310,000 shares at 129p.
Rich history
The rich history of Dr. Martens dates back to 1945 when 25 year old Dr. Klaus Maertens, a German soldier, poignantly designed a unique air-cushioned sole for his broken foot. Teaming up with his friend and engineer, Dr. Herbert Funck, they subsequently began producing their shoes.
In 1959, Northampton-based shoe manufacturer R Griggs bought the rights to manufacture the sole in the UK and as part of this entered into an exclusive and perpetual global licensing agreement with the Funck and Maertens families, where it pays them a 2% royalty on everything produced. This is accounted for in the P&L through operating expenses - making the huge margins that Dr. Martens has all the more amazing!
A year after the deal, R Griggs went on to launch its first product, the eight holed 1460 boot with the distinctive yellow welt stitch, grooved sole and black and yellow heel loop. The shoe was quickly adopted by postal delivery workers and factory staff but the shoe then became popularised in the 1970s, an era marked by "Two Tone" music, goths, punks, rockers, and skinheads, when Dr. Martens (or DMs) were embraced as a symbol of rebellious self-expression, fuelling a surge in sales and solidifying the brand’s position. An early influencer was singer Pete Townshend of The Who, who wore Dr. Martens as a symbol of his working class pride and rebellious attitude.
In 2014, the private equity firm Permira paid the Griggs family £300m for the business, subsequently reshaping the Dr. Marten’s leadership team, including the appointment of Kenny Wilson as CEO in 2018. Three years later in January 2021 and much enlarged, the business joined the main market at 370p with Permira subsequently selling down part of its holding but still retaining 36%.
Wilson, coming from a background in other consumer-branded businesses, including Levi Strauss, has changed the business during his time. These days, for instance, Dr. Martens directly sources nearly all its shoes and boots through third party manufacturers (13 sites in Asia) with just 1% produced at Northampton from where they are distributed either to Dr. Martens’ 13 distribution centres or directly to distributors or wholesale customers. Wilson has already simplified the group’s ranges, introduced new IT systems and transformed the business model from a family run wholesale business into a fast growing digital-led DTC consumer brand with international reach - it now sells in over 60 countries, with Europe, the Middle East and Africa contributing 44% of sales followed by Americas at 42% and APAC at 13%.
Unique Brand Identity
Sometimes fashion fortunes are made by launching at the younger end and drifting older with the customer with new ranges but Dr. Martens hasn’t had to do this because it seems that customers like the brand so much that they buy the same shoes again, with over 60% of UK sales (its largest market) coming from repeat customers. A typical buyer tends to acquire a pair in their late teens and then goes on to buy an average 2.8 pairs, according to Wilson.
Such longevity of its “trendiness” is rare but the corollary is that 75% of what it sells each year is Continuity and has stayed the same for years. In fact around 40% of sales is the original 1460 boot. This gives the business strong pricing power, confirmed in market surveys, which is obviously important in this high inflation time.
The “Originals” range, most renowned with Dr. Martens, represents 50% of sales. Originals is rooted in three key iconic styles, which are the 1460 boot, the 1461 shoe and the 2976 Chelsea boot, all with the distinctive features of a Dr. Martens’ boot, namely the trademark yellow welt stitch, grooved sole and black and yellow heel loop. Variations in different colours, materials and prints have subsequently been added.
The “Fusion” range is approx 35% of sales and also has a strong Dr. Martens feel e.g. a chunky sole plus often yellow stitching. The range contains platform boots and shoes, sandals and heels, and ramps up or tones down the core brand DNA, for example, putting some extra height in the heels such as with its Chelsea boots. Innovation to stretch the brand across many subsegments of the footwear sector has played a crucial role and these are growing quite quickly as evidenced by the success of their sandal products, which now constitute 6% of total revenues compared to 3% in the previous year.
The remaining 15% of sales is made up of children’s shoes and accessories.
Direct-to-consumer acceleration
As consumers can only buy Dr. Martens shoes if they want the yellow stitched sole, Wilson’s light bulb moment a few years back was the realisation that the younger cohorts coming into its target age groups could be sold to directly. Not only does DTC allow it to carry a wider range than the wholesale channel, who might only hold the core Dr. Martens model, but ecommerce and retail are also 4x and 2x more profitable than wholesale. The gradual expansion of DTC has helped sales surge from £291m in 2017 to £1bn in FY23, while EBITDA increased more than 6-fold from £37.5m to £245m during the same period, despite the blip last year.
Broker Investec, for instance, says it makes between 2-4x the revenue per pair of 1460s via its website or its own store, equating to c. £124 after VAT versus just £50 from a distributor. Even allowing for higher distribution and store operating costs for D2C, e-commerce generates 55% EBITDA margins (pre central costs), making for EBITDA per pair of £68.20 versus £31 in its own stores and £15.75 for wholesale. The broker also highlights that it’s unusual for e-commerce to be so profitable but puts it down to low product returns as most people know their shoe size and so there is no need for expensive reverse logistics.
…by optimising distributor network
A key aspect of their DTC strategy has been the conversion of some countries’ distribution networks to being owned (e.g. France, the Netherlands, Germany, Nordics, Italy and recently Japan). Although this approach may involve culling the less productive wholesale customers, it ultimately leads to a higher quality customer base and complements the expansion of the company's own stores.
To capitalize on this opportunity, Wilson plans to open 25-30 new own stores this year, adding to its existing 204. In particular, he envisions the potential to more than double its store portfolio in EMEA and across the pond. Notably, the USA will see at least half of all the new store openings.
By channel, DTC revenue has increased to 52% of total sales in FY23 with ecommerce sales +6% at 28% of sales mix and Retail +30% YoY to 24% of sales mix. Before long it seems that DTC will rise beyond 60% but this isn’t to say wholesale is declining - this also continues to expand (+3%) and enables the brand to reach a broader range of customers globally where the Group does not have a presence or is infilling in large countries like the US.
Vast untapped growth
Wilson’s punchy statement is that by targeting its efforts in just seven strategic countries – UK, US, Germany, France. Italy, Japan and China – where it has identified 154m people with similar characteristics to its existing 16 million customers - and based on current average purchase frequency and average spend, there is a £6bn revenue opportunity or growth headroom of nearly 5x last year’s sales. Consensus eps forecast is 10.3p for the year ending March with 12.1p and 14.1p for the following two years. I am not too fixated by short run forecasts and whilst H1 will be weak, H2 will see things massively improve. My gut feel is that in six months’ time, investors will reappreciate the return to mid teens sales growth and the shares will surge; I am a buyer.
