Big Lots (BIG)

Summary

We focus on smaller companies with Ft. Knox balance sheets and large & sustainable free cash flow yields and we are typically seeking a mid-teens FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation, through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.  We also focus on small and micro-cap stocks because there is a much better chance to find an attractive investment opportunity which is under-followed or undiscovered.

One larger company we believe is under-valued is Big Lots (BIG), a non-traditional discount retailer that has undergone a strategic repositioning under CEO David Campisi, who arrived in March 2013.  His Strategic Plan (discussed below) appears to be working as BIG has achieved nine consecutive quarters of positive comp store sale growth (see Comp Store Sales chart below). We believe BIG is attractive at current prices trading at 0.5x revenues, 6.5x LTM EBITDA, and a 9% unleveraged FCF yield.  BIG has a “Ft. Knox” balance sheet with net debt of about $90m or 0.25x LTM EBITDA and an investment grade credit rating.  Importantly, BIG is also a “Cannibal” to use Charlie Munger’s term for companies that aggressively repurchase shares,  BIG’s diluted shares outstanding have declined from 78m at year end 2010 to about 45m at present, and we expect further declines over the next few years.  We believe this is the proper use of excess capital given the over-stored environment in U.S. retail.  BIG stores we have visited offer substantial savings on everyday items that we believe consumers actually want or need to purchase with good quality and value.  The Strategic Plan has shifted BIG towards a more consistent offering for consumers, relying less on opportunistic closeout purchases which led to BIG erratic financial results and distrust from investors.  In our view, the consumer remains value oriented and these basic everyday items at big discounts are attractive.   

The Company has1445 stores in the U.S. averaging about 33,000 square feet (22,000 square feet of selling space).  The Company seeks to provide customers with great savings on value-priced merchandise, including trend right import merchandise, consistent and  replenishable “never-out” merchandise, and brand-name closeout merchandise.   BIG’s key merchandising categories are: Food (16% of total revenue), Consumables (18%), Soft Home (12%), Hard Home (9%), Furniture (22%), Seasonal (16%), and Electronics & Accessories (7%).  Food includes beverage & grocery, candy & snacks, and specialty foods departments.  Consumable includes health and beauty, plastics, paper, chemical, and pet departments.  Soft Home includes home décor, frames, fashion bedding, utility bedding, bath, window, decorative textile and area rugs departments.  Hard Home includes small appliances, table top, food preparation, stationery, greeting cards, and home maintenance departments.  Furniture includes upholstery, mattress, ready to assemble, and case goods departments.  Seasonal includes lawn & garden, summer, Christmas, toys, and other holiday departments.  Electronics & Accessories includes electronics, jewelry, hosiery, and infant accessories.

BIG stores are located across the U.S. with largest store concentrations in the following states – California (159); Texas (116); Florida (103); Ohio (96); North Carolina (74); Pennsylvania (69); and New York (63).  BIG leases almost all of its stores.  In early 2014, BIG closed all its stores in Canada (89 stores) which became a discontinued operation.

We believe as BIG continues to generate consistent operating and financial performance, investor perception could change.  We believe BIG can achieve modest revenue growth, stable comp store sales, and improved EBITDA margins in 2016 and 2017, and this could result in adjusted EBITDA of $400m+ in 2017 (versus $370m LTM) and trade for 8x adjusted EBITDA with a near debt-free balance sheet, or a market cap of about $3.2b in 2017.  BIG has about 45m total shares outstanding today which we believe could be about 40m by year end 2017.  Based on a $3.2b market cap and 40m shares outstanding, BIG could have a share price of about $80 per share or close to 60% higher than current prices.

New CEO and Strategic Plan

In May 2013, David Campisi became CEO of BIG.  He previously served in various roles at Sports Authority from 2004 including CEO and left in 2011.  He developed and implemented a three year Strategic Plan in 2013 and 2014 which was a multi-year plan and roadmap for the future.  Before he arrived BIG had consistently posted negative comp store sales and financial performance was erratic which led to investor distrust.  The Strategic Plan is focused on three key Pillars – A) the Customer (aka Jennifer) as embodied in merchandising, marketing, and store execution; B) Employees (aka Associates) including acquiring and retaining top talent to execute; and C) Shareholders, including enhance operating model while providing consistent financial returns.  The Strategic Plan focused on improving operating margins to 6% within three years.  The Strategic Plan focused on key items that were important to customers – 1) competitive prices; 2) new products and of good quality; 3) consistent supply of key products; and 4) food to always be fresh and in date.  There was a major focus on addressing these customer desires. 

