Danier Leather: Reminiscences Of My First Research Report

As I was going through my old records the other day, I stumbled upon my first equity research report on Danier Leather (TSX: DL). By fluke, as I was flipping through the report reminiscing of the fun I had researching and writing about the stock, I realized that it was literally six years to the day that I had written the report. As that moment smacked of serendipity, I thought it would be worthwhile to look at what has happened with the company at the corporate level since then, to see if my thesis worked out as I had predicted, and to write about some of the lessons I have learned from that experience.

I have posted the report in its original form on Slideshare, for anyone who wishes to read it:

Danier Leather Research Report (September 26th, 2004)

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Upon re-reading the piece, the first thing I noticed is how novice I was back then. In hindsight, this is actually understandable because at that point I had only seen a handful of research reports prior to writing it, and I was in the process of completing my “Advanced Corporate Finance” class in undergrad, which essentially taught me some of the tools needed to do such a stock analysis. With that said, I think it was amazing that I was able to complete the analysis and write the report given my total lack of real investment knowledge or mentoring at that point in time.

In six years after having written the report, I completed my CFA designation, worked in mutual fund sales, worked at a quantitative equity research firm, and worked as an analyst on a sales & trading desk. In addition, I have completed my MBA at Ivey. In essence, after both the educational and hands-on work experience in the capital markets, I believe I have a more holistic tool-box necessary for researching a company, analyzing a stock, and making an investment presentation. With that said, I would like to make a few observations:

• The Difficulty of Forecasting - Being fresh out of university, having never seen a sell / buy side research report before, and having absolutely no knowledge about fashion or the market for luxury leather goods; I somehow made fundamental forecasts 10 years out for Danier Leather. Now, anyone that has spent time reading academic research knows that the theoretical value of a common stock is the residual equity cash flows to infinity discounted back to present value at the appropriate cost of equity capital. I applaud anyone that has the ability to make the hundreds of assumptions that go into a traditional DCF analysis, as this requires intelligent thought, hard core research, access to management, and a sizable serving of luck in making estimates. However, I frown upon my previous analysis. As evidenced on page 7 of the report, what I essentially did was one DCF analysis and did ten different scenario analyses. This produced theoretical stock values of $6.56 to $11.72 (I’ll spare you the detailed assumptions). I am definitely supportive of performing scenario analysis; however, it must be performed with realistic assumptions. I believe what I did, and what many other professional analysts do, is create assumptions and massage the numbers so as to produce a DCF value that is in-line with what the current stock price is. A much more appropriate way to do this is to take the current stock price, and test for assumptions that make the current price true. This “reverse DCF” allows for you to see very easily whether or not the market is being rationale in its pricing. Regardless, I glanced at what my estimates were in 2004 and what actually transpired since, and my estimates were not even close. Looking at the Exhibit 1 below, you can see both earnings and EBITDA jump around wildly. The lesson here is that nobody should be making long-range forecasts for firms where you can barely forecast the next six months.

Exhibit 1:


• Uncertainty Of The Future – Although I briefly mentioned catalysts on page 9 of the report, it was impossible for me to know both how and when those catalysts would appear. Given the intonation in the report, at that time I understood Danier’s management to be worried about an unwanted Takeover Bid. Fast-forward 5 ½ years and the real catalysts that appeared were an NCIB and a Dutch Tender Auction this past January. The Dutch Tender Auction alone reduced the total share count by 23.88% to 3.5mm total shares (SVS and MVS) outstanding. While the stock took a few weeks to respond, it has gained 113% this year, as shown below in Exhibit 2. I think the lesson learned here is that the catalysts that you believe will occur may never actually happen, or may take longer than anticipated. Anybody could have seen that Danier Leather’s management was buying back stock very accretively, however, the stock just never responded in a timely fashion. The second takeaway is that you can try and forecast what catalysts will occur, however, you can never really know what will transpire unless you are actively trying to make a desired outcome occur. The best way to make money is to buy cheap assets and let the invisible hand do its job.

Exhibit 2:


• Value Creation - Although there is certainly a market and economic effect on the stock price of Danier Leather, it is apparent that there has been no going-concern, shareholder value creation over the past 6 years. The question is why? One the one hand, I understand that multiples and equity valuations have come down significantly over the past 6 years, for both fundamental and non-fundamental reasons. However, Danier Leather was reasonably priced to begin with (relative to normalized earnings and book value). The first rational explanation would be that Danier Leather is not truly earning its economic cost of capital, hence the stock not continuously marching up. The other explanation is that Danier Leather was truly undervalued for approximately six years and the stock market did not care about it. This is plausible as the CEO, Jeffrey Wortsman, continuously bought back stock over that time frame. In fact, Danier Leather had 6.9mm subordinate and multiple voting shares outstanding in 2004, and through both an NCIB and Dutch Tender Auction, reduced the number to 3.5mm by 2010 (see exhibit 1). Wortsman owns 1.2mm multiple voting shares, so I doubt he would have repurchased shares if either forms of buy-back would have caused permanent loss of capital for his own shares. The lesson here is that value creation can take a lot longer than you expect, and it does not always come from operating the business itself.

