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Digital Brands Group (NASDAQ: DBGI): A Discount Entry Opportunity

Digital Brands Group (NASDAQ: DBGI): A Discount Entry Opportunity
Written by
Michael Sheikh
Published on
December 5, 2022
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Digital Brands Inc (NASDAQ: DBGI) was recently the target of naked shorting ahead of the HC Wainwright S-1 deal that recently brought in $10 million in capital for the company. What a lot of short-term investors haven’t grasped, is the strength of their underlying retail business and the greatly improved balance sheet over the past 3 months. The recent filings chronicled the dramatic turnaround in their balance sheet and dissected the combined business which should conservatively produce $35 million in revenues. This is an ideal play for the fundamental investor betting on the arbitrage of a go-private takeover of a mispriced stock.

Short Thesis - Continued Dilution

The shorts want investors to believe that DBGI is a diluting machine and that their intentions cannot be trusted. DBGI is a fashion brand, and there is always an intense capital outlay to manufacture the clothing line. Over the past couple of years, they had to resort to convertible note financings to keep up with their pace of growth. Their success as a brand was causing a larger and larger need for capital as they lost more and more market cap due to the overhang. The issue was that they didn’t qualify for PO finance and had to resort to these toxic convertible deals. At the end of September, they were holding about $10 million of convertible debt with interest amassed over many seasons. The shorts want investors to believe that this overhang still exists when in truth it has been most certainly fully converted.

Reality- New PO Funder Ends Reign of Dilutive Financing (Transformative Moment)

When news of the S-1 hit all investors saw was another new wave of massive dilution instead of the accretion of earnings that this acquisition would bring into a newly restructured entity capable of unlimited sales growth due to a financing line, and a Customer Acquisition Cost (CAC) of $15, the lowest in the fashion industry which averages $75. All fashion brands have a structural financing problem. They need to float the six months it takes from ordering a fabric to producing the finished product landed in a warehouse in the United States. Fashion and apparel companies normally use specialty financiers called Purchase Order lenders, but they require a successful track record of completion. Unfortunately, DBGI didn't conform to the purchase order model until it was just announced on the latest earnings call. This was a transformativemoment for the company because many of the fashion brands they plan to purchase (like Sundry) are not of large enough scale to get their PO facility. This Purchase Order Financing facility gives them unlimited growth potential without creating the need to raise more money. The reign of toxic money has come to an end. Any future need for financing is for accretive growth.

Recapping the Massive Trading Volume

How DBGI can trade many multiples of its float and go nowhere is what many investors were scratching their heads about when they looked at the price action of DBGI. The answer is not an easy one, but what happened was a confluence of players entering and exiting all at the same time. There was the Naked Short contingent that HC Wainwright probably tipped off that a massive S-1 was hitting. There was an army of short-busting YouTubers hell-bent on getting a squeeze. There were toxic noteholders frantically converting ahead of the S-1, trying to capitalize on the liquidity. The most important of the players is the fundamental investor, that looks like a bagholder, but in truth, they are ideally positioned to reap the fruits of the institutional wave about to hit the stock. The company was dramatically deleveraged over the past three months. It was a painful process that started with a low float of 540,000 shares and continues the daily drip to roughly over 1 million post-split new shares and ballooned the outstanding shares count to close to 1.6 million by the time the S-1 was ready as the end of November. Oasis Capital and First Fire converted daily at the end of October, blowing through close to $10 million of notes and interest. The company could announce the status of these notes as they appear to be fully converted. Investors could see that announcement in the coming days, and it could serve as an additional catalyst. The derivative liabilities also go away if these notes were converted, revealing a clean, healthy balance sheet in the next reporting period.

Smart Money Converts @ $9.31 - No More Dilution Threat

During this time, they also got one of the major debtholders, Black Oak, to convert their debt holdings to stock at $9.31 because they saw the value of what was created and the path forward. This is an early smart money debt investor who first invested when it was private. When they agreed to the conversion to preferred, their ownership percentage represented 2/3rds of the company. They chose the conversion to preferred because they understood the CEO’s vision, results, and the PO financing in place that could drive hypergrowth to the brands and offer them a very rich exit with minimal downside risk. The move to convert and clean up the balance sheet was calculated because if the stock price increases due to the value creation or increases due to the threat of a go-private move, the investor wins big in either scenario. Investors need to realize that this is smart money that doesn't see any future dilution; otherwise, they would have held onto their debt.

Debt Tied to Performing Assets

DBGI had $3.5 million of debt tied to Bailey’s 44 acquisition and just added an additional $2.5 million of debt for the Sundry acquisition. They have a total of $6.0 million in long-term debt. The performance of the brand essentially backs this debt. While there might not be a performance clause for these acquisitions, having debt as part of the purchase price serves the same purpose. These sellers were so sure that their brands would perform that they took part of the purchase price as debt and have the brand's future cash flow pay them off.

