ablokhin
The following segment was excerpted from this fund letter.
Steven Madden (NASDAQ:SHOO)
Steven Madden is a fashion footwear designer and seller with a dominant market position in the North American wholesale market, particularly in the women’s fashion category. Major wholesale customers span the broad consumer spectrum, from Nordstrom to Macy’s to Amazon, mass market, and off-price retailers. In addition, the company operates a small fleet of its own stores and complementary wholesale businesses in apparel and accessories, as well as a small international business.
While the company would not have existed at all in the first place if not for founder Steven Madden’s skill in designing fashionable shoes, the most important thing to understand about this business is that it now has little or nothing to do with the company’s skills in designing fashionable shoes. The business model’s repeated success over time has been driven entirely, in our opinion, by its supply chain model.
To understand this, we first must look at the broad footwear industry’s supply chain model. For decades, this has remained roughly the same. Shoes have been manufactured in China, originally because labor was cheap, and Chinese manufacturers over a period of time had built the necessary capacity to handle the world’s shoe needs, which also helped to build a labor force with the necessary skills. As you know, this happened in most other industries, as well. On this side of the world, at least in part due to the very long lead times required to ship shoes from the other side of the world, shoe vendors and their retail customers generally have planned for two main seasons each year: Spring and Fall/Holiday. Shoe vendors and their customers would get together nine months ahead of these planned seasonal deliveries to the retailers; the shoe brands would show their customers what they planned to sell for the upcoming season, and retailers would place their orders then. The shoe brands would then place their orders with their manufacturers.
In an industry subject to the whims of fashion, and the unpredictability of weather, there are some obvious flaws with this process. To cite an oversimplified example, if you place a big bet, nine months ahead of time, on bright orange boots for the winter season, and it turns out that you arrive at the selling season and nobody likes bright orange, plus the weather doesn’t cooperate and winter never really appears, you have a problem.
For decades, the industry accepted these risks and consoled itself with the thought that it was at least getting a deal on the cheap Chinese labor. Without delving too far into our opinions on the historical skills of fashion industry management teams generally, we would argue that there always had been a flaw in this thinking, as well. We think it would be clear to most people that the per-unit cost of a product is only one component of your final profit and return on your investment in that unit of inventory. Another obvious input to that equation is the price at which you eventually sell that unit of inventory. If your orange boots eventually sell for 90% off, or get tossed into the trash, your great deal on the cost of manufacturing them doesn’t matter much. Even worse, you probably still have a few months of orange boots that nobody wants still chugging across the Pacific Ocean, and on your balance sheet in inventory.
There are less obvious flaws in this business model, as well. For as start, you have cash invested in an unwieldy string of inventory that is very long in terms of both time and distance; this slows down your inventory and working capital turns and ties up cash that you could be reinvesting in your business or returning to your shareholders. Furthermore, this lengthy, inflexible supply chain has opportunity costs that are not quantifiable. For example, if you happen to guess correctly on fashion and weather, and everyone loves your product, you have limited or no ability to replenish supply of your winning products. So, maybe you didn’t place a huge order for the bright orange boots, but it turns out everyone loves them, and your customers’ shelves are empty; they are begging you for more of these great orange boots, but you can’t get them from your manufacturer on the other side of the world for three months, even if you decide to pay up and fly them over. By this time, its now spring, and the demand is no longer there. Not only do you miss that opportunity, but your customer files this away in their memory, and they are less likely to place a big bet on you in the future.
More recently (although it’s no longer that recent), one additional issue made these traditional supply chains even more outdated: for a good 15 years or so now, Chinese labor is no longer even cheap. So now you have all the flaws of the China-based supply chains without any benefits at all, we would argue. However, despite the fact that this sourcing model hasn’t made any economic sense for a very long time, and despite several large external nudges – including Trump-era tariffs, Pandemic lockdowns and massive disruptions to supply chains around the world afterward – which should have caused shoe companies to take a good look at their supply chain for the first time since 1995 or so, there has been shockingly little progress made on modernizing supply chains over the past few years. A few companies have talked about moving some production to other Asian countries for cheaper labor, which still doesn’t solve the majority of the problems we discussed above, still leaving you with a long, unwieldy, and inflexible supply chain.
