Description

I believe that CAB is an overvalued retailer with troubling near-term trends and weakening new unit economics. Guidance for 2014 is extremely aggressive and I struggle to conceive of a scenario where they are able to meet it. I conservatively estimate fair value for CAB to be between $40 and $52/sh, or down ~20-40% from the current price.

Situation/Summary

Cabela’s (CAB) is a North American specialty retailer of outdoor recreational products and branded credit card issuer with a strong skew towards hunting products (largely firearms and ammunition) which made up almost half of their sales in 2013. CAB’s core gun and ammo business is in the process of lapping a “surge” in gun demand driven by fears over increased regulation in the wake of the Sandy Hook Elementary School shooting in December 2012. This dynamic is well-known by the investor base, but I would argue that management is using this idiosyncratic event to hide significant secular weakness in the underlying business.

Despite having an underlying business with dramatically deteriorating KPIs, CAB trades at 22.1x adjusted trailing earnings and 18.5x 2014 consensus earnings, which I believe is grossly aggressive. On my own 2014E numbers, CAB trades at 22.6x, an absolutely egregious multiple given the rapidly weakening business.

In short, my work on CAB suggests the following key points:

1)        Comparable sales trends are significantly weaker than expected

2)        Loan loss reserve releases have been liberally used to boost historical earnings

3)        Already weak new unit economics are rapidly deteriorating

4)        Guidance is extremely aggressive and borderline illogical; the day of reckoning has been pushed back to Q4

5)        Free options exist from a secular decline/stagnation in firearm sales and/or increased competition                                                                                 

Based on the above, I believe that CAB will significantly miss guidance and consensus estimates for 2014 and should be worth only $40-52/sh at a target multiple of 14-18x my 2014 adj. EPS of $2.91/sh.

Description

CAB is a North American specialty retailer of outdoor recreational projects. They currently have 51 stores which average 116,000 sqft each. 28 of these are legacy stores opened before mid-2008, the remainder are considered “next generation” stores and can be broken up into traditional next-gen (~83,500 sqft/store) and the smaller footprint “outpost” stores which average 40,000 sqft/store and are located in smaller markets. The stores are present across the continental U.S. & Canada with a skew towards the Midwest/Prairie regions which has a receptive audience to the hunting-skewed product mix. Approximately 70% of retail sales are made in their physical locations with 30% going through a direct channel which is majority online but also includes a legacy catalog business. Just under 50% of retail revenues are related to hunting equipment, with the remainder split somewhat evenly between general outdoors (camping, fishing, etc.) and apparel. CAB also has a very substantial branded credit card program which they market to their customer base and yields rewards which can be used in store. At the end of Q1 2014, there were 1.8M active accounts with 3.8B in balances outstanding. Recently CAB has initiated a large push for growth, opening up 10 new stores in 2013, with another 14 planned for 2014. The 2014 store additions will increase retail square footage by 17%.

1) Comparable sales trends are significantly weaker than expected

Over the past couple of quarters, CAB has been printing increasingly poor comparable sales growth numbers. While some deterioration was expected due to the lapping of the significant “surge” in the winter of 2012-13, the level of declines are far beyond what should have been expected. Meanwhile, management has failed to own up to these very weak trends and has instead continued to hide behind the well-known dynamics of the one-time “surge” dropoff.

As shown in the chart below, comparable sales were up significantly throughout the winter of 2012-2013, including comps of 12% in Q4 2012, 24% in Q1 2013, and 10% in Q2 2013. While it should be no surprise that the lapping of this surge should be tough, the negative 10% comp in Q4 2013 and 22% in Q1 2014 are beyond terrible. The magnitude of results can be more clearly seen by comparing 2-year stacked comps which show negative comps over the 2-year period from Q1 2012 to 2014. Furthermore, management has guided to continued 10-13% comp declines in Q2 and indicated that comp sales were down 16% for the first three weeks of Q2 – there is clearly no imminent recovery here.

Management was confronted by the 2-year stacked comp data on the Q1 call and failed to adequately answer the question, indicating that performance should improve in the back half of the year as the gun impact becomes less impactful (the same gun impact which is being adjusted for in the stacked comp analysis):

Mark Miller (William Blair): “… Can I also ask about your perspective on the 2-year stack comp. Is this a useful framework for us to look at? … Does this mean that other parts of the business would be, I guess, flat to down on a 2-year basis?”

