Wall Street Still Doesn't Get It
In the typical investment banking firm, analysts follow an industry or industry segment as well as individual companies in that segment. Their analysis and recommendations are usually the major influence on an individual company's share price. This is the reason we see the share prices of dot-com companies not being judged by the standard and time-honored methods of valuation. That is a multiple of earnings. Since the dot-com companies don't have earnings - most have a negative cash flow - the Street has devised new analysis tools - future earnings - to justify today's pricing.
In 1996, realizing that most Wall Street analysts did not understand the dynamics and drivers behind the catalog and DM industry, the Direct Marketing Association launched an initiative to educate them. Unfortunately, the DMA didn't realize that its students were not absorbing the lesson - this in spite of more than 12 sessions with analysts in which the DMA and individual public companies tried to tell the direct marketing story. The problem, it seems, is that rather than explaining the principles of direct marketing through traditional investor presentations, the DMA may have to do a basics of DM for the analysts, concentrating on the drivers for a company.
We say this because it's obvious that if Wall Street analysts who follow Lands' End don't grasp the story they are telling, then probably no analyst understands DM.
Story of Lands' End
About a year and a half ago, Lands' End stock was trading for around $20 - this as a reaction to poor earnings performance, which primarily resulted from an inventory overstock situation that called for major reductions to liquidate the inventory. This was down from around $50 about a year earlier. Then there was a management shakeup, and a new team came on board. It realized the problem and both changed the merchandise mix/look, began to liquidate the dead inventory and launched a major e-commerce effort to both liquidate inventory as well as grow into the new channel for sales.
Since then, Lands' End has made periodic announcements about its successes on the Internet, now representing close to 10 percent of total sales for the company, increased sales in its specialty and corporate sales divisions and the reduction in dead inventory, which dramatically reduced borrowing expenses. By any normal criteria, this would push up valuation, and it did. In a span of one year, the share prices increased from $19.75 on Nov. 13, 1998, to $83.31 on Nov. 10, 1999, a 322 percent increase - an amount normally reserved for e-commerce and tech firms.
On Nov. 11, the company's announcement of third-quarter results and looking forward had these highlights: It beat the consensus third-quarter earnings by 12 percent; its year-to-date earnings were up 258 percent; and its inventory dropped 38.9 percent. Moreover, with overall sales for the nine months up 4.8 percent and selling, general and administrative expenses down 3.4 percent, one would have thought that the Street would have been jumping up and down with joy at this performance. Lands' End did state there would be a 5 percent to 10 percent reduction in page count over the next two quarters and a closing of several outlet stores.
However, the analysts rewarded the announcement with a "sell" recommendation, and its stock plummeted more than 35 percent, recovering the next day to a share price of $55.50, a 33.4 percent drop in two days.
What Went Wrong?
From our conversations with several analysts, post the dramatic drop, there were two themes. First, they saw the drop in sales as translating into a drop in profits. Second, they reacted to a statement in the middle of the release that reported lower gross margins than in the preceding year because of higher liquidation sales, which for the quarter were 16 percent of all sales.
The problem is that the analysts still don't get it. Taking these two points in reverse order, let me try to explain where the analysts are missing the boat. First, the liquidation is "too high a portion of sales." The reason for the high liquidations is that the management team correctly understands that carrying old inventory is a waste of capital resources. In addition, fortunately, they have found their e-commerce site a better way of liquidating than traditional methods - outlet store and sale catalogs and sale pages within the catalogs. Indeed, they have indicated that a major portion of the page-count reduction is from less sale pages/catalogs, not from any need to cut back or that the full-price pages were unproductive.
The reduction of pages is where Wall Street really demonstrates that it doesn't get the direct marketing model. Unlike the brick-and-mortar world, where stores closings bring with them expenses that are not covered by sales (i.e., store leases, fixture write-offs, staffing severance, etc.), a catalog company can cut pages at NO expense. That's right, the only potential problem is using up a paper commitment - if one exists. This is the ideal situation, when a company can cut out an activity without incurring an expense. Until Wall Street analysts understand the drivers that move a catalog company, they will never be able to put the right weight on the various decisions. This one in particular is a great example of not understanding a fundamental asset of cataloging, almost total flexibility.
As to lower gross margins because of an inventory liquidation strategy, Lands' End should have been applauded and rewarded, not punished. The wisest thing any company can do is to rid itself of this useless inventory. When the company is in a situation as was Lands' End with a sizable overstock of dead inventory, the only wise course is to take deep markdowns to move it out in as short a time period as possible. This necessitated the deeper liquidations and resulted in the liquidations growing as a portion of total sales and a lowering of the gross margin. But the corresponding decrease in selling expenses more than offset this lower margin and in a few months when the margins return, it will be very beneficial to the bottom line.
As Wall Street has again demonstrated, it still has a lot to learn about remote shopping - and when they finally start evaluating the e-commerce companies on performance, not future, they had better understand the channel's drivers. This is why we feel that everyone - public and private - should be supportive of the DMA's efforts to educate Wall Street. This is twofold, first through contributing to the campaign and, second, by supporting it through active participation on the committee. They are only doing it to benefit marketers, not to hype the DMA.