Investors are right to be wary of private equity IPOs but is the lack of enthusiasm for Dr Martens shares overdone?
In most cases I’d say avoiding the shares of companies that have recently been owned by private equity is good advice. The private equity industry has developed a reputation for taking stock market investors for mugs. The focus on short term profits, financial engineering and fattening up a business for sale has allowed many PE sellers to make small fortunes and leave problems such as excess debt and underinvestment for the next owners to sort out.
I don’t think this applies to Dr Martens which listed on the London market in January.
The shares initially performed quite well but have been sinking like a stone since the early summer. This is despite reiterating its IPO profit guidance in June at its full year results and in a first quarter trading statement in late July.
They now sit at 369p just above their recent low of 362p on 12th October.
Why is the stock market so downbeat on these shares?
The simple and obvious answer is that they were initially sold to investors at too high a price with a valuation of around 30 times forecast earnings.
That said, there were good reasons for putting a high price tag on the shares. The business had tripled revenues in the three years to March 2021 and improved its profitability significantly. It stacks up well on key financial ratios:
- Gross margin of 60.9 per cent
- Operating margin of 24.6 per cent
- Free cash flow margin of 15.2 per cent
- Return on operating capital (ROOCE) of 62.9 per cent.
These are attractive numbers and when combined with a strategy to drive mid-teens percentage growth in revenues with further margin improvement you can see why you could get a very high valuation for the shares. Investors across the world have been paying very high valuations for shares with characteristics like this.
The company has not been stuffed full of debt. it has been well invested with new stores and distribution assets, whilst the main directors own plenty of shares. Marketing expenditure as a percentage of sales is going up and it looks to have done a good job.
Could the steady drift down in the shares just be put down to the fear that Permira still owns over 40 per cent of the stock and will one day dump it on the stock market?
Permira has proven to be a good owner of the business since 2014 and the strategy of the current management looks to be a good one.
Like many other consumer brands, Dr Martens is cutting out third parties and selling more of its products directly to the end consumer both through stores and over the internet. Direct to consumer (D2C) sales means that the company does not have to give away some of its profit to wholesalers and can therefore earn higher profit margins. The target is to increase D2C sales from around 43 per cent to 60 per cent over the next few years and boost margins with it.
Customer engagement seems to be good, especially with younger buyers with recent launches on platforms such as Tik Tok going better than expected according to the company.
The key worry right now is that its supply chain will not be able to generate the sales forecasts that are currently out there. The company relies heavily on an Asian manufacturing base but has been shifting production away from China to places such as Vietnam, Laos, Thailand and Bangladesh. Not many people would be surprised to hear that container loads of Dr Martens boots were sitting on a quayside somewhere in the Far East and unable to get to Europe and the US.
The other issue is product quality and the fickleness of consumer fashion.
Dr Martens charges high prices for its products – between £100 and £200 generally – and the risk is that making them with cheap labour in the Far East could lead to quality issues and a diminution of the brand.
That said, pick up a pair of Levis jeans or Nike trainers and look at where they have been made. It’s a risk that all fashion brands face and explains why their margins are so fat.
Could it just be that too many investors believe that Dr Martens current streak of profitability will not last?
Its 1460 boots and Chelsea boots have been popular for decades but they have moved in and out of fashion, whilst Dr Martens itself was on the brink of bankruptcy back in 2000. Investors who have been burned owning shares of companies such as Superdry will be aware of the big risks that come with buying into a consumer brand story.
The company is due to announce its half year results to September 2021 on 9th December and has not updated the market for three months. It may do so shortly but i can see nothing pencilled in the results diaries.
Judging by the trend in the share price and what’s going on with global supply chains, you would not be surprised if the company warned on profits. If it doesn’t then there’s a chance that the shares could bounce back strongly.
I can buy the argument for not investing in shares like this, but at just over 20 times the next year’s rolling earnings per share (EPS), the shares are on half the rating of Nike (40x) and a big discount to companies such as Adidas (29x). This doesn’t mean that Dr Martens shares are cheap and comparing them with global sports brands is probably a little unrealistic.
That said, this is a business that recently ticked a lot of boxes. What it lacks is the investor confidence that they are sustainable. We will shortly find out whether the current pessimism is justified.
Dr Martens:Current Forecasts
|Free cash flow||91.9||136.8||165.8|