Ralph Castner (CAB CFO): “Well, I think at least in the second quarter, that math of the 2-year comp being about flat seems to be pretty close. It's deteriorated a little bit in the first quarter, so maybe in the second quarter you look at the 2-year comp being down a little bit. Clearly, as we move out through the back half of the year, and the gun impact becomes less impactful, we would expect improvement of the 2-year performance.”

It should also be noted that management explicitly attempted to “juice” sales in Q1 through promotional activity in the firearm category – these very weak results are after these extraordinary promotions:

Thomas Millner (CAB CEO): “I think it was really in January, February, when we're going up these -- against these big numbers. In firearms and ammunition, it was more of a visceral response to try to make something happen. And we sacrificed hundreds of basis points of margins in modern sporting rifles and in other categories of guns and in some ammo specs to try and make something happen and drive some business. And oddly, as it unfolded during the quarter, and even into April, as we throttled those more aggressive, deeply discounted products back, it didn't -- business remained at the same level, so we were probably unnecessarily aggressive.”

Another way of illustrating the weakness in gun sales is by comparing comp declines vs. the change in the number of firearm background checks conducted. Because background checks often preface a purchase, they have historically been an outstanding coincident (and slightly leading) indicator of gun sales, with an r-squared of 80.6% over the last 17 quarters. If one regresses the change in firearm background checks vs. comp sales, the underperformance in Q4 and Q1 is very striking.

Source: http://www.fbi.gov/about-us/cjis/nics

Essentially, the surge should have had a major impact. All things equal, we would have expected Q4 comp sales to be down 4.8% and Q1 comp sales to be down 10.5%. The actual results, at 10% and 22%, are so far below those estimates that something else exogenous must be going on which management is failing to own up to, instead preferring to hide behind the veneer of industry headwinds and continuing to kick the expectations can down the road.

2) Loan loss reserve releases have been liberally used to boost historical earnings

Being a consumer lender, CAB has benefited significantly over the last 5 years as delinquency and charge-off rates on consumer loans have come down significantly, from over 4% at the beginning of 2010 to ~1.5% today. This decline in charge-offs has (correctly) led to loan loss provisions coming down dramatically over this same time period. However, I would argue three things:

a)        The large-scale decline in provisions has been a major tailwind to historical EPS

b)        Reserve releases have historically been used “strategically” to hit EPS targets

c)        Both a) and b) can no longer happen as loan loss reserves appear to have hit an effective floor

a)  The large-scale decline in provisions has been a major tailwind to historical EPS

In every single quarter going back to at least 2010, provisions (dollars reserved against possible credit card losses) have been lower than charge-offs (actual net amounts written-off from the credit card portfolio). The logical next question is, “how can this be sustainable in the long-run?” While in the short-run reserves can be repeatedly drawn down, in a “steady state” scenario, provisions have to be at least equal to charge-offs (in fact, they have to be greater in the event a loan book is growing). The table below indicates the difference between provisions and charge-offs in each year and the impact from these unsustainable reserve releases on EPS

b) Reserve releases have historically been used “strategically” to hit EPS targets

While charge-offs as a percentage of balances have declined in a steady and orderly pace over the last 4 years in line with a continuous recovery from the recession, provisions as a percentage of balances have declined considerably more erratically, as shown in the chart below:

Perhaps unsurprisingly, these major drops in provisions have not been random, and have rather tended to been used in quarters where some additional EPS was needed in order to meet estimates. Some of the largest drops include:

• Q1 2011 – reduction in provision allowed CAB to generate $0.08 in unsustainable EPS, enough to beat estimates by a penny
• Q2 2011 – reduction in provision allowed CAB to generate $0.05 in unsustainable EPS, enough to beat estimates by $0.04

Note that the Q1 2012 drop was also significant, but the $0.06 in gains was not needed to beat EPS by $0.07.

c) Both a) and b) can no longer happen as loan loss reserves appear to have hit an effective floor

