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2019-10-16 20:41:29

Zumiez (NASDAQ: ZUMZ) is a retailer that caters to young men and women. In particular, ZUMZ focuses on selling clothing to customers into the skater lifestyle look. ZUMZ operates more than 700 stores across the US, Canada, Europe, and Australia. In my view, this gives investors geographical diversification and proves that ZUMZ can be successful across the globe. As a result, this makes ZUMZ long-term growth prospects very appealing. Finally, regarding its valuation, I think that ZUMZ still has considerable upside left in it due to its strong FCF and healthy balance sheet. Thus, I believe ZUMZ is an attractive buy at these levels.

Source: ZUMZ's website. The company caters to a younger audience interested in skateboarding.

Overview

At a high level, ZUMZ is a straightforward retailing business. Its products are divided into five categories Men's Apparel, Women's Apparel, Accessories, Footwear, and Hardgoods (mainly skateboards). So, it's fair to say that the business is rather straightforward and simple, which is a nice plus from an investment point of view. Moreover, ZUMZ's focus on skateboarding and its target demographic gives it a definite competitive advantage within that market niche. This is because, according to management, other retailers have preferred to widen their target market at the expense of focusing on a particular consumer.

Source: ZUMZ's 2019 10-K. Young men are ZUMZ's primary demographic.

In my view, management's strategy of focusing on a single market niche is ideal. This is because retailers that try to become a one-stop shop for several different niches will likely lose their edge against other specialized retailers (like ZUMZ). After all, I believe that being the best at one thing is better than being mediocre at many. This is why I like ZUMZ's management. In my opinion, their good judgment has translated into a stellar track record. For context, since 2010, ZUMZ has compounded its revenues and earnings at a CAGR of 10.22% and 19.49%, respectively.

Source: Yahoo Finance. ZUMZ's fundamentals have consistently improved over the years. Unfortunately, it seems that the shares have underperformed.

Furthermore, ZUMZ's management seems to be very shareholder-friendly and prudent. You see, so far they've managed to keep their balance sheet debt-free, while at the same time repurchasing their stock. I believe that both initiatives are a testament of an executive team focused on delivering shareholder value over the long-term in a sustainable way. Moreover, the C-suite seems also highly capable of adapting to the rapidly evolving retailing landscape. For example, ZUMZ's unique approach to localized retailing and e-commerce appears to be highly profitable (more on this later). This is particularly remarkable because the retail sector is being disrupted by tech giants like Amazon (AMZN).

Focused on the consumer

I believe ZUMZ stands out among other retailers due to its consumer-centric culture across the whole organization. This is why it manages to keep growing its revenues YoY despite the massive headwinds the retailing sector faces. You see, ZUMZ's management continuously tries to stay in touch with their customers' biases and tastes.

This includes clearly articulating our culture-driven lifestyle brand position and showcasing our ability to connect with the target audience in an authentic engaging environment that is uniquely curated by our people, all the way down to the local level. (…) Our customers want to express their individuality through many different avenues, which can drive unique assortments even in trader areas only miles away from each other. Over the years, we spent significant time and resources improving our localized merchandise assortments to investments in our people and technology that enhance the customer experience at each touchpoint. Our teams across the organization put a significant amount of effort into understanding our customers. (…) These teams are in tune with the local and national trends that are important to our customers, and can speak authentically to them across all of our channels.

- Rick Brooks, ZUMZ's CEO.

In fact, ZUMZ manages to cater to trends within each geographic region. They accomplish this through hiring managers and staff that are in tune with the culture of the consumer in each specific area. As a result, this allows ZUMZ to double down on the precise products that those particular consumers desire. Thus, this diminishes the chances of having obsolete inventories, which benefits ZUMZ's margins. I believe that this flexible approach to inventories, brands, and stores allows ZUMZ to save costs by optimizing its inventory and minimizing obsolescence charges. This also gives ZUMZ the ability to withstand sudden shifts in demand, which is vital for modern retailers.

Image source.

A modern retailer

The company also has a very refreshing approach to e-commerce. Unlike conventional retailers that are getting crushed by Amazon, Zumiez has embraced e-commerce and using it to its advantage. In my view, their distribution centers allow ZUMZ to better serve consumer demand without needing to store massive inventories on site. As a result of its logistics strategy, ZUMZ can handle fluctuating demand across the brands and categories it offers without losing money on unsold products. This also ties in with the previously mentioned strategy regarding minimizing obsolescence charges. After all, in their last earnings call, management mentioned the benefits of always trying to operate at relatively low inventory levels, rather than being filled with excess product.

