Description

Dick’s Sporting Goods (DKS) $48.10

Dick’s Sporting Goods presents investors one of the few brick and mortar retailers with a genuine tailwind.  The Sports Authority liquidation creates a meaningful catalyst for DKS, which was already successfully executing its own store expansion in the healthy retail category of athletic/athleisure.  As the remaining dominant player in the sporting goods space, DKS trades at 6.6x EBITDA and 14.1x earnings with the founding family in charge owning over 20% of the economic interest and 62% of the vote.  While industry insiders will tell you CEO Ed Stack embodies the company’s namesake (so to speak), in his 30+ years at the helm, he has proven a shrewd operator with a keen eye toward capital allocation.

Basic background

Dick Stack started Dick’s as a bait and tackle shop in 1948 in Binghamton and grew the business into a two store chain when he handed the reigns over to his son Ed in 1984.  By 1994 DKS operated 22 stores and relocated to Pittsburgh. Eighteen years later came DKS’s IPO in 2002 with 130 stores and over $1bn in revenue.  Today Dicks Sporting Goods operates 37 million square feet across 644 Dick’s stores, 73 Golf Galaxy stores, and 19 Field & Streams stores representing 7.5% annual store unit growth over the past 4 years.  Dick’s are sporting goods superstores with an average size of 50,000 sq feet and sales breaking down by category to 45% hard lines, 35% apparel, and 20% footwear.  Prior to The Sports Authority liquidation, management projected store saturation at 1,100 units providing a runway to double the store base.  While investors should never put much faith in those types of projections, we believe there is ample room for store unit growth.

The Sports Authority (TSA) and Sports Chalet Liquidation

The significant leverage Leonard Green & Partners put on TSA combined with increased competition from DKS and Amazon finally resulted in a bankruptcy filing in March.  It’s one thing face a weak, over-levered competitor.  It’s quite another to have 20 million square feet of competitive face completely disappear from the market.  Herein lies the crux of the thesis. In May, no bidders showed up for TSA as an operating business and TSA was forced to announce a complete liquidation and closing of all 460 doors.  Around the same time (April) a 47 unit chain Sports Chalet also filed and decided to shutter.  All told, 20 million square feet is leaving the market, with all TSA stores to be closed by the end of August.  This compares against DKS 37mm sq feet.  TSA and Sports Chalet combined represented approximately $3bn in sales vs. DKS $7.2bn.  

Why do we believe DKS will take a significant part of this market share as opposed to meeting a similar fate to TSA?  As a Modell’s executive explained to us, DKS’s strategy included opening stores nearby (or even across the street) from a TSA.  Having been inside both concepts many times over the years, it is clear why.  TSA has never been a very good merchandiser and the customer experience is terrible, especially compared to DKS.  There are 200 TSAs within 5 miles of a Dicks and 350 within 10 miles.  Proximity dictates it is not a stretch to assume DKS picks up a significant portion of that $3bn revenue.  In the short term, TSA’s liquidation will hurt DKS’s sales as DKS explicitly will not price compete with TSA during the liquidation.  However, not only is this baked into the most recent DKS guidance at Q1 in May, we think it’s likely Stack is sandbagging earnings by assuming , “we do believe that there will be some pull-forward out of the fourth quarter into right now through this liquidation process. We really expect to see a bigger benefit to this beginning in 2017.”  Having checked the inventory displayed at a number of TSAs when back-to-school hasn’t even started, it strikes us that DKS will benefit sooner than 2017 and Stack is being overly conservative.

We claim no precision in quantifying the impact of the TSA liquidation on DKS, but we have some data points to take a stab.  TSA/Sports Chalet were $3bn in sales with DKS overlapping in approximately 75% of the locations. If DKS recaptures half the direct overlapping market share that would represent $1.1bn in sales ($3bn x 75% x .5).  At DKS 10% EBITDA margin we would have another $110mm of EBITDA vs. last year’s EBITDA of $728mm. If DKS recaptures 75% of the neighborhood mkt share, incremental EBITDA would be $168mm.  Note we should use a higher EBITDA margin since they are simply increasing the volume and velocity at existing stores.     

An additional benefit is that DKS was the successful bidder on TSA leases and will take over 31 locations which provide another bump in store growth on top of the 45 stores they have been opening annually.  A typical DKS store averages a hair under $10mm revenue per year (50K sq ft) vs. the TSA average of $5.7mm (35K sq ft).  Splitting the difference provides a further incremental $243mm in revenue, or $24mm in EBITDA.  Putting it all together TSA/Sports Chalet liquidation could provide incremental EBITDA of $200mm off of a $730mm base.  Reasonable people can postulate different outcomes, though we think the framework is valid.  Note the street projects a $110mm EBITDA increase for 2017, which looks low to us since organic growth should provide $50-100mm as there will be 90+ more stores by the end of 2017 vs. 2015 (our base of comparison as 2016 is being impacted by the liquidations).  