During 2014 and 2015, management began to execute on the Strategic Plan.  A major focus of the strategic plan has been the “Edit to Amplify” program, where weaker categories and SKU’s have been eliminated and stronger segments and SKU’s have been expanded.  Another key component of the Strategic Plan is the QBFV (Quality, Brand, Fashion, Value) program where merchandise in stores must offer certain standards of quality and value to customers in order to remain in stores.  SKU’s are scored 1 to 4 points on each of these areas and an SKU must hit a minimum total to remain in stores. 

The Strategic Plan’s merchandising strategy seeks to offer customers a product assortment of value-priced merchandise that is meaningful to the customer, combined with improving the shopping experience.  The Edit to Amplify strategy uses the two separate “Edit” and “Amplify” components to exceed customers’ expectations.  The “Edit” component focuses on continuously evaluating the product mix and downsizing or eliminating those departments or product offerings that management believes the customer does not prioritize or where the Company does not maintain a competitive advantage.  The “Amplify” component enhances the assortment of those merchandise categories or products the Company believes are important to the core customer’s shopping experience and where it believes it has a competitive advantage.

BIG’s business has historically focused on selling value-based merchandise sourced through closeout channels, resulting in inconsistent offerings to its customers.  In 2014, the Company implemented a merchandising strategy to improve the consistency of the value-based merchandise available in its stores by reducing its reliance on sourcing closeout offering in certain merchandise categories. In order to improve the consistency of its merchandise, BIG introduced disciplines for purchasing merchandise through a ratings process that measures quality, brand, fashion, and value (QBFV).  This more disciplined approach enables BIG to compare the potential performance of traditionally-sourced merchandise, either domestic or import, to closeout merchandise, which is generally sourced from production overruns, packaging changes, discontinued products, order cancellations, liquidations, returns, and other disruptions in the supply chain of manufacturers.  BIG believes this greater level of focus on customers” expectations enhances its ability to provide a desirable assortment of product in merchandise categories and improves inventory turnover.  BIG closeouts are more focused in its Food and Consumable segments where it opportunistic purchases of brand name items can be a competitive advantage in terms of price.

The Strategic Plan has moved BIG from a closeout retailer focused on opportunistic buys where many items purchased were bought at big discounts but were not products customers were interested in purchasing.  This resulted in erratic merchandising and financial results.  This more focused and consistent approach to merchandising recognizes that with a 22,000 square foot store, it is essential that BIG focus on these categories where it has some advantage or can compete effectively.  The Strategic Plan focuses on categories which are “Ownable” where the Company has some distinct competitive advantage.  Ownable categories are Furniture and Seasonal.  One reason Furniture is Ownable is that BIG sells upholstered furniture and mattresses while major discounters Wal-Mart and Target do not.  “Winnable” categories are Soft Home, Hard Home, Food, and Consumables.  These are categories where BIG believes it can compete effectively against other retailers.  The Company’s SKU count has decreased considerably with current merchandise being items that the customer wants and which are offer good quality and value and this lower SKU count has also helped control expenses.  Ownable categories Furniture and Christmas Trim are destinations for the customer and have meaningful competitive advantages and future sales growth potential.  A significant amount of furniture is supplied through a strategic relationship with Ashley Furniture and for mattresses supplied by Sealy and Serta.  The Company offers very attractive entry price points for quality furniture and mattresses in Furniture segment which the customer can carry out on same day basis.

Some key advantages for Furniture category include: 1) BIG is the only coast to coast furniture retailer with low to moderate price furniture targeted to its customers’ needs and pocketbook; 2) BIG offers product with strong QBFV (Quality, Brand, Price, Value); 3) BIG has had Proven Success in Upholstery, Case Goods, RTA, and Mattresses; 4) BIG offers key brand names including Serta, Simmons, Ashley, and Sealy; 5) BIG has another competitive advantage in offering Buy Today, Take Home Today; and 6) BIG has strongly managed vendor partnerships.  Management hopes to grow the Furniture category by double digits for the next several years.

In the last two years, BIG has implemented a private label credit card program, partnered with Alliance Data Systems in Dallas, Texas, where credit approvals are quickly provided by Alliance.  The Company has also started a lease to own program for its furniture sales which has also met with success.  These two programs are helping sales by providing BIG  customers more purchasing ability.

