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Stock Strategist

Seeking Small-Cap Moats: Tumi Holdings

Luggage maker Tumi travels toward moatworthy status in the luxury goods industry.

This article is part of Todd's monthly series "Seeking Small-Cap Moats." The introductory article can be found here. New articles in the series are published on the fourth Wednesday of every month.

With the holiday season--and thus the shopping season--upon us, it seems as good a time as any to feature a consumer goods company in our monthly "Seeking Small-Cap Moats" article. At the very least, it'll give us an excuse to do some on-the-ground research while we're at the stores in the next few weeks.

It takes an impressive company to establish an economic moat in the highly competitive consumer goods industry, where margins tend to be thin, consumer tastes are always changing, and a series of fashion missteps can derail a firm's growth story.

It's even more difficult to establish the massive brand strength required to carve out an economic moat in the luxury consumer goods industry, where companies like  Burberry (BRBY), Hermès International, and  Tiffany have built their timeless brands over decades and have established themselves as standards of quality and fashion leadership.

Armed with an aura of exclusivity, luxury goods companies tap into their brand equity to charge premium prices and generate consistently high profit margins. Naturally, attractive margins invite competition, but it can take decades for a would-be competitor in the luxury goods industry to establish an enduring global brand.

One company that appears well on its way to firmly establishing a moat in the luxury goods industry is Tumi Holdings , which manufactures and distributes the eponymous brand of high-end luggage and travel accessories.

Here are some quick facts about Tumi:

  • Market cap: $1.4 billion
  • Headquarters: South Plainfield, New Jersey
  • Insider ownership: 3%

Tumi was founded in 1975 by a former Peace Corps volunteer who began importing leather bags made in South America. In 1983, the company began to set itself apart by using ballistic nylon to create durable yet lightweight luggage and bags. Over the next three decades, Tumi endeared itself to frequent travelers who didn't mind paying up for high-quality luggage and travel products.

In 2004, Tumi was acquired from the founding family and other shareholders by U.K.-based private equity firm Doughty Hanson, which stills owns about 13% of the shares and has two board seats. The company went public in 2012 after Doughty Hanson helped Tumi build its footprint in Asia and establish a stronger retail presence.

Tumi's growth strategy is ambitious, as it plans to rapidly increase its store count in North America and Western Europe in the coming years to 300 full-price stores (currently 95), 100 outlet stores (currently 33), and 100 airport stores (currently four). Outside of North America and Europe, Tumi aims to expand via wholesale to high-end department stores, specialty stores, partner stores that resemble Tumi's company-owned stores, and e-commerce. At year-end 2013, about two thirds of Tumi's annual sales were derived from North America. Sales to Asia-Pacific accounted for 18% of sales, but travel demand is growing rapidly in the region as per capita incomes increase. This could provide a steady long-term tailwind for Tumi products in the Asia-Pacific region.

It’s encouraging that Tumi has increased its average net sales per square foot at its stores from $629 in 2009 to $1,088 in 2013. According to a survey by eMarketer that was published earlier this year, Tumi's revenue per square foot placed it 12th best out of more than 200 U.S.-based retailers (Apple was number one). This type of store performance should help Tumi negotiate increasingly favorable leasing terms as it expands it into new markets.

Moat
At Morningstar, when we evaluate a luxury goods company for a potential economic moat, we start by asking the following questions:

  • How strong are gross and operating margins? Since 2010, Tumi's gross margins and operating margins have hovered near 58% and 18%, respectively. These levels fall into the lower end of the range we'd expect for a luxury goods company, but they're still indicative of a company with relatively strong pricing power. Its margins also compare favorably with mass-market competitor Samsonite International, whose gross margins and operating margins have been around 53.5% and 13.5%, respectively, over the same period.
  • Is the brand strength based on historical or timeless cultural references, images, or popular icons that would be hard to replicate? Tumi hangs its hat on the image of the sophisticated and affluent traveler--the "global citizen"--who effortlessly circumnavigates the globe and does so in style. It doesn't have a monopoly on this image, of course, but only a handful of companies can back up the statement that their products are preferred by this type of traveler. Samsonite, by comparison, promotes more of an adventurous, common traveler theme to appeal to its target mass-market audience.
  • Is there high-fashion risk? In general, we find that areas of the luxury goods market that are less sensitive to the whims of customer taste have more durable moats. There's certainly some fashion risk in luggage and travel products, but far less than in categories such as apparel or footwear. In other words, it's far less likely that someone will swap out their luggage each year to keep up with the current fashion.
  • What is the product mix of the company? In 2013, Tumi travel products (e.g., carry-ons, luggage, and garment bags), business cases (e.g., backpacks, messenger bags, and soft business cases), and accessories (e.g., wallets, key fobs) accounted for 44%, 42%, and 14% of annual sales, respectively. At Morningstar, we think that luxury products that are purchased less frequently (such as engagement rings, watches, and leather goods) tend to give sellers more pricing power. The majority of Tumi's products fall into this category.

