Investment Thesis (Long): Big 5 Sporting Goods

Big 5 (“BGFV”) has 50-100%+ appreciation potential as we enter a prolonged period of upward earnings revisions and sentiment shift, and as technical selling pressure abates.  While the stock has been strong off of historic lows, the Street is dramatically underestimating the near-term and normalized earnings power of the business as it recovers from the prior recession.  Opening pitch to our thesis begins this April 30^th (after-market) with a Q1 earnings report that should be a Grand-Slam, exceeding Street estimates by 25%+, followed by significant increases to 2013 full-year EPS estimates (currently at $1.05) that should exceed 2014’s current consensus ($1.20).  

The closer is $2.00+ of 2015 EPS the company can generate (vs. $0.69 in 2012) only assuming 3% comparable store sales growth (“comps” or “SSS”) beyond 1H13. If Big 5 can get back to their historic operating margin of 6-8%, we think there is an additional $0.10-0.70/share of upside above our $2.00 estimate. Valuation remains very compelling based on our 2014 projections at: 9.5x EPS, 4.7x EV/EBITDA, 12% FCF yield, and a 2.8% dividend yield -- a 35-40% discount to peers DKS and HIBB despite 2.5x the EPS growth.

Situation Overview

Big 5 is a 414 store value focused sporting goods retailer, primarily focused in the western states.  The company began an aggressive store expansion prior to the recession (+23% units from 2004-2008), which lead to massive operating margin deleveraging (8.2% in 2004 to 2.1% in 2011) as the company’s core markets and middle-class customers were hit disproportionately by high unemployment and foreclosures (50% of stores in CA).  Sentiment has also remained negative as the company was late to participate in the consumer recovery with many investors believing their model is fundamentally flawed. Several activists accumulated large positions (Stadium Capital: 15%; Sagard Capital: 9%) thinking the company should cut SG&A, close underperforming stores and change the merchandise mix.  Stadium got a board seat, Sagard was unsuccessful, and while the fundamentals and stock price improved, it was more due to an improving economy rather than a shift towards the activist’s strategy.

The current opportunity exists because:

1. Technical selling pressure as Sagard exits its position
2. Favorable Q1 revenue dynamics that the Street is not accounting for
3. Fixed-cost leverage is underappreciated by investors

Key Investment Points

1. We expect ~20% near-term upside as several “beat-and-raise” quarters (starting with Q1) should add $0.20 to 2013 EPS expectations.  At the current 13.5x multiple, the incremental EPS adds $2.70 (20%) to the stock price.
2. We expect a further 60-80% upside in 12-18 months as the market turns to valuing BGFV based on 2015E normalized EPS of ~$2.00.  This only assumes 3% comps beyond 1H13 and below average historical operating margins.
3. Free optionality on balance sheet, store growth, and dividend increases.

Investment Point #1: Best In-Class Comps Drives Near-Term Upside in Q1….Let’s Play Ball!

The opportunity presents itself as the sell-side and investors fail to appreciate the fundamental strengths of Big 5’s business.  Rapidly accelerating comp trends over the past four quarters [-3%, 1%, 5%, 6.5%] are driving massive fixed cost leverage (occupancy, distribution, store, and employee expenses).  Our diligence suggests that Q1 sales should far exceed guidance/estimates, leading to a large Q1 positive earning’s surprise and significantly increased estimates as their sales recovery story drives upfield.  We are estimating ~11% SSS growth versus guidance of high-single-digits and consensus at 8%.

Comps:  Our channel-checks and several other factors give us confidence BGFV can generate double-digit comps for the first time in 20-years – an incredible achievement for a relatively mature store base, especially versus peer comps last quarter for DKS [+1.2%] and HIBB [+4.9%]:

• Weather has been optimal on the west coast vs. poor on the east coast.  BGFV’s core markets are California (51%), Washington (12%), Arizona (9%), Oregon (6%), and Colorado (5%).  The beginning of the quarter was cold and snowy in their mountain regions, driving sales of winter softgoods and hardgoods.  Weather turned warm in March right on cue setting up well for sales of spring goods (ie. baseball).
• Gas prices have declined materially and are now ~8% below last year. 
• Guns & Ammo (~12% of sales) are still “on-fire” posting approximately +30% comps (based on LQ).
• Traffic to their stores has turned positive for the first time in several years.
• Upgraded branded assortments are attracting first time customers.

Margins: We are expecting +150bps of gross margin expansion versus +50 bps for consensus.