Consolidated Earnings Projections

Sundry EstimatesThe company has yet to provide firm guidance but is expected to do so after the Sundry deal is officially closed. Sundry is quite profitable and had a net income of $3.7 million in 2020 and $1.75 million in 2021. This could catalyze as investors get to explore the company's growth strategy. Right now, the combined revenues of the merged entity are at $30 million. With their new multi-brand site off to a spectacular start, they announced a 36.5% increase in average order value. This means $30 million in revenue translates into $40 million of revenue by being better at increasing their shopping cart value. The brands are in growth mode, and the last quarterly results showed 58.3% growth year over year and 273% year over year in Q2 2022. For these reasons, a 20% growth year over year for both businesses and the stickiness of the increase in order size could lead to $50 million in revenue.

Valuations

Public market multiples are always higher than private market multiples. According to the guidance by the CEO, the lowest private market multiple for the business is 1.5X revenue. Assets, however, are valued at cost. If they enact their go-private strategy, the company would be looking for a purchase price north of $75 million. This rough math works out to $18.75/share on a fully diluted basis assuming 4.0 million shares in the O/S. This is the lowest fair value of DBGI right now. The company's current market cap is based on 3.345 million shares at $3.60/share or a $12 million market cap. What is so interesting is that they have about $5.0 million of that earmarked in cash. Their use of proceeds used $5.0 million for the Sundry acquisition and $2.3 million to pay outstanding promissory notes. They also said in the S-1a, “we may also use a portion of the remaining net proceeds of this offering, if any, to acquire other complementary businesses in addition to Sundry.” The writing is on the wall for more ACCRETIVE acquisitions. The irony about the Sundry acquisition is that it was accretive, but investors chose to focus on structural issues with the company versus the fundamental valuation. Since the company has at least $2.0 million in cash, it pegs the enterprise value at $10 million. This very attractive enterprise value will be accumulated by hedge funds in the retail sector looking to arbitrage against the backdrop of a go-private strategy. A 13-G filing indicates shareholders who gobble up a 10% or great share in the company. It's reasonable to expect funds to band together and force this arbitrage. Even at $15/share, the economics are attractive to pursue the arbitrage to take it private and then spin it out via another public offering a year from now at a much higher multiple with very little risk due to the massive price dislocation. Investors should watch for a 13-G filing in the near future, indicating fund accumulation.

The Go Private - Nuclear Option

This option of going private has already been discussed, meaning values will need to be higher than the lowest private market valuation to stop the move. How long will the current management tolerate this mispricing environment before soliciting bids? Right now, they seem intent on beefing up revenues in anticipation of a go-private strategy which could be only one quarter away. This situation is similar to the go-private move of Meta Materials (NASDAQ: MMAT) and Meta Materials Pfd (OTCMKTS: MMTLP). These stocks saw massive price appreciation once a timeline of going private was established. Adding to the go-private pressure is the lack of stock incentives for management. The shareholder proposal for the executive incentive plan was voted down on October 13th, essentially denying the execs any additional compensation. This is the harsh reality that these executives faced due to their inability to stem the crumbling stock price. Shareholders punished them, which means management is eager to prove themselves worthy of bonus compensation, which should help drive the stock higher in the future. The flip side is that their lack of compensation may make them push harder to go private and pick a suitor more amenable to a fairer compensation package.

Investor Summary

A lot of misinformation has been flying around, and hopefully, this article clears things up for investors. The recurring theme is that DBGI is undervalued in the short-term, medium-term, and long-term. No matter what the metric, the company is underpriced. In the coming quarter, the company projected profitability with the Sundry acquisition, and the analysis strongly supports that contention. With no more convertible notes to short against, the shorts have nothing to hang their hat on. The S-1 financing is done, and it's akin to ripping off a bandaid and should be factored into the price. The naked shorts seem to have closed their position out on the S-1 financing as they have no more reason to drive the price lower with no offering out there. There are no more structured sellers in the deal. Still, it looks like DBGI is quite attractive to value investors and institutional investors willing to arbitrage the idea of going private. The stock will likely recover nicely as positive news regarding their acquisition gains steam. It's unclear whether DBGI's freshly cleaned balance sheet and exciting revenue growth will drive sales or force the company to pursue a go-private strategy. With a $10 million enterprise value, the stock is poised to run sitting at major long-term technical support.

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Disclosure: Insider Financial and its owners have NOT been compensated for this article. This article was written by a guest contributor and solely reflects his opinions.

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