Description

An investment in Dick’s Sporting Goods (DKS or “Dick’s) is not for the feint-of-heart, given the seemingly daily negative news flow from pretty much every company in its universe of suppliers and competitors -- Nike, Under Armour (“UA”), Big Five, Academy Sports, Hibbett Sports (“Hibbetts”), Foot Locker, Finish Line, etc.  Sellside sentiment is overwhelmingly negative (only 3 buys out of 28).  However, as a medium to long-term investment, Dick’s represents an attractive, contrarian opportunity to double capital in the next three to five years as industry headwinds ultimately become consolidation tailwinds.

Down 50% year to date, at $27 per share, Dicks currently trades near all-time lows, at approximately 9x 2017 EPS, and 0.37x revenues -- multiples that are right around the ones last seen at the bottom of the financial crisis.  Some of this decline is warranted as the company recently (August 15^th) guided down 2017 EPS by approximately 20%, to $2.80 to $3.00, citing a “very competitive and dynamic marketplace”, and the undertaking of actions (presumably price cutting) to “aggressively protect our [market] share”.  However, we believe the stock has been oversold, and the actions that Dick’s is undertaking are not only necessary, but are strategic and will ultimately accrete long-term value.

Like most brick and mortar (“B&M”) retailers, Dick’s is currently facing a near perfect storm – wholesalers going more direct to the consumer, AMZN threatening its retail channel, and a general decline in foot traffic .  However, most notably, these retail headwinds are even more daunting for the other sporting goods B&M retailers, and given the tremendous struggles of those competitors, DKS should not only be the last man standing, but with a solid balance sheet, flexible lease obligations, e-commerce leadership, and aggressive approach, ultimately rebound.

Company Description

With annual revenues of approximately $8.6bn (FY 17e) and a market cap of $3bn, Dick’s is the leading omni-channel sporting goods retailer, offering an extensive assortment of authentic, high-quality equipment, apparel, footwear and accessories through its dedicated associates, in-store services and unique specialty shop-in-shops.  The company owns and operates its stores (and e-commerce sites) under its flagship brand Dick’s, Golf Galaxy and Field & Stream.  Dick’s also manages an all-in-one service for youth sports through its Dick’s Team Sports HQ, which offers free league management services, mobile apps for scheduling, communications and live scorekeeping, customer uniforms and FanWear and access to donations and sponsorship.  Headquartered in Pittsburgh PA, and founded in 1948  by the father (Richard Stack) of the current Chairman and CEO (Ed Stack)’s father (who controls the company via voting shares) Dick’s owns and operates 704 flagship stores and 129 specialty stores which includes Golf Galaxy, Field & Stream and others specialty concept stores.

On August 15^th,  Dick’s reported disappointing earnings (comps of +0.1% v 2-3% guidance; adjusted EPS of $0.96 v consensus of $1.00) for the quarter ending July 29, 2017 and held a conference call that was perhaps the most negative in its history, sending shares tumbling by 24% on the day.  Not only did the company guide 2017 EPS down from a range of $3.65-$3.75 to $2.80-$3.00, but a normally swaggering and confident Ed Stack painted a dire picture for the industry, pinning the difficult market on everything from irrational pricing behavior by its competitors to vendors’ shift in distribution strategies.    

Accordingly, the company’s response to this environment was that “By design, we will be more promotional and increase our marketing efforts for the remainder of the year, as we will aggressively protect our market share.  We have updated our outlook to reflect these investments.  We continue to believe retail disruption creates opportunities for us as we look long-term”.  Moerover, the CEO said such an environment could continue “possibly in perpetuity.”

This was surprising given that the company has normally kept above the fray of price wars among the lower-tiered vendors.  What made if even more surprising was that the company had actually bought back 3.4m shares at an average price of $41.56 in May (and perhaps the beginning of June) – underscoring a massive and unforeseen drop in industry sales from mid-June to July.

Investment thesis

Though we believe that Dick’s will continue to face near-term headwinds, expectations and guidance have been reset to reasonable and achievable levels, and the company is taking steps to position itself for long-term success in an industry that will see rapid consolidation.

Broken growth retailer now a consolidator and market share gainer

While there is no doubt that the sporting goods industry has been overstored for years, the numerous bankruptcies of The Sports Authortity (TSA), Gander Mountain, Sports Chalet and Golfsmith combined with competitors that are arguably on their last legs (e.g., Academy, Hibbett), portends a favorable landscape for Dick’s once the dust settles.

