Why Duluth Holdings' Quarter Was Better Than It Appeared

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Duluth Holdings (NASDAQ: DLTH) third-quarter earnings report was -- on the surface -- a mixed bag, featuring eye-popping retail sales growth along with bottom-line earnings that came in below expectations, causing shares to tumble.

However, the company had already signaled that short-term earnings would be muted as it invests rapidly to build out its store base. The market is missing the forest for the trees by overreacting to a single quarter.

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Retail sales growth was through the roof

For the quarter, net sales were up 25% to $83.7 million. Breaking down the sales mix, the company's retail segment grew 101% year over year -- much more quickly than its direct (e-commerce and catalog) business -- contributing more than a third of the company's total sales for the quarter.

While the company isn't releasing store-level sales data yet, CEO Stephanie Pugliese did talk in broader terms about Duluth's store-level performance:

Duluth's retail stores are proving to be a powerful customer acquisition tool. This quarter, more than a third of all new customers made their first purchase in a retail store. And the company said that its retention rate among retail customers is even higher than in its direct business.

Slower growth in direct sales wasn't unexpected

On the flipside, the company's growth in direct sales came in at just 4%. The company continues to see a steady decrease in shipping revenue as consumers have come to expect (and hold out for) free shipping. While that caused overall gross margins to decline 120 basis points to 56.6%, product margins were actually up compared to last year as Duluth products maintained their pricing power.

The company also intentionally reduced its digital ad spend and avoided deep discounting online in the third quarter, noting "we were far more focused on having promotional flexibility and firepower in the fourth quarter." That move seems prudent given the importance of the holiday selling season.

Should investors be concerned about direct sales growth trending down into the mid-single digits this year compared to the double-digit growth rates of the past? Direct sales look healthy enough to me. Even with the decline in shipping revenue, direct sales are up 5.5% year to date, smack in the middle of the company's 5% to 6% guidance for 2017.

Additionally, the company claims that its retail stores -- after temporarily causing direct sales growth to slow in a new market -- eventually have the opposite effect, boosting direct sales in that market to grow at twice the rates of markets without stores. The company has seen that play out in its first four markets with mature retail stores, and is already seeing a reacceleration of direct sales in the Chicago market, where its first stores opened a little over a year ago.

About that EPS loss

Admittedly, the headline numbers showing a diluted earnings per share loss of $0.03, compared to positive earnings of $0.01 last year don't look great.

One major factor was the company's pre-opening expenses, which ballooned 35% year over year as Duluth opened three new stores in the quarter and five additional stores in November.

Getting those five extra stores up and running in time for the holidays will allow Duluth to ring up more sales in December, but it also pulled some pre-opening expenses into the third quarter that would have otherwise been recognized at the end of the year. As a result, next quarter, the company expects pre-opening expenses to come down to a range of $1.7 million to $1.9 million, compared to $2.7 million this quarter.

The company also reaffirmed its sales, earnings and adjusted EBITDA guidance for the full year. Assuming Duluth is able to hit those targets, the larger-than-expected loss this quarter seems like a non-event.

Looking ahead

For investors who take the long view, the key to Duluth's future growth lies in its retail operations. The company opened 15 new stores in 2017, bringing it to total of 31 today. And with plans to open another 15 next year, by the end of 2018, the company should be nearly halfway to its long-term goal of 100 stores.

During the call, CFO Dave Loretta explained:

While the retail expansion is already driving the company's top-line growth, over time, this should eventually translate into solid bottom-line gains as well.

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Andy Gould owns shares of Duluth Holdings. The Motley Fool recommends Duluth Holdings. The Motley Fool has a disclosure policy.