Description

Big Lots is a short. Big Lots is a closeout retailer with 1,556 stores and is in the process of closing 155 stores by the end of January 2006 (which is also the Company’s fiscal year end). The Company sells a wide variety of closeout merchandise, including consumables, hardlines and toys. Big Lots also offers a line of seasonal items and an assortment of merchandise for the home, including furniture and home decor. In addition, the Company sells wholesale merchandise to national and regional retailers, as well as smaller retailers, distributors, liquidators and wholesalers through trade shows, mailings and the Company’s wholesale web site. Its target market is comprised of customers with less than $50,000 in annual household income.
About 70% of the merchandise is discretionary purchase oriented.

BLI competes with dollar stores as well as Wal-Mart. The competition has been aggressively expanding its store base within the Big Lots store radius over the last several years and that trend is expected to continue while Big Lots plans to shrink its overall store base. Stores such as Dollar Tree have consumable merchandise as a greater percentage of its total mix. As the Company has shifted to more discretionary items, there are less compelling reasons to go their as a destination. They are not alone in doing close outs anymore.

The Company makes basically all of its profit in November and December. This November, even against an easy comparison of -6.1% a year ago, the company reported a gain of 0.7% (traffic decreased 3.9%). A large part of the 0.7% improvement was attributed to the inventory liquidation events at the closing stores. Sell-side analysts had been projecting an increase of 2-4% in November comps at the end of October yet the stock is still at much higher levels than it was during that time.

The Company has had negative traffic at its stores in 19 out of the last 21 months. They have been making up for this concerning trend with higher basket items to squeeze out unimpressive comps against easy comparisons. This higher basket trend is largely due to the selling of more expensive discretionary items in its store base such as furniture. BLI is starting to anniversary the higher priced items and I expect comps will start to reflect the customer traffic trends in the coming year. The CEO believes raising prices is not a great strategy for its customer base as they are very focused on bargain hunts. Gross margins have been deteriorating as pricing for merchandise has not compensated for across the board cost increases (energy, insurance, rent escalators, medical etc…). Conditions at the company are likely to get worse when the comps mirror the traffic trends and the operating leverage cuts the other way.

The new CEO, Steven Fishman, is enjoying a honeymoon period for the time being. Previously, Fishman was CEO of Frank’s Nursery & Crafts and Rhodes Furniture, both of which ended up being disasters. He did have some success as CEO of Pamida. He has announced some store closings and cost savings of $30 million (which will only offset increased costs like insurance, energy etc…). This $30 million in announced savings is an underwhelming figure given some bull expectations of as much as $100 million (with no expectation of just an offsetting dynamic).

Expectations for next year are around 3.0% comps, gross margin improvements, significant EBITDA improvement and decent FCF. There is very little chance of this happening given the many challenges the company faces. Consensus EPS is $0.46 next year assuming these very optimistic assumptions.

BLI stock is quite expensive from a valuation standpoint even if they hit these very aggressive numbers. The stock is trading at 9.9x trailing EBITDA and 26.7x forward EPS while a more appropriate multiple might be 6.0x EBITDA and 15-17x forward EPS. If management is to be believed, the Company should generate $70MM in free cash flow this year (assumes $155MM of FCF in Q4) which would take the TEV multiples down to 8.8x FYE January 2006 and implies a FCF yield of 5% for the full fiscal year. Next year, assuming all the optimistic assumptions noted above, the FCF yield would be 6% (excluding cash costs to exit stores/restructuring which I believe would actually chop this FCF yield almost in half). Put in the potential for significant comp declines and the cash use becomes significant. Assuming the Company hits its Q4 cash flow guidance and the 3.0% comp assumptions etc… for next fiscal year, the forward TEV/estimated EBITDA for fiscal year ended 2007 would still be around 7.7x.

There is also some real estate value – one analyst suggests $5-$6 per share. This theoretically helps provide a floor for valuation but it is overly optimistic. The bulk of the value is in distribution facilities – we think it’s likely closer to $2-$3 per share having witnessed what other retail warehouse/distribution facilities truly garner. They lease almost all of their store base.

The revenue multiple might be considered cheap (.33x next fiscal year) and the bull thesis is that if they could get back to historical profitability levels then the stock is too cheap. Most bulls we talked with a few months ago were giving the new CEO 6-9 months to see some evidence of a turnaround. The EBIT margin is currently around 1.5% (around 2.1% is expected next year to yield the 46 cents of consensus) and the historical best was 8.6% in 1995. A lot of competition (especially in its store radius) has emerged over that time and as a result gross margins have substantially deteriorated. Getting back to a respectable margin will be difficult since the opportunities for cost savings are limited (the CEO’s big initiative yielded just $30MM which is mainly an offset to increasing costs) and the comps are likely to significantly decline as they anniversary higher priced merchandise initiatives and the comps start to mirror traffic trends. These stores have very little reason to exist – Wal-Mart offers prices that are lower/comparable on most of its items.

One caveat – I’m expecting a half decent comp for December as the company raised advertising and is aggressively liquidating the closing stores. Nonetheless, I think the profitability will suffer as a result of the heavy promotions and core business trends and profitability will continue to worsen over the coming year.

Catalyst

Continuing or worsening traffic trends
Continuing gross margin deterioration
Anniversarying of its big ticket mix shift
CEO honeymoon ends