Dick’s has historically traded at a high and growth multiple (15x EPS over the last 5 years, approximately 20x+ over the last decade), based on a solid and consistent track record of execution and innovation.  Indeed, prior to this year, Dick had grown revenues from $3,1bn in 2007 to a projected $8.6bn for 2017, growing its store base from 487 in 2008 to 797 of July 29, 2017, arguably justifying such a multiple.  EBIT (adj) margins had expanded from 6.3% to 8.2% in 2015, before the company started facing the headwinds brought on by the factors listed above.

Dick’s recent struggles have been a particular contrast to the expectations coming into the year, which were relatively favorable, given the bankruptcies of Dick’s competitors and Dicks’ reputation for execution.  Still, while Dick’s Q2 same store sales came in below guidance, compared to its B&M competitors, it was a homerun:

Dick’s: +0.1%

Foot Locker: -6.0%

Hibbetts: -11.7%

Sportsman’s Wearhouse: -9.0%

Academy: -8.3%

Essentially, Dick’s increased its market share by 8 to 10%, picking up 70-90 bps of the market.  This market share gain should accelerate in the coming quarters, as privately-held Academy (5-5.5x leveraged) and Hibbetts (no real e-commerce presence) are both struggling with foot traffic declines, and will probably have to either significantly reduce their footprint or face liquidity crises.  Meanwhile at the end of Q2 (July 2017), Dick’s had only $60m in net debt, and as more set forth below, has a flexible lease schedule, strong relationships with vendors and a viable and thriving e-commerce business. 

Attractive valuation

While we do not believe that DKS will garner its historical growth multiples in the near future, it is trading at levels equivalent to its trough GFC multiple (0.37x EV/Sales; 4x EV/EBITDA ), and near an all-time low at 9x EPS.   Notably, this factors in a trough EBIT margin that is not unreasonable, and to a large degree self-inflicted, due to the company’s desire to gain market share while eliminating several of its B&M competitors.  We believe that once the company shows signs of progress and its market share gains become more apparent (again, keeping in mind that a mere five months ago, the company was seeing very favorable trends), the P/E multiple should expand to 13-15x EPS based on both a discount to historical as well as comps and ROIC.

Best Buy (BBY) playbook being implemented

As referenced in both the media and analysts, Best Buy, as the best positioned electronics retailer, has turned around its operations, increased same store sales and improved operating margins as it has successfully fended off Amazon.   Essentially, starting in about 2013, BBY took on key initiatives that DKS should be able (and has already begun) to execute, including (i) price matching; (ii) using BBY stores as e-commerce warehouses, (iii) setting up high-end vendor branded shops; (iv) increasing both the emphasis on and training for customer service; and (v) aggressively reevaluating its real-estate strategy (including tempering store expansion) and negotiating lease extensions.

Being the last B&M sporting goods retailer with a national brand, economies of scale and presence (TSA was the other one), Dick’s is particularly well-positioned to execute the BBY playbook, and Stack has essentially acknowledged that this is core to their strategy.  Perhaps most importantly, Dick’s is in a stronger competitive position than BBY was in 2013, and Dick’s also has the benefit of learning from BBY’s mistakes in execution. 

Private label, consolidation and enhancement of relationship with vendors

In March 2017, after a comprehensive strategic review the company announced a new three-tiered system of vendors, consisting of segment A or “strategic vendors”, with whom Dick’s will significantly increase their business (and presumably vice versa), segment B or “transactional relationship” vendors and segment C who will essentially be eliminated, thereby rationalizing the bottom 20% of Dick’s vendor base.  The reallocation of space and increased collaboration with its segment A vendors (such as Nike) and additional focus on private brands (to essentially fill in for the eliminated segment C vendors) should ultimately lead to stronger relationships, product selection and in the long-run, stabilized gross margins.  In fact, Dick’s private brands are expected to grow to $1bn in sales this year, propelled by its Calia label (by Carrie Underwood), which is already its #2 women’s label, two years after launching.

Part of this (particularly the emphasis on another private label brand, Second Skin) was in response to UA’s new arrangement with Kohl’s (which has had a negative impact on both UA and its retail partners due to a lack of segmentation and product differentiation), as well as the recognition of the consolidation of vendors throughout the industry.