Turning to Madden: this company has operated its supply chain much differently. The company has a small manufacturing plant on Long Island, which it uses to manufacture small quantities of shoes created by their design team. They then use their own retail stores to test demand for their new creations. From there, they can choose to pursue their winners; but more importantly, they can abandon their losers. Madden doesn’t need to have a high success rate in designing fashionable shoes. They can design 20 shoes, scrap the 17 that are terrible and have no demand, and pursue the three that work. This does in fact create what we might call an illusion: Wow!, Madden has been really good at designing shoes for a long time. Most investment observers of fashion industries spend all their time looking at merchandise and taking guesses about whether the company is making pretty stuff or not; we believe they completely miss the fact that a company’s supply chain actually determines whether they are presenting a greater or lesser proportion of the pretty stuff.
So, at this point, Madden then can present their winners to their wholesale customers, such as Nordstrom. Nordstrom can feel much more confident about the bet they are placing in a product that already has demonstrated some success. Madden then can place its orders with their manufacturers, and that is where another key differentiation of the business model kicks in: especially for newer, higher-fashion shoes, they have established supply relationships with manufacturers in places such as Mexico. As this manufacturing is much closer than China, the turnaround time on these orders is significantly shorter, which removes a significant portion of the fashion and weather risks and also allows for the placement of replenishment orders if the Company’s retail customers want more. Incidentally, labor and shipping costs are also lower than they would be in China. Madden only has maybe six weeks of cash tied up in inventory in its supply chain, rather than 6-9 months.
Now, we must point out that Madden still places a significant percentage of orders with Chinese manufacturers, especially on more basic, established, large-volume shoes, for which fashion risk is less problematic. They have done this, in large part, due to the scale of the Chinese manufacturing base; perhaps they would have struggled to find manufacturers of the scale they needed in nearby regions. However, especially since the Trump-era China tariffs, the company has been reducing its reliance on China further. Most importantly, Madden started that period with a much more advanced supply chain than its competition and has only improved its position further because of these continuing shifts in its supply chain. Therefore, we established our initial position in the stock, and why we continue to hold a large position now. The market first beat up companies it viewed as “China stocks,” which was fairly arbitrary, since most companies in most industries are “China stocks.” More recently, the market clobbered consumer companies generally after large retailers such as Amazon, Wal-Mart, and Target admitted they had been planning for overly optimistic sales growth after the wild rebound period of late 2020-2021. The stock has been caught up in both of these market uncertainties, at many times leaving expectations and valuation very low.
Meanwhile, Madden’s financial results have demonstrated the superiority of its business model, although those results have been mostly ignored. Growth rates and margins remained steady during the period in which the industry was struggling with China tariffs. More recently, as its retail customers cut back on their orders significantly across most industries, the company had to cut its 2022 fiscal year EPS guidance by (5%); this, however, was after raising it by 6% earlier in the year. The overall effect of its customers’ inventory adjustments has been limited. More importantly, the market has failed to notice that both the longer-term China issues (which still exist) and the shorter-term inventory adjustments by customers actually play to Madden’s strengths. As highlighted above, Madden already has the supply chain everyone else should be building. Furthermore, because of this, in a period during which customers do not want to place up-front orders for shoes, Madden is one of the few companies which, first, did not have nine months of orders nobody wanted already backed up in its supply chain, and second, is able to meet customers’ preferences to place orders closer to need, should there prove to be better demand than expected.
With the stock recently bouncing off valuation levels last seen during the actual, full-blown recession of 2008-2009, we remain very confident in the company’s business model, and in fact we believe it has emerged from the era of China tariffs, Pandemic lockdowns, and the post-Pandemic supply chain disruptions and wild demand variations even stronger than before. We plan to continue to hold a significant position.
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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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