Total loan loss reserves as a percentage of balances have come down reasonably consistently from over 4% in early 2010 to 1.3% in Q4 2013 and 1.4% in Q1 2014. Conversely, charge-offs declined more rapidly, reaching sub 2% levels by 2011 and have plateaued just north of 1.5% for the last ~8 quarters or so. Now that provisions are at a level consistent with (in fact slightly below) the chargeoff rate, I do not believe that there is additional room for management to use this pool of excess reserves as a “piggy bank” to help with a) and b) above. In the future, the laws of mathematics means that provisions will have to closely mirror charge-offs, creating a tangible headwind to future EPS and removing one of the levers available to management to successfully manage future earnings.

3) Already weak new unit economics are rapidly deteriorating

A major aspect of management’s recent strategy has been the rapid rollout of “next-gen” and “outpost” stores, with 10 new stores opened in 2013 and 14 new stores planned for 2014 representing a 17% increase in retail square footage. Management speaks very highly of this concept, noting that sales per square foot are significantly higher than the legacy store base:

Thomas Millner (CAB CEO): “At the end of the first quarter, for the trailing 12-month period, the 14 new stores that were open for the full period at sales per square foot of nearly $500, outperforming our legacy store base by approximately 46%. We continue to be pleased with the performance of our new stores and it is important to note that the sales penetration of firearms and ammunition within each of our store formats is nearly identical. These new stores give us great confidence about the cadence of store openings we've announced for 2014 and 2015.”

Bullish analysts point to this growth platform as a key aspect underpinning the current high valuation and their even higher price targets. So given how attractive this concept is, the IRR must be outstanding, right? Wrong. In management’s own analyst day presentation from March 26th, they indicate that the target IRR on next generation stores is… *drumroll* 12.6%. Given that many management teams run at corporate hurdle rates higher than 10%, this is far from an exciting number.

Furthermore, this IRR is predicated on sales volumes of $450/sqft. When speaking with IR, they claim this is very conservative – after all, they did $500 per sqft in the last 12 months, didn’t they?

To be clear, management isn’t lying when they suggest that new stores did $500 per square foot in the last 12 months. That is definitely true. However, what they are failing to mention is that over these 12 months, sales per square foot for new stores have been declining dramatically. I calculate seasonally-adjusted sales per square foot for stores opened in the last 12 months to be merely $380/sqft in Q1 2014, down from ~$600/sqft a year ago.

As seen in the chart above, this decline is stunning and at a y/y drop of almost 35% is well in excess of what would be expected from the lapping of the surge. Management has not yet owned up to this troubling trend, instead deciding to repeatedly focus on the LTM sales number of $500/sqft, but the conclusion is decisive. Furthermore, the rapidly deteriorating sales per square foot directly impacts the profitability of new stores. Even assuming similar 4-wall EBITDA margins, the mechanical impact of a drop from $450/sqft (in management’s target economics to $380/sqft is a drop of 150bps in the IRR. Never mind the additional downside suggested by the sales trend and/or the impact of any operating leverage at the store level on 4-wall margins…

4) Guidance is extremely aggressive and borderline illogical; the day of reckoning has been pushed back to Q4

Despite obvious and worsening headwinds, management has stubbornly refused to change its FY guidance for 2014, instead pushing back the bulk of their target profitability further and further back. The end result of this pushing is that the guidance implied for Q4 2014 is borderline illogical – analysts appear to have “backsolved” Q4 based on management’s full-year guidance and have willingly ignored the feasibility of hitting the number. Note that when management guided down expectations for Q2 while maintaining “high single digit to low double digit full year EPS growth”, the analysts appear to have just barely fit themselves inside of management’s guidance range by taking Q2 down to the top end of management’s guidance, Q3 to the middle of management’s guidance, and the FY estimates to the very bottom of management’s guidance at ~7% implied EPS growth - all of this maneuvering appears to be done with the goal of somehow fitting within management’s guidance range.

