Description

Hibbett Sports

Note:

Hibbett is reporting earnings tomorrow morning. Our thesis is not predicated on tomorrow’s report but rather intense competition within the industry and Hibbett’s disadvantaged positioning. Google Trends indicates that Hibbett experienced higher levels of search interest in the weeks leading into the end of the quarter for back to school albeit from a low comp. The Q2 SSS expectation is 6.6%.

Hibbett would need to materially improve their operating margins and grow sales for us to exit the position. If there were a beat tomorrow and physical store sales continue their downward or flat trend, then we would look to add.  

Thesis

Hibbett Sports’ (HIBB) historic business model is broken and the Company is attempting to pivot to an e-commerce strategy to maintain relevance. The shift to e-commerce will impair margins and cannibalize existing stores sales. Competition will only increase as Nike, Hibbett’s largest vendor, accelerates direct to consumer sales. At best, we believe the Company is worth ~$18 per share or ~40% lower.

• Retail footprint is not returning its cost of capital. Further unit development will result in capital destruction.
• E-commerce is accelerating the cannibalization of physical store sales while producing a lower margin.
• E-commerce sales were boosted by significant markdowns to clear inventory in 2H 2017 leading to pressure difficult comps for 2H 2018.
• Nike, >50% of product purchases, is disrupting their distribution channels with their own direct to consumer effort further increasing competition for Hibbett.

Background

Hibbett Sports is a sporting goods retailer focused on smaller markets typically located in Wal-Mart shadow centers (~80% of units) or in malls (~20% of units). Sales mix is skewed toward footwear (55%), followed by apparel (28%) and equipment (17%). Historically, Hibbett presented investors with an attractive retail story – an internally funded store expansion into markets with low-cost labor and cheap rents while returning excess capital to shareholders via a share buyback. This formula worked well and drove ROIC higher for Hibbett shareholders until 2014. In 2014 the tides turned - comps underperformed and margins followed. The unit expansion began to crack as Hibbett saturated its core southern markets and began expanding into new states.

The Shift

Management is now focused on growing their e-commerce sales (launched in July 2017) and expanding store count into larger markets like California. This is a distinct shift in strategy from the foundation of Hibbett’s growth.

Expansion into California was first mentioned on the FY 2016 Q4 earnings call. The first store in California was opened in FQ3 2017. California is the exact opposite of low-cost operations with a high minimum wage and expensive rent. Management believes California will lead the Company’s growth on its path to 1,500 stores (currently 1,079).

The shift to developing units in California and pushing an e-commerce site are indicators that management believes their historic franchise, built on a different strategy, is no longer viable and facing increasing threats.

With that, let's analyze the numbers to support this thesis.

Unit Economics

Below is Hibbett’s store model laying out the unit economics and associated returns from their June 2018 roadshow presentation. We have a few issues with this presentation:

• ROIC is calculated with 38% tax rate. (presentation was created well past tax reform - just sloppy)
• Comp sales need to average 5.6% annually for five years for Hibbett’s model to scale. Average SSS comp since FY 2010 was 2.6%.
• Total investment is understated. Inventory averaged $250 per store with $88 of accounts payable for net inventory of $162k. Gross PP&E per store ~$220K up from ~$170K pre-financial crisis. Granted, some of this extra PP&E is from logistics and support, but all of it is necessary to operate a single store. We believe the total investment and support for a single store is closer to ~$380K.
• Incremental contribution margin is shown at 41%. Backing out estimated rent and D&A we get an incremental contribution of 44%. Using incremental EBITDA margins as a proxy – Hibbett’s highest record incremental EBITDA margin was 29.2% on comparable store sales of 9.8%. While this is burdened by overhead (which is partially variable due to marketing and incentive compensation) it was only achieved with an SSS 75% higher than planned. Average Incremental EBITDA Margins are in the mid-teens.
• Sales per square foot – at maturity, sales per square foot are projected to be $190. Highest record sales per square foot since FY 2010 was $169 in FY 2013 or 11% below the “mature” store. Sales per square foot averaged $159 since FY 2010.

All this to say that four wall ROIC is heavily overstated. We have significant doubts that Hibbett will be able to return to growing unit counts without destroying significant amounts of capital.

Adjusted Same-Store Sales

Hibbett includes e-commerce sales in its same-store sales calculation. This creates the need to adjust sales performance to determine the health of its legacy physical store sales. We believe the inclusion of e-commerce sales in the same-store sales calculation hides the effects of cannibalization from physical stores from investors.