Subsequently, on June 30^th, Nike announced that it would be selling products directly on Amazon.  Though this headline had an immediate (negative) impact on the sporting goods retailers, Nike’s products were already being sold on Amazon via third party vendors (which was the main impetus for Nike’s announcement – to maintain better control of such products), and based on our and others’ review, the products being sold on Amazon are among the lower-tiered ones.  Indeed, recent comments by Under Armour suggest that the company recognizes the need to further differentiate and segment its product by retail channel (i.e., high end for Dick’s more mainstream/low-end for Kohl’s), and despite both Nike and UA’s desire to sell more DTC, they will need a strong B&M retail partner.  Given the industry struggles, there is essentially no other choice but Dick’s.

Online presence underrated, and additional investment in supply chain should yield further market share gains.

Dick’s has evolved its model far more aggressively and successfully than most of its B&M peers.  The company’s online sales increased to 9.2% of total net sales for Q2 2017 (versus 8.5% a year ago and versus 2.9% five years ago) growing by 19% to a runrate of approximately $800m, on track for their goal of $1bn by the end of next year.  The company recently brought its fulfillment in-house, and while this will (and has) lead to some execution disruptions, it should ultimately be accretive to margins.   Moreover, even a cursory review and comparison of Dick’s website versus its main traditional, hard goods competitors (Academy, Big Five, Hibbetts) demonstrates the massive breadth and depth advantage that Dick’s has over the field.  For example, Dick’s has 185 basketball SKUs versus Academy’s 51 and Hibbett’s 41.  Similarly, Dick’s has 12 Callaway driver SKUs, while Academy has 1 and the others don’t carry them.  This is not cherry-picking – one can search virtually any hard sporting good brand, and the results will be similar.

Dick’s first mover advantage continues to further distinguish the company and its efforts in this area are, and will continue to be, relentless.  Though the company should generate $700m+ in operating cash flow this year, it will be reinvesting a significant amount of that in e-commerce and fulfillment, further extending its lead over the other direct B&M (i.e., non-Amazon) competitors.

Solid balance sheet and lease flexibility enables Dick’s to withstand, and possible capitalize on, the B&M sporting goods carnage

Beginning in the early 2000s, Dick’s started to sign shorter initial leases (with similar extensions) of 5 to 10 year terms rather than 10-15, and the company currently has 25% of its leases coming due within the next three years.  Given the recent liquidations and struggles of its former and current competitors, Dicks should have a good opportunity to lower its rent expense while capitalizing on better locations. 

Team / youth sports foothold and aggressive move into sports apps could provide upside

Dick’s currently owns two of the best known and penetrated youth sports apps – Blue Sombrero and Gamechanger.  A nascent and rapidly growing market, youth sports apps represents a tremendous opportunity for both advertising and eventually revenues for DKS.  Though early in the execution of its strategy, the company is also tying in their apps and partnership relationships with the largest youth sports leagues including little league baseball and pop warner football via their Team Sports HQ (which has over 30m users).   The company’s focus on this area is manifested in both its promotion of Lauren Hobart (formerly head of marketing and on-line operations) to President and its purchase of 10m email addresses from the TSA liquidation (which should also benefit their overall e-commerce strategy).

Potential call option on take private or Amazon takeout

Though highly unlikely, Amazon could conceivably buy Dick’s. Call option of Amazon buying Dick’s.  Given Dick’s reputation, relationships and distribution system, to the extent Amazon wanted to go into sporting goods and expand their own distribution system, Dick’s would seem the most viable candidate in the space.

Additionally, given the depressed price and large ownership of the CEO (Stack owns over $800m of stock; 26% of class A and 88% of class B voting stock), a take private is not out of the realm of possibility.

Risk Factors

Further irrational behavior by industry participants

Amazon aggressively increasing penetration

Execution around e-commerce and supply chain initiatives

Continued margin deterioration driven by both lower pricing and mix

Conclusion

The struggles of sporting goods and athletic wear vendors and retailers have been well propagated, and we believe, already priced in the stock.  Dick’s not only recognizes this but is going for the jugular in eliminating its B&M competitors.  While the street views this as a permanent impairment to gross margins, these intentional actions will better position Dick’s for the long-run.  Ultimately, the company should be able to execute on the BBY playbook– and is arguably better positioned than BBY was when it embarked on its turnaround plan.

Catalyst

Bankruptcies/liquidiations of competitors

Progress in e-commerce fulfillment

Rebound in same store sales

Take private / M&A