Even after sell-side anlaysts took the above steps to reduce the EPS required in Q4, the implied Q4 consensus is still a 32% increase in adjusted EPS from Q4 of 2013. This is despite:

• EPS growth for Q1 at negative 49%
• Implied guided EPS growth for Q2 at negative 19% (and consensus expectations at negative 6%)
• Q4 2013 EPS being the highest ever EPS CAB has ever recorded with the highest ever quarterly operating margin
• Deteriorating KPIs in the rest of the business

Even if I assume that CAB can miraculously best the record-setting operating margins that occurred in Q4 2013 by 100bps, by my numbers, hitting $1.89/sh in Q4 earnings would still require a 40% y/y increase in revenue and a 34% increase in comparable sales. Note: the sell-side ignores this uncomfortable reality by assuming operating margins for Q4 of 14.0%, over 200bps higher than their highest margin quarter ever, and they still don’t even get to management’s implied midpoint guidance.

Another note is that management refuses to explicitly call out the Q4 guidance, instead letting sell-side analysts back into the number. I believe this is because they know how ridiculous it would sound out loud, and would also force them to revise guidance lower (as the “low double digits” portion is clearly not attainable):

Matthew Nemer (Wells Fargo): “You gave some pretty good -- I think reasonably newer guidance for the second quarter and the third quarter of this year. Why is the fourth quarter sort of open-ended at this point?”

Ralph Castner (CAB CFO): “Well, only because we felt like you kind of backed into it. We gave you the full year, and gave you the second and third quarter. So that's the only reason for excluding it.”

5) Free options exist from a secular decline/stagnation in firearm sales and/or increased competition

While I am ascribing explicit value to the below, I believe there is the potential for additional meaningful downside from the following:

• Potential secular decline or stagnation in firearm sales
• The total number of guns (legal and illegal) in the U.S. is estimated at 270-310M, or almost one for every man, woman, and child
• Firearms, if well maintained, can last for a tremendously long time – current sales are being driven more by an expansion in the number of firearms rather than the replacement of older/obsolete firearms
• To project out current sales rates implies further expansion in already high firearm ownership
• The corollary to this is that longer-term, firearm sales almost have to decline
• There is also the potential for material regulatory action – the U.S. has some of the most lax firearm regulations in the world and I believe the risk here is skewed towards “more stringent”
• Increased competition in outdoors/hunting-oriented retail
• Sportsman’s Warehouse (SPWH) recently IPOed and has a significant growth plan of their own, believing they have a store base potential that is 6.1x greater than their current footprint of 49 stores
• SPWH operates on a no-frills model, and is likely to contribute to pricing pressure for CAB in geographies of overlap
• Elevated inventory
• While management explained away elevated inventory levels by invoking the late arrival of spring, there is some risk that the  166 days of inventory in Q1 (materially higher than the 4-year average of 134 days) presents some downside risk
• If meaningful, this could further weaken poor sales or present near-term downside risk to margins from inventory write-downs

Valuation

I believe that management’s guidance and the consensus estimates for 2014 are materially overstated. Based on my own estimates of new-store sales levels @ $400/sqft and comparable sales in Q3 of 7.4% and in Q4 of 5.2%, (all of which could be materially lower), I believe that 2014 FY adjusted EPS should come in at $2.91 per share, 18% below consensus. I believe a “fair” multiple for a business with moderate growth prospects (while new store IRRs are weak, they are still above a reasonable hurdle rate) should be 14-18x EPS, although once presented with full knowledge of the weakening KPIs, investors may choose to put a lower multiple on CAB’s earnings. Based on this valuation range, I believe it is reasonable to expect CAB to trade down to between $40-52/sh ~9 months from now when Q4 results come out, or 20-40% below the current trading price

Risks

The major risk here is that management can somehow, miraculously, pull out a phenomenal Q4 and meet their targets. However, I believe there are a myriad of ways that this could go wrong, and see absolutely nothing in the current KPIs which would suggest that this is at all a reasonable outcome. One thing that could conceivably improve/stabilize is the new unit economics – if management could ever get new unit sales rates back up to the $450/sqft range, the combination of reasonable returns on capital and low borrowing rates could generate ~2.5c in EPS per new unit opened which could reignite the bull case and have sell-side analysts running reasonably attractive EPS cases 5 years out. However, my belief is that $450/sqft or better is currently already embedded in sell-side expectations and that the risk here is clearly to the downside.

Note: Transcript data provided by Seeking Alpha

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