Shoes and accessories retailer DSW Inc. (NYSE:DSW) reported fourth-quarter numbers recently that impressed investors.
Designer Shoe Warehouse missed revenue estimates, but smashed earnings expectations. Comparable sales rose in the quarter. Gross margins improved, as did operating margins. Meanwhile, the revenue guide called for positive comps next year (excluding the impact of the 53rd week) and the earnings guide called for nearly 10% growth year-over-year at the midpoint.
In other words, the report checked all the boxes for a supposedly struggling retailer.
DSW stock soared as a result. It rose 11% to just shy of $22.
But the exciting thing about DSW stock is that this may be just the beginning of a much bigger run. Here’s why:
DSW Stock Is Nearing Critical Inflection Points
When looking at retail stocks in this down-trodden retail environment, investors want to see three things: positive comparable sales growth (meaning customers are choosing to shop at the retailer over alternative online options), gross margin expansion (meaning online competition isn’t dampening the company’s pricing power), and operating expense leverage (meaning the retailer is successfully taking costs out of the system). If a retailer checks off those three boxes, then the stock should head higher.
DSW stock hasn’t checked off those three boxes for a while.
Comparable sales growth has been negative for two consecutive years. Gross margins have been in free fall from roughly 30% to around 28%. Operating margins have likewise compressed from nearly 10% a few years ago to right around 7% today.
But things are starting to change at DSW.
Comparable sales growth was 1.3% in the fourth quarter, the best mark all year, thanks to renewed strength in the company’s core footwear segment. Gross margins expanded 260 basis points in the quarter due to favorable sourcing and lower markdowns. Operating margins expanded even more (270 basis points), as the company continued to cut fat out of its operating model.
In other words, all three boxes were checked in the quarter. That is why DSW stock roared higher after the report.
Looking ahead to next year, it’s likely that all three boxes get checked off again and DSW stock keeps grinding higher.
Rewards Boost DSW Stock
Comparable sales growth (excluding the impact of the 53rd week in fiscal 2017) is expected to remain in positive territory in 2018. This seems like a reasonable goal. The big thing about Designer Shoe Warehouse is that roughly 90% of DSW segment sales are driven by Rewards members. Those Rewards members have proven to be exceptionally loyal over the past several years — even with online alternatives marching to the forefront.
Next year, those Rewards members should spend more than ever because DSW is rolling out multi-purpose stores with manicure and shoe repair stations. Plus, the company is overhauling its Rewards program to include perks in relation to manicures and shoe repairs. All in all, this should lead to a big spending surge from Rewards members. Because those Rewards members drive the majority of DSW sales, comparable sales growth should remain positive next year.
Moreover, gross margins are just starting to inflect upward after a multi-year decline. Management feels confident that this uptrend can continue. The new store roll-outs will cause a surge in operating expenses, but it’s fairly likely that strong sales growth helps offset some of those higher expenses. Consequently, gross margin expansion should flow through to operating margin expansion.
All in all, DSW should be able to check off the three important boxes for retail stocks next year. With all those boxes checked off, DSW stock (which trades at just 13-times forward earnings) should head higher.
Bottom Line on DSW Stock
The big reason to buy this stock is that the company is just starting to upgrade its stores and Rewards program. For most retailers, that is a hit-or-miss move. But because Rewards members are such a huge driver for DSW sales, store updates and better Rewards perks should drive fairly strong sales and earnings growth.
DSW stock is still pretty cheap ahead of that forthcoming catalyst. As such, now looks like a good time to buy before a strong fiscal 2018.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.