Description

There is a great deal to like when a value investor considers an investment in apparel retailer, Big Dog Holdings Inc (BDOG). The company currently sells for about six times earnings, four times free cash flow and less than two thirds of net current assets! Despite lower sales the company recently reported a solidly profitable fourth quarter and 2002. This company has been swept down with the poor market sentiment towards retailers over the past few months.

The Business

Big Dogs develops, markets and retails a branded, lifestyle collection of popular-priced consumer products, including activewear, casual sportswear, accessories and gifts under its BIG DOGS brand. The company develops apparel products, which include a wide variety of basic apparel and related products, with an emphasis on being functional rather than fashion-forward or trendy. These apparel products include graphic T-shirts, shorts, knit and woven shirts, fleece items, loungewear and boxer shorts. The company’s products are centered around the signature BIG DOGS logo and "Big Dog" characters and are designed to appeal to a broad range of customers. The BIG DOGS brand is targeted to convey a sense of fun, humor and a "Big Dog attitude," whereby each customer can feel that he or she is a "Big Dog." Furthermore, the company believes that the millions of dog and other pet owners in the United States, as well as children, have a strong natural affinity toward the dog-related images and themes in Big Dogs graphics. In addition, the company believes that the positive image the brand brings to being a "Big Dog" has a special appeal to large-size customers. As a customer, I can attest to the fact that these stores are fun to visit and difficult to leave without buying something. I would encourage you to go to the website and take a look (bigdogs.com).


There are some unique features to the company’s successful strategy. First, merchandise is sold directly to the consumer in company stores. Thus, the company tightly controls the presentation and image of its products. Second, product development is low-cost, as the merchandise is stable in design and not fashion oriented. The company has stayed out of the fashion market and has focused on selling merchandise that is basic apparel that emphasizes its brand. Finally, production costs are kept low, as the company does not manufacture any of its products. The majority of its products are manufactured overseas, primarily in Asia, the Middle East and Turkey.

Big Dogs products were first sold in 1983 but operations remained limited through 1992 when the operation was ramped up. Harvard MBA, Andy Feshback co-founded the company in 1992 and has led it through it current growth. The number of stores has grown from 5 in 1993 to 209 as of December 31, 2002. Seven new stores were opened last year. The company has 37 stores in California with the rest of the stores spread throughout the country.

Performance

(Dollars in Millions)
2002 2001 2000 1999


Net Sales 109 112 115 110


Gross Profit 62 63 66 63


EBITDA 7.6 8.4 11.9 12.0


Net Income 3.8 2.6 1.8 5.2


EPS .45 .31 .17 .43



Obviously, this is not a growth story, as the business looks very mature with the company not demonstrating any revenue growth over the past four years and falling EBITDA. On the positive side, the company has maintained its profitability and has continued to generate strong free cash flow even during the difficult retail environment of the last six months.



Recent Performance

Fourth quarter profitability was solid despite an 11.6% sales decrease. Fourth quarter EPS came in at $.44 per share, but this is deceptive as it reflects a very low tax rate as the company took advantage of some long term tax losses. If one adjusts EPS to a more reasonable tax rate of about 36%, earnings would have been about $.32 per share which is excellent in this environment. Gross margins improved to 56.9% versus 55.9 % last year and operating expenses were down about 3%.

For 2002 earnings, adjusted for a higher tax rate, came in at $.33 per share. Comparable same store sales decreased 6.2% for the year. What makes this story compelling is the free cash flow that this business generates. In 2002, the company generated, again adjusted for a higher tax rate, about $.50 of free cash flow which is pretty nice for a two dollar stock! There is no reason to expect at this point that the company cannot continue to generate this type of cash flow even in a weak retail environment.

Free Cash Flow for 2002 (Dollars in Millions)

Net Income $3.8

Depreciation and Amortization 2.8

Capital Expenditures (1.3)

Tax Rate Adjustment (1.0)


Free Cash Flow $4.3 ($.51 per share)




Outlook

2003 started at about the same pace as the fourth quarter, but recent sales trends have been encouraging. The company has a positive outlook for the coming year and my expectation is that the company will generate at least $.50 of free cash flow even without much improvement in the economy.


Balance Sheet

The balance sheet is rock solid. At year-end the company had $6.2 million of cash and no debt. The current ratio is 5.1. Working capital is $27.2 million or $3.24 per share. The inventory turn is about 1.9 times. The tangible book value is about $3.74 per share.

Valuation

Price = $1.95

EPS = $.33 P/E = 5.9

Free cash flow per share = $.51 P/FCF= 3.8

Net Current Assets = $3.12 P/Net Current assets = .63


The numbers speak for themselves.


Concerns:

The company recently received a notice from NASDAQ that its stock price has fallen below the threshold required by the national market for the public value of publicly traded shares. Thus there is a significant risk that if the company cannot get its share price up over the next two months that the company’s shares will be moved to the NASDAQ Small Cap Market or worse the OTCBB. This would certainly hurt the liquidity of these already difficult to trade shares.

The above problem is related to the fact that management controls over 68% of the outstanding shares. This makes it difficult to improve the liquidity and limits the voice of outside shareholders. In addition, there is a risk here that instead of slowly trying to build back the share value, management will make a low bid to take the whole company private.

As noted above, the company has demonstrated no ability to grow sales over the past few years. The business may have reached maturity or management lacks the ability to grow it to the next level. This is a problem if you are looking for growth, but as I noted this a value story.

Summary

Big Dog represents an opportunity to invest in a solid and simple business at a price that gives no value to the company’s excellent cash generation ability and at a deep discount to its net working capital.


Catalyst

At this point there is no clear catalyst to drive these shares higher other than the ridiculous valuation. My belief is that management is frustrated with the valuation of the shares and is considering several alternatives to enhance shareholder value.

Catalyst

At this point there is no clear catalyst to drive these shares higher other than the ridiculous valuation. My belief is that management is frustrated with the valuation of the shares and is considering several alternatives to enhance shareholder value.