Below is our math for year-over-year % change in physical sales per average unit and a corresponding graph. As can be seen, the physical units are bleeding out at an increasingly rapid pace despite weak comps. The comparable sales, inclusive of e-commerce, hides the cannibalization of the higher margin physical sales.

E-commerce Cannibalization

We believe these maps reinforce our above math that e-commerce is cannibalizing physical retail sales. The first is Hibbett’s unit locations by state as of FY 2018. The second is Google Trends for search interest in Hibbett Sports from 6/30/2017 to 8/23/2018 [the life of the e-commerce sales]. Here is a link to the Google Trends results. Google Trends

Management has cited that 25-30% of their e-commerce sales come from markets with no physical store. Before any analysis, this is indicative of the macro environment as retailers are facing increasing competition as Hibbett is selling product in markets with no presence. However, this is true for Hibbett’s physical locations as well, resulting in increased competition from digital storefronts for Hibbett’s core customer. This eliminates Hibbett’s previously held advantage of being the only nearby sporting goods store (a fact they continue to cite). Instead of being the sole provider in a neighborhood, they are now competing with hundreds of online retailers.

e-commerce Bump

It appears that Q3 2017, Q4 2017, and even Q1 2018 benefitted from clearance sales and inventory rationalization through the Hibbett’s e-commerce channel. Clearance prices likely drove Hibbett’s traffic attracting price-sensitive consumers, which is a very different accomplishment from acquiring customers willing to buy a full price product from Hibbett. We have yet to see how Hibbett’s e-commerce platform performs with a majority of full price products.

This tailwind from clearance sales will be a one-time benefit and will become a headwind in the future as Hibbett inventory returns to normal levels. The Company laps its e-commerce launch in the second half of FY 2019.

Competitive Advantage?

Management claims the competitive advantage to Hibbett’s e-commerce offering is diversification of selection allowing the customer to see different brands at the same time they are shopping… Not sure how to break this to them, but there is this thing called Google. Comparison shopping already exists, and Hibbett is not solving a problem or offering a better solution with their e-commerce site.

Larry the Landlord

No doubt you have likely seen discussions about CAC (customer acquisition cost) being the new rent. This concept holds true for Hibbett as well. In the Q1 2018 CC management maintained e-commerce’s breakeven estimate of $50-60 million which will likely end up in the midpoint of the range due to investment in search and social advertising to drive traffic. The shift in digital advertising will alter the margin structure of the e-commerce platform, lowering the contribution margin per sale as paid search and social are variable expenses. As Booking.com is well aware, and Hibbett will soon learn, Google is one helluva expensive drug and difficult to get off of.

Assuming all incremental net advertising spend for Hibbett is attributable to digital advertising for e-commerce and no mix shift in ad dollars year over year, then Hibbett is paying 10% of revenue in “rent” for digital traffic. This compares to ~6% of sales paid to physical rent. We expect the advertising as a % of revenue to increase over time as Hibbett moves to offering more full price product in their e-commerce channel.

Nike

Nike is very public about their move to make direct connections with their customer and eliminate “undifferentiated doors” from their wholesale business. The economics of this shift are extremely compelling for Nike. Nike has the opportunity to capture its distribution partners gross margin $’s for itself.

Some notes from Nike’s Investor day in 2017 [emphasis is mine]

Pricing Transparency

“It's also clear that we operate in an age of powered consumers. They set a new expectations from brands. In their mobile-led world, their options are really limitless. They are infinitely informed. As an example, more than 80% of shoppers consult their phones for price comparisons and availability before they shop in brick-and-mortar. And that's why we're so focused on building a seamless marketplace.”

E-commerce Competition

“So I want to ask you to think about the future. Our consumer can place an order on NIKE.com or through our SNKRS app and have it delivered the same day in key cities around the world. Your favorite team wins a championship. And in a few days, we have designed, manufactured and delivered brand-distinctive, innovative product to your doorstep. Not just for certain products, not just in certain colors. For all of our products. No other brand in our industry can do what NIKE does to inspire and engage millions of consumers around the world.”