We believe BIG’s Strategic Plan has the Company well-positioned strategically for what consumer want today.  We believe consumers are still struggling economically and maintain a strong value orientation.  BIG supplies everyday items, including its Food and Consumables segments as well as other segments, which meets basic needs for the consumer with greater quality and value and consistency than in prior years.  Consumers can realize quite substantial discounts and savings on everyday items.  BIG has carefully targeted segments where it believes it can compete effectively.  These major discount retailers do not carry items that compete that directly with the Furniture segment of BIG and this gives the company one competitive edge.  We expect BIG’s Furniture category which is currently its largest segment (22% of total revenues) and we expect this percentage to increase over the next couple of years.

We believe housing, particularly at the entry level, is one of the stronger parts of the U.S. economy currently as housing starts have lagged for many years and demand for entry level housing has built up.   The low-cost and good quality merchandise sold by the Furniture segment plays very well into these current trends as millennials move into entry level housing and purchase furniture.

Capital Programs in 2014 and 2015

In 2014, the Company started the roll out of two capital programs – 1) coolers and freezers and 2) point of sale systems upgrades – and these continued into 2015.  The cooler and freezer program was tested in approximately 100 stores in 2013 with the goal of increasing the convenience for the core customer in the Food category.  An additional 650 stores were added by the end of Q3 2014 and during 2015 an additional 650 stores were added.  The Company currently has approximately 1,300 stores with coolers and freezers.  The introduction of coolers and freezers help BIG get authorized to accept customer benefits qualifying for government assistance programs such as supplemental nutrition assistance program or SNAP.  This provides another source of funds to spend at stores.  During 2014, the Company also began a POS systems upgrade program to improve the speed of transactions, increase functionality, and reduce maintenance burden as prior hardware was nearing end of useful life.  The roll out of new POS systems was completed in 2015.

Closeout Merchandise

Although reduced in certain categories, the sourcing and purchasing of quality closeout merchandise directly from manufacturers and other vendors, typically at prices below those paid by traditional discount retailers, continues to represent an important competitive advantage for BIG’s business model.  The Company has built strong relationships with many brand name vendors and these relationships, along with its purchasing power, enable BIG to source merchandise that provide exceptional value to its customers.  One of the key factors in building its vendor relationships is BIG’s ability to purchase significant quantities of closeout merchandise and then control its distribution through BIG’s broad store footprint, in accordance with the vendor’s guidelines.  BIG believes its sourcing model, along with its strong credit profile, provide a high level of service and convenience to vendors.  BIG expects to continue to deepen its relationships with its top 200 vendors.  BIG’s sourcing also includes bankruptcies, liquidations, and insurance claims.

Marketing and Advertising

The Company promotes its brand through various methods, including television, internet, social media, in-store point-of-purchase, and print media.  In all markets, the Company designs and distributes printed advertising circulars, through a combination of newspaper insertions and mailings.  In 2015, the Company distributed multi-page circulars representing 31 weeks of advertising coverage, which was a one week increase from prior year.  The Company creates regional versions of these circulars to tailor its advertising message to different markets, depending on product availability, climate, and customer preferences.

The Company has a customer database, which it refers to as the Buzz Club, and this is an important marketing tool that allows the Company to communicate in a cost effective manner with its customers, including email delivery of its circulars.  In addition to Buzz Club, the Company operates Buzz Club Rewards program, which allows it to send specialized promotions to targeted customer groups with the intention of expanding their desire to shop at its stores.

The marketing strategy has also been improved under the Strategic Plan.  In 2015, the Company introduced the ad campaign “Shop Big Lots First” and reenergized its focus on the Buzz Club Rewards program through increased new member sign up in excess of 20% in stores and online.  BIG has moved aggressively into new communication channels including e-circulars, paid search, display, and social media.  Facebook followers now exceed 3m.

In addition, the Company uses in-store promotional materials, including in-store signage, to emphasize special bargains and significant values offered to its customers.  Total advertising expense as a percentage of total revenues was 1.9%, 1.9%, and 1.8% in 2013, 2014, and 2015.

E-commerce

E-commerce has been a key initiative for the last few years and BIG has recently formally launched this initiative which it believes its customers want.  However, the Company is approaching ecommerce cautiously, in gradual phases.  The first phase is the customer orders product online and it is shipped to her from the distribution center in Columbus, Ohio.  Initial SKU’s are about 3,000 items limited to products that lend themselves to easy fulfillment.  BIG maintains its mindset on e-commerce is “Crawl, Crawl, Walk, and Run” and to move cautiously forward.  The Company has estimated revenues of about $20m to $22m for 2016 and an operating loss of about $10m to $12m.