• Merchandise Margins: should be up 2x over the +25bps consensus expectation.  We triangulate via:
  • 1Q12 merchandise margins were -160bps due to minimal snowfall in key markets - leading to a mix shift away from higher margin winter-related products and increased promotions. 
  • 1Q13 results should recapture a good portion of last year’s decline, especially with the favorable winter weather trends.  Additionally, the lack of California rain should drive strong spring sell-thru in Q1 (and Q2).  
  • The strength of guns/ammo (a low margin category) will continue to be a gross margin drag of approximately 60-80bps, but we have included that pressure in our estimates. 
  • BGFV’s IT investments are starting to bear fruit leading to improved inventory management and stronger initial selling margins.
• Fixed Cost Leverage:  Acceleration in comps will lead to fixed cost leverage significantly higher than expectations.
  • Occupancy/Distribution leverage: BGFV typically leverages occupancy and distribution costs on a blended 2.5% comp, so a ~10% comp should generate around 110bps of leverage to gross margins.  As a point of reference, they generated 80bps of fixed gross margin leverage in Q4 on a 6.5% comp.
  • SG&A leverage – management has historically done a phenomenal job of keeping expense growth low.  They are able to leverage SG&A expense on a 1.0-1.5% comp vs. competitors requiring comps well above 3%. We expect SG&A to grow ~4.5%, providing ~200 bps of SG&A leverage. 

The table below summarizes our expectations versus last quarter, guidance, and sell-side.

Investment Point #2: Normalized Earnings Should Approach $2.00-2.70 off a 3% Comp and 6-8% OM

Given the inherent leverage in BGFV’s model, a 2-3% comp can produce 25-30% of EPS growth. We expect BGFV to generate $2.00 of 2015 EPS only assuming a 3% comp and a return to historical (but below average) margins. Historical operating margins averaged 7.1% from 1998-2007, which was reduced to 3.5% during the recession; every 3% comp translates into roughly 70bps of margin expansion (20bps of merchandise margin and 50bps of SG&A leverage) or $0.35 of EPS. A 3% comp in 2014/15 translates into $1.13bn of 2015 sales. At 6% operating margins, they’ll generate $2.00 of fully-taxed earnings (assuming no share buyback).  Management has targeted a return to historic 6-8% EBIT margins, which would translate to EPS of $2.10-$2.70 depending on comp assumptions in 2014/2015.  We see no barriers in returning to peak sales/sq ft but our 2015 estimates still remain 5% below this level. In addition, their e-commerce platform launches in 4Q13 and we’ve included zero benefit to future sales or EPS. Retailers typically garner 5-10% of revenues from e-commerce. BGFV is currently booking $0.04 of annual expense as they roll out the platform and this could turn to $0.20 of profit at 5% of sales. The incremental $0.25 of EPS is not included in the $2.00-2.70 we are projecting for normalized earnings.

Investment Point #3: Free Optionality on Balance Sheet

By the end of 2013, BGFV will be close to net cash positive. This is fairly significant for a business that had >4x leverage at one point and has averaged around 1-2x for the last 10 years. We believe this creates significant optionality to increase the dividend, repurchase stock, or accelerate store growth.  In 2014, they’ll generate around $1.40/share of excess FCF (post-dividend).  For every 1-turn of leverage the company could pay a $3.25 special dividend.  We believe the company is likely to increase its dividend significantly and/or pay a special dividend. The CEO currently owns 4% of the company and this would be the easiest way to pay himself in a tax-efficient manner without monetizing his investment.  A $3.25 special dividend would net him $2.7mm or nearly 4x his annual compensation.

Valuation: Cheap on an Absolute and Relative Basis

BGFV is too cheap on both an absolute and relative basis, especially when factoring in its rapid sales improvement and EBIT margin expansion.  On an absolute basis, shares are trading at 9.5x our 2014E EPS, 4.7x EV/EBITDA and at a 12% FCF yield.   Those multiples are far too low, especially when EPS growth will be >70% this year and 25-30% in ’14 and ’15 based on a 3% comp run rate.  On a relative basis, BGFV trades at a 30-40% discount to HIBB/DKS on PE and EBITDA.  BGFV does have slightly less square footage growth (1-2%), which does not warrant the same growth multiple of peers, but the magnitude of the discount is highly unwarranted and we are assuming a 15% discount in our target valuation. Additionally, with BGFV’s unlevered balance sheet, they have the ability for above-average store growth, should they pursue that strategy.

Over time, we believe the company is worth $27/share -- 13x normalized earnings of at least $2.00/share plus $1.20 of cumulative dividends (not assuming increases). This also does not include the $0.25/share of incremental EPS we expect from the e-commerce roll-out. We think within 12-18 months the earnings leverage will become apparent and the market will begin to price $2/share+ of EPS.

 Risks or Potential Curve Balls:

1. DKS aggressively opens stores in CA: the company already has 14 stores in CA but we believe their model and customer is far different than BGFV.
2. Housing rolls over and employment trends deteriorate.
3. Guns/Ammo sales hurt margins more than expected.
4. The Sport Authority aggressively promotes/discounts.
5. Gas prices spike higher, impacting their core customers’ wallets.
6. E-commerce roll-out is delayed. We think it could add $0.25 of incremental EPS but have not included it in our estimates.