“This focus on mobile is actually a crucial part of our future growth. Already this year, more than 50% of our NIKE Direct digital revenue comes via mobile experiences in the U.S. And we're well positioned to capture even more with this portfolio. We now know that when consumers engage with us across multiple touch points, we're able to serve them more completely. They run with us. They train with us. And then they buy with us. And the retention for those consumers more than doubles as a result. And our most engaged experiences drive our highest revenue per member.”

“We're also redefining the merchandising process, so we can offer an increasingly differentiated assortment not found anywhere else in the marketplace. This creates incredible opportunities. More than 1/3 of our offering will be distinct to NIKE.com and exclusive to members, and an aggressive shift towards this vision is already underway. At the same time, we're injecting the energy and freshness consumers crave through the Express Lane that Michael talked about earlier. This enables NIKE.com to introduce new styles each week and create product based on analytics and local insights faster and more directly. NIKE Direct already has 3 speed pilots activating this year. And in the next 5 years, we expect 50% of seasonal styles to be delivered in less than 90 days through our Express Lane. The strategic shifts towards the new models of access, exclusives and Express Lane are all part of a member-first, member-centric vision for NIKE Direct.”

“A key part of this growth will be driving consumer connections with our new Nike+ membership program across the entire NCEx. We are really excited about the power of this program and its ability to drive growth. Over the last 2 years alone, we grew membership at nearly 30% per year. We currently have over 100 million members. And those are people, 100 million consumers who want to be connected with our brand. And our Nike+ membership program will more than triple that over the next 5 years. We also know that membership drives significant value. Nike+ members who shop via our mobile apps spend 3x the amount that guests spend on NIKE.com.”

“we are growing our NIKE.com business at a rate well into the double digits, faster than any other dimension. And we see significant growth ahead. As we think about this space, it remains underpenetrated.”

Industry Disruption

“About 1 year ago, we saw the earliest signs of consumer-led disruption in our industry. And that disruption was, of course, digital. We told you that we didn't believe retail was in a steady -- or we did believe that retail was not in a steady state, rather retail would continue to be challenged. However, at NIKE, we view digital disruption as a tremendous opportunity, a tremendous opportunity to once again connect more deeply and directly serving consumers and ultimately igniting NIKE's next horizon of growth. So we developed the Consumer Direct Offense, we realigned our organization against that offense and we're now accelerating our execution.”

Nike take-aways

Hibbett’s e-commerce platform will be competing against better-funded competitors and vendors, namely Nike, who boast a unique offering including – same day delivery in major cities, exclusive inventory, and an eco-system of applications creating a scale advantage.

Hibbett will be at a significant disadvantage to Nike in larger markets reducing Hibbett’s ability to capture incremental customers from its e-commerce site without discounting on price. As previously mentioned Hibbett will no longer be the only store in a 15-minute drive, but rather, every one of their customers will have the Nike store in their pocket.

To frame this disadvantage, Hibbett’s management cited 130,000 downloads of their app since its inception. In comparison, Nike has >100 million Nike+ members. Nike’s membership base is global, but regardless of what assumptions are made, to back into a United States base, the numbers dwarf Hibbett’s.

It is not just Nike but every other national and regional retailer that is moving to expand their e-commerce marketplaces. Ultimately, online sales will come down to pricing and unique product offerings, for which Nike holds the cards…

Further hurting Hibbett is its reliance on Nike’s products. Nike has accounted for 107.2% of growth in all sales since FY 2014 (when the tides shifted in the business).

Valuation

Financial projections get difficult here as some of the scenarios we went through seem overly painful at first sight, but, with the added context of the disruption in retail and unique problems faced by Hibbett, we do not view them as ridiculous.

For our base case valuation, we utilize the Street estimate of EBITDA. The Street has EBITDA flat in 2018 and 2019 at ~$69 million. We see downside risk to the Street’s numbers as they bake in flat comps which we believe will be difficult to achieve given the intense competition in the space. With flat sales, year-over-year margins will continue to be pressured due to cost inflation. Given these facts, we believe a ~4x EBITDA multiple is reasonable which places the business at a ~$18.

We would not be surprised to see the business continue to deteriorate over time and fall below ~$18 per share.

Risks

• Management successfully turns the business around
• Nike’s DTC effort fails increasing their reliance on wholesale
• e-Commerce is successful and drives sales growth with higher margins than physical stores
• New store unites perform in line with management’s estimates

Catalyst

• Continued Growth in Nike's DTC business
• Physical store sales continue to fall
• e-commerce sales dissappoint on margin and overall growth