Why we like the business even without the TSA liquidation

Dick’s has a long track record of growth.  Sales, EBITDA and Net Income have grown at 11%, 13% and 13% annually, over the last decade.  Gross margins have been stable between 28% and 30% over the same 10 years while EBITDA margins have crept up from 8% to 10%.   DKS maintains effectively zero leverage. As detailed above, there was already ample runway for square footage expansion, and the TSA liquidation will only improve this situation.  However there is room for margin expansion on a stand-alone basis due to operational improvement initiatives detailed below.

One area where Dicks has excelled is becoming an important sales partner for both Nike and Under Armour.  The two represent 20% and 12% of Dick’s merchandise purchases respectively.  From Nike’s perspective Dick’s represents an important customer though it’s only 2.5%.  Note that NKE has no 10% customers. With respect to Under Armour, Dick’s is their largest customer represents 11.5% of UA sales.  NKE  trades at 24x earnings and 16.2x EBITDA while UA trades at 69x earnings and 29x EBITDA.  DKS offers similar exposure to the brands and trend a fraction of the valuation.  

Related to UA and NKE, DKS has redesigned its footwear department to a full service model and has claimed very good (although undisclosed) return on the investment.  DKS also began carrying Skechers in every Dick’s, which according to Weinberg at FFANY, is going very well to date.  Footwear represents 20% of DKS sales and the rollout of the new footwear departments will grow from 52 units in Q1 to 180 (25% of the chain) by year end.

Historically, Dicks has used (Ebay owned) GSI Commerce as the backbone of its ecommerce business.  That ends in January 2017 when their “in house” system goes live.  They have spent a material including $21mm going in 2016, but the spending effectively goes away this year with only $6mm projected in 2017.  The company expects the transition to net 30 bps of incremental consolidated margin ($25+mm per year) on a recurring basis.  The old GSI contracts required DKS to pay transaction fees, which cease with the transition.  As Ecommerce has grown from 5.3% of sales in 2012 to 10.3% in 2015, the value of the in house system will accrue at a higher rate.  Golf Galaxy and Field & Stream were successfully launched on the in house platform in 2015 providing confidence that the Dick’s transition will be seamless.

Management and Capital allocation

Chairman and CEO Ed Stack owns a 20% economic interest in the equity and 62% of the vote through the dual class share structure.  Tightly controlled entities are a double edged sword with economic alignment as the major positive and lack of accountability to shareholders being the negative.  Of course there are good examples of this set up, like anything John Malone is involved in, and bad examples, like anything the Portnoy family controls.  My read in this case is falls closer to the good even though Ed clips a healthy $8.5mm annually all-in, leases his plane back to the company and has a few relatives on the payroll.  The company currently sports a $0.605 annual dividend (1.2% yield) and guidance assumes they will repurchased $100-200mm worth of stock in 2016 representing 2-4% of the outstanding equity.  Management has a history of stock repurchases with the fully diluted share count down 11% by the end of this year vs 2013.  The company has spent over $1bn in repurchases from 2012 through 2015.

Risks:

The two biggest risks to Dick’s ongoing success are the “Amazoning” of the category and a potential slowdown of athletic footwear and athleisure apparel.  With respect to Amazon, there is no question they will continue to fight for market share with Dick’s.  Ed has contended that the coming launch of their own omnichannel platform makes ecommerce a net positive, pointing to data points like ecommerce sales doubling in new markets when a bricks and mortar Dicks enters the region.  Ed believes the physical stores are essential and Amazon is at a disadvantage for not having them.  Without question, Amazon will be a fierce competitor along the way.  

On the risk of athletic and athleisure slowing, it’s tough to make a long term call.  If there is a real turn in the trend it will hurt them.  We are short Under Armour which works as a hedge and they are just wildly overvalued on a standalone basis.

Summation and valuation

Putting it all together, we have a well-run retailer with a significant tailwind in the liquidation of its largest direct competitor. At 6.6x 2017 consensus EBITDA DKS looks cheap.  However, the street appears to be underestimating the medium term earnings power.  Putting together the value drivers detailed in the write up produces an EBITDA in the $990mm range.

We think 8x EBITDA is a reasonable multiple for DKS, which applied to 2017/2018 EBITDA of $990mm produces a $71 stock price.

Catalyst

Catalysts

• Dick’s taking market share as The Sports Authority liquidates

• Continued organic store growth

• Launch of  in-house omni-channel platform

• Full service footwear initiative

Risks

• It’s Amazon’s world and we just live in it

• Slowdown of athletic/athleisure trend