Seasonality

BIG’s business is seasonal, with the majority of revenues and profits generated in Q4 (ended January 31).  BIG historically receives a higher proportion of merchandise and carries higher inventories, and incurs higher outbound shipping and payroll expense as a percentage of sales in its third fiscal quarter (ended October 31) in expectation of increased sales in Q4.  Q4 results are generally favorable due to higher sales and certain of its costs, such as rent and depreciation, being fixed and do not vary as sales increase.  Working capital requirements generally peak near the end of Q3.  In 2015, BIG’s total debt, including borrowings and letter of credit, peaked in November 2015 at about $383m, under BIG’s $700m unsecured credit facility.  At January 30, 2016, BIG total debt was $66m, including $62m in borrowings and $3m of LC’s.

Financial Results for YTD 2016

Q1 revenues were $1.31b or up 3% versus $1.28b in prior year, and Q1 adjusted EBITDA was $91m versus $80m in prior year as BIG leveraged operating expenses on comp store sales growth of 3% in Q1.  Gross margins in Q1 were stable at 39.5% versus 39.3% in prior year.  BIG also raised its guidance for adjusted EPS for 2016 to $3.35 to $3.50 per share and maintained it comp sales guidance for 2016 of low single digits.  This compares to comp store sales of +1.8% and adjusted EPS of $3.01 in 2015.  Q1 Seasonal and Furniture segment sales were strong and these two Ownable segments are expected to be major drivers of revenue over the next couple of years.

Strong Cash Generative Business Model and Attractive FCF yield

BIG has a highly cash-generative business model with a solid ROIC.  BIG has consistently generated FCF year after year.  Over the past six years, cumulative cash from operations is about $1.8b or over 70% of today’s enterprise value of $2.4b.  BIG generated about $220m of FCF in 2015 and we expect a similar amount in 2016.   BIG trades at about a 9% FCF yield unleveraged at today’s prices, with decent prospects for growth in revenues, adjusted EBITDA, and FCF.  We believe the Company could generate FCF of close to $250m in 2017 or a 10%+ FCF yield at today’s prices. 

BIG’s cash generative business model enables it to concurrently make organic growth investments and repurchase large amount of common stock.  The combination of these shareholder-driven activities, concurrently executed, likely represents a powerful driver of long-term shareholder value creation.  With modest revenue growth, we think BIG can grow adjusted EBITDA, operating income, and EPS from current levels.  We believe BIG could earn adjusted EPS of $4 per share in 2017 and up to $5 per share in 2018.

Strong Competitive Position In Non-Traditional Discount Retailing Industry

We believe the Company has built a stronger and improved competitive position in non-traditional discount retailing industry under its CEO David Campisi who joined BIG in early 2013.  The strategic planning process or SPP he implemented when he arrived focused BIG on retail segments and were either Ownable or Winnable.  Many segments and SKU’s have been eliminated under Campisi’s “Edit to Amplify” and QBFV (Quality, Brand, Fashion, and Value) programs where he focused BIG on merchandise that customers actually wanted and which provided good value rather than opportunistic closeout purchases which were often items the customer had no interest in purchasing.  The result is that BIG today has a much stronger line up of categories and SKU’s where it can compete effectively, even against TGT and WMT.

Well-Positioned Product Offering for Today’s Value-Oriented Economy

We believe BIG’s current merchandise offering, improved under the Strategic Plan, offers strong quality and value products which the U.S. consumer wants and needs to purchase.  Price savings can be quite substantial relative to the same items purchased at Target, for example.  We believe consumers continue to struggle and continue to look stretch their purchasing power and BIG offers a very attractive source of everyday and basic items which they can purchase with large savings. 

Well-Positioned for Entry Level Housing Recovery

We believe entry level housing is one of the strong areas of the U.S. economy today as several years of depressed supply and pent up consumer demand has built up.  BIG’s Furniture and attached Soft Home categories we believe offer today’s consumers the opportunity to furnish and decorate new accommodations at hard to match entry levels prices.  We believe these categories could remain strong for BIG for the next couple of years as we expect these

Strategy Under CEO Campisi Creating Greater Consistency in Results

David Campisi became CEO of BIG in May 2013 and since then has implemented a strategic plan to create greater consistency in BIG’s merchandise assortments with less focus on closeout merchandise.  Merchandise selection is much more consistent for customers and focused on quality and everyday value items rather than opportunistic closeout merchandise.  Closeout merchandise had the effect of creating inconsistent financial results as comp store sales were volatile from year-to-year, depending on which quarters had the benefit of attractive closeout merchandise purchases.  Customers would also come into stores and find items they were seeking were out of stock.  The result of this more consistent strategy and focus on good values for items that customers want every visit has been nine consecutive quarters of positive comp store sales.