(…) we're getting a little bit of leverage out of some of the fixed cost structure within our distribution network. (…) We had some initiatives around some of the shipping cost that we have around moving product around our store system, that has actually taken into fruition and create some value (…) it's how do we optimize product within a trade area, how do we optimize those shipping algorithms. So where we do see increases in split at times, we're able to offset that through other types of shipping (…). So we're super happy to be leveraging distributions shipping cost, (…) specifically with our distribution center located in California. But like many things at Zumiez, we try to be really creative (…).

- Chris Work, ZUMZ's CFO.

As a whole, I believe ZUMZ is an excellent example of a successful modern retailer. It's flexible and quick to adapt to consumer tastes at a local level. Its fixed costs are minimal, and its logistics strategy focuses on reducing obsolete inventories and shipping costs. On top of that, it tries to lever the power of e-commerce across its operations. In my opinion, this makes ZUMZ a unique retailer. As a result, Zumiez continues to open new stores throughout the world. This is in stark contrast to many other retailers, which seem to struggle with fixed costs and continue closing down their stores. In my view, ZUMZ's successful retail formula gives it ample runway for worldwide growth.

Source: ZUMZ's 2018 slideshow.

Strong prospects

Furthermore, ZUMZ is in top-notch financial condition. This is especially true when compared to other retailers, which often seem to be dangerously indebted. For instance, ZUMZ's balance sheet has very little goodwill or intangibles. This tells me that optimistic M&A valuations don't inflate ZUMZ's financials. Moreover, ZUMZ's balance sheet is actually debt-free! In fact, ZUMZ has substantial cash reserves that provide management with much flexibility for opportunistic M&A and organic growth.

This is why, as a whole, I would rate ZUMZ's financial health with an A+. Furthermore, I believe that ZUMZ's strong financial position will allow it to acquire competitors at low prices whenever a macroeconomic downturn occurs. After all, recessions are typically an excellent opportunity for companies with sound balance sheets and ample cash reserves. This is because competitors crushed by debt often face bankruptcy and sell their assets at a discount. This doesn't mean that ZUMZ wouldn't suffer in a recession, but I do think that it can survive one and come out of it even stronger.

Also, it's worth noting that ZUMZ is a profitable free cash flow machine. You see, ZUMZ's FCF yield is quite impressive, especially when compared to the current 10-year US Treasury bond yield of 1.76%. For context, my FCF estimate for ZUMZ is $69 million, which implies an 8.59% FCF yield. So, put differently, ZUMZ's FCF yield is 4.88 times larger than the risk-free rate. However, it's worth noting that ZUMZ doesn't offer a dividend. Thus, any potential gains will only be realized through price appreciation. Going forward, I believe that more investors will take advantage of such a generous FCF yield. As a consequence, this should help ZUMZ's stock price to increase proportionally.

Valuation

In my view, ZUMZ's valuation is relatively straight forward. First, it's evidently in a stable position, and its outlook still includes further growth for its revenues and earnings. According to analysts, going forward, ZUMZ's revenue growth should be approximately mid-single digits (4% to 9% until 2020).

I will concede that ZUMZ's growth rate isn't enough to consider it a growth stock. However, have in mind that the retail sector isn't growing by leaps and bounds either. For context, the US' retail sector forecasted growth is only 7.8% until 2023 (this figure includes AMZN). So, I would say that ZUMZ's revenues will probably continue to increase in tandem with the rest of the industry. Then, based on those figures and historical financial results, I proceeded to build my valuation model for ZUMZ.

As you can see, my valuation model suggests that ZUMZ is significantly undervalued. The results imply that there's a 49% potential upside from the current price levels. This is mostly because, according to the CAPM, ZUMZ's FCF yield should be 6.65%. Thus, it's fair to say that the stock does appear to be mispriced and ripe for opportunistic value investors.

Conclusion

In my view, ZUMZ appears substantially cheap. This is despite being an FCF machine and consistently generating shareholder value year after year. Moreover, its prospects and financials are supportive of a higher valuation as well. So, over the long-term, I do believe that ZUMZ should trend significantly higher as it continues to expand organically and opportunistically through M&A. My valuation model suggests a whopping 49% potential upside. However, in my view, a billion-dollar valuation seems reasonable for ZUMZ, which implies a 25% potential upside from current levels. Thus, my price target for ZUMZ is at least $38.81 per share.

Thank you for reading, and good luck.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ZUMZ over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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