Tumi satisfies most of the criteria that support an economic moat. Even though Morningstar doesn't cover Tumi Holdings, and the company hasn't been vetted by our moat committee to produce an official Morningstar Economic Moat Rating, I'd argue that it has established a narrow economic moat based on brand-driven intangible-asset advantages.

Risks
Beyond the risks outlined in the company's annual report, I'd be concerned if Tumi began discounting its merchandise or emphasizing its entry-level offerings, as that may reduce the exclusivity appeal to more affluent customers who then would be less likely to pay higher-end prices.

Tumi's ambitious store growth in North America and Europe may be a "growth for growth's sake" strategy, leaving long-term shareholder value as a secondary concern. Ideally, the company will roll out new store locations only when those locations serve to strengthen the brand and generate consistent returns above its cost of capital.

I'm not a big fan of the executive incentive package that the board has established. Annual bonuses, for instance, are based on adjusted EBITDA, which as a cash-flow measure ignores important items such as changes in working capital and capital expenditures. As an earnings measure, adjusted EBITDA doesn't account for normal expenses like interest and depreciation. By comparison,  Coach's (COH) annual executive bonuses are based in part on earnings per share, and Burberry's are based on profit before tax. These seem like more appropriate metrics for a luxury retailer and are at least more aligned with equity owner interests. To be fair, Tumi's board does have the right to penalize management for excessive store operating costs and high capital expenditures for new stores. The question is, would the board freely exercise that right in the event of cost overruns, or would it try to avoid potential confrontation with management?

Valuation
Tumi has laid out some aggressive long-term financial targets, including mid- to high-teens revenue growth, operating margins in the mid-20% range, and EPS growth in the high teens. With the stock price fairly stagnant since the 2012 IPO, it seems the market isn't fully convinced that these targets are achievable.

Assuming management can deliver high-teens EPS growth in the longer term, the stock doesn't look entirely expensive here around $21. With an estimated 2014 price/earnings ratio of 24, this would imply a price/earnings-to-growth (PEG) ratio around 1.3 times. Still, I'd like to get a better margin of safety before buying, so I'd look to start a position below $17 per share.

This might be an early opportunity to invest in a burgeoning luxury brand, and Tumi is a name I plan to keep an eye on in the coming months. As such, I'll need to stop by the Tumi store on Michigan Avenue here in Chicago this holiday season to get to know the products and store setup a little better.

Favorite Ideas
As of Nov. 20, here are my top five watchlist candidates (in no particular order):

  • Winmark (WINA): More research is needed on the threat of online competition and potential changes to franchisor liability, but John Morgan and team are an impressive group of capital allocators.
  • Raven Industries : It's probably going to be a rough year or two with a slow agriculture equipment market. If you're going to own shares, you need to be patient.
  • Culp (CFI): Management is making the right capital-allocation decisions, and the balance sheet is solid.
  • Sun Hydraulics (SNHY): The company reported a strong third quarter with all major geographic regions posting double-digit year-over-year sales growth. Current expectations are high, so I'm waiting for a pullback to add to my position.
  •  US Ecology : After a recent sell-off, the wide-moat company is currently trading below our $43 per share fair value estimate and is worth further research.

Previous installments of this series:

The next article in this series will be published on Wednesday, Dec. 24.

Todd Wenning, CFA, owns shares of Sun Hydraulics, WD-40 Company, and Raven Industries. You can follow him on Twitter at @toddwenning.

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