Comp Store Sales Have Stabilized and Started to Grow in Response to Strategic Plan

BIG has endured several years of negative comp store sales due to poor merchandising focus among other reasons.  Since joining in May 2013, Campisi has eliminated many weaker and underperforming segments and SKU’s and sought to focus the Company on merchandise categories which are important to the customer and in which BIG can effectively compete.  His “Edit to Amplify” and QBFV (Quality, Brand, Fashion, Value) programs have reduced slow moving SKU’s and increased merchandise inventory in segments and SKU’s where BIG can be competitive and which are important to customers.  This strategic plan was developed in 2013 and early 2014 and began to be implemented in 2014 and is starting to take hold as BIG has had nine consecutive quarters of positive comp store sales.

Differentiated Strengths from Key Competitive Threats of Dollar Stores and Amazon Online Competition

We believe most of the items sold in the Company stores are less likely to be purchased online, including products in the Food and Consumables categories, Seasonal products, and Furniture products.  Food and consumables are purchased close to need on a recurring basis.  Furniture products are large and do not lend themselves to online purchases as much of other items.  Dollar Stores sell very little furniture, little mattresses, very little Christmas Trim or outdoor patio furniture.

Dollar stores are more focused on Food and Consumable items, which can represent up to 70% of dollar store sales, and do not include many of the products sold in BIG stores.  Dollar Stores are also generally significantly smaller than the Company’s stores.

Attractive Upside Potential

In 2015 BIG generated $220m of free cash flow (we define as cash from operations less capex). We believe BIG can grow revenues and adjusted EBITDA in 2016 and 2017 based on low single digit comp store sales, stable gross margins, and improved  SG&A expense leverage on a stable store base.  We believe that adjusted EBITDA margins can move back towards historical levels as these investments are leveraged against higher revenues.

We believe BIG could achieve adjusted EBITDA of $400m+ and free cash flow of $250m in 2017, and a balance sheet with almost zero net debt.  Furthermore, we believe BIG could concurrently repurchase about 4m common shares per annum to reduce total shares outstanding to about 40m or less by year-end 2017.  We believe BIG could trade for $3.2b or 8x adjusted EBITDA in 2017 with zero net debt and about 40m total common shares outstanding or a share price of about $80 per share (60% higher than current prices).

Aggressive Share Repurchase Program Could Drive Long Term Shareholder Value

BIG has been an aggressive share repurchase (or a “Cannibal” to use Charlie Munger’s term for companies that aggressively repurchase their stock).  The Company has repurchased over $1b of common stock over the last six years, including over 10% of total shares outstanding in the latest 12 months.  BIG recently completed an additional $250m share repurchase program.  We believe BIG’s management is committed to driving shareholder value and this includes continued major share repurchases.  We expect BIG to spend at least $200m per year on share repurchase in 2016 , 2017, and 2018 and reduce its diluted shares outstanding to 40m or less.  We believe this consistent repurchase of shares with BIG’s strong FCF will eventually put upward pressure on the share price.  It will be important for BIG to show stable to modest growth in its business in terms of revenues and adjusted EBITDA.  BIG’s diluted share count was 78m at year end 2010 and is presently down to about 45m and we expect further declines.  We believe this large share repurchase program is the proper capital allocation decision, versus opening new stores, given the over-stored retail environment in the U.S. market.

“Ft. Knox” Balance Sheet Enables Value Creation

BIG has a “Ft. Knox” balance sheet with a net debt position of about $90m at Q1 of 2016 or about 0.25x LTM adjusted EBITDA and BIG’s balance sheet has an investment grade rating.  We believe management has positioned BIG to generate $200m+ of FCF per year in 2016 through 2018.  Therefore, we think BIG could end 2017 with total shares outstanding of about 40m or 10% lower than current 45m shares, as BIG’s strong free cash flow is directed toward share repurchases.  BIG management believes the industry is over-stored so we do not expect major growth in new stores but rather strategic repositioning and improvement in individual markets as weaker stores are closed and replaced with stronger stores.

Conclusion and Target Price

Based on 8x our estimated EBITDA of $400m for 2017 with zero net debt and about 40m diluted shares outstanding by 2017, we believe BIG could trade for an EV of close to $3.2b or $80 per share or more versus $52 per share today (+60%).  If BIG continues to execute and its non-traditional discount retail business performs as we expect, we think our target price can be achieved.  Further, we believe BIG has a well-established competitive position in discount retailing with important products and services that consumers want and that, as a result, over the next couple years, we believe BIG could prove an attractive acquisition to a strategic or private equity acquirer.