• Intrinsic Value - One thing that must be kept in mind is that intrinsic value is a moving target. Although this is technically incorrect because it does not take into account return on capital and cost of capital, let’s take book value as a proxy for intrinsic value. At the time of the report, the stock was trading at $11.20 with a book value $8.83, indicating that price was 1.25x intrinsic value. Over the course of the six years, book value increased to $12.00, and the stock price is now $11.93, indicating that it is almost fully valued. So, in essence, intrinsic value of the firm increased (through both profitable operations and accretive share buy-backs) over time, and the market has responded to reflect it, although one can argue that the market still has not fully rewarded Danier Leather yet. If I were considering purchasing the stock at this point in time, it would be wise to do a full-blown analysis to determine value, and then relate that to the current price of the stock. This should be done when one is considering both purchase and sale of a stock.

• Relative Valuation – This methodology was mis-used in the research report that I wrote, as the share values ranged from $7.83 to $25.60. I should have had the presence of mind to understand that some of the metrics and peers I was using did not contribute to realistic share value estimates, and I should have cut them entirely.

• Owner-Operator Model – It is absolutely imperative to have alignment between management and shareholders, and the best way to do this is to ensure the leaders of the firm own alot of stock. An even better scenario is when management is not only monetarily committed, but emotionally committed. Jeffrey Wortsman currently owns 1.25mm MVS, which gives him 78.6% of voting rights of the company and a ~35% economic interest. Although I hate the MVS structure, his massive ownership stake virtually guarantees that he will do right by shareholders. He has also been with the firm since 1986, indicative of an emotional commitment to the firm, as he has essentially built it from the ground up. While the combination of these two factors does not ensure that mistakes will not be made (the Power Center expansion strategy for Danier Leather), it will ensure that they will be rectified very quickly and that shareholder value creation will be at the forefront of management's minds.

• Growing Per Share Value By Downsizing - Unless a firm enjoys an inherent competitive advantage, it is the Board of Directors and management that drive the direction of the company, which should ultimately build value. Most people view growth in stores, units, and revenues as the de-facto form of value creation. This is simply not true. In 2004, Danier Leather had 98 stores, $178mm in sales and 377,527 sqf of retail space. From the chart below, you can easily see that sales have dipped and essentially flat-lined since then. Retail square footage has plummeted by 16%, and the number of stores has been reduced to 90. The most notable aspect here is that all of the shrinkage has come from a reduction in the number of Power Centres, and a retracement of the growth strategy. However, Danier Leather is now more lean, efficient, and actually profitable, which is the key to a higher equity valuation. The lesson? Higher per share profitability is the key to a higher stock price. Moreover, as evidenced by the increasing cash balance over the course of the six years, profits in the form of free cash flow is what is important.

• Value Is The Answer – So, let’s assume that my assessment of the per share value of Danier in 2004 was correct. You would have watched the stock plummet to $2.30, and rebound to $11.93, where it is trading at today. In essence you would have made no money on the trade, and in fact, lost six years of compounding potential. This is precisely why it is important to buy stocks that have a significant margin of safety embedded in the purchase price. You never know if the stock will go up or down, but you want to stack the odds in your favour. Moreover, you really want to purchase stocks where the intrinsic value goes up over time, because then you achieve the holy grail of investing - intrinsic value growth plus the closing of the price to value gap. Let’s assume for a moment that you had bought DL when it first hit $7.00 (my recommended entry price) on August 16th, 2006 (let’s also assume my re-assessment of value was the same in 2006 as in 2004) and held until now, you would have generated a pre-tax return of 70%. Annualized, this translates into a compound return of 13.76%, which is not bad, considering the TSX is flat over that time frame. Lesson? Sticking to the basics by buying companies with growing fundamentals at cheap prices is what will give you decent returns over time. The hard part is having the patience to stomach the volatility, as you would have lost 67% of your capital from entry in DL at $7.00 before it turned the corner.

Okay, eight lessons is enough for one night. I’ll be back shortly to post on my experiences in China and Hong Kong this past May.