Description

Thesis

A couple of years ago I downloaded the popular FaceApp to see how closely I will resemble my father when I’m older; the results were fascinating and a little disturbing. If OLLI were to perform the same experiment, it would see Big Lots (BIG) staring back at it with a market cap and multiple to match. Two recent writeups have given excellent tactical reasons to short OLLI, whereas here I will focus on the single biggest reason we believe OLLI is a long-term short: its market saturation point will come much sooner than bulls hope, and the current valuation implies. We peg the stock’s long term present value at ~$34. However, we waited a little too long to publish this note, so please be sure to read our thoughts on tactically trading this stock given its recent ~30% fall.

Business description

OLLI is a high growth regional deep discount hardline “closeout” retailer with 409 stores and aspirations of going national. ~70% of annual sales and an even larger percentage of profits stem from closeout deals (closeouts have the highest margins in OLLI’s assortment). Closeout bargains are OLLI’s only point of significant differentiation relative to competitors like WMT and DG.

Why have you ever even heard of OLLI?

In a way, BIG really is OLLI’s “father,” because it gave OLLI life. Ten years ago, OLLI was a regional closeout pipsqueak with no chance at going national, because BIG dominated national-scale closeout buys with its ~1,400 stores. However, BIG abruptly decided to (nearly) exit its closeout business, leaving ~$1.5 of annual closeout sales up for grabs. OLLI (correctly) pounced on this opportunity and has been gorging itself on juicy deals and fat merchandise margins ever since. BIG’s abdication of the closeout market is what gave OLLI its “decade plus growth story” runway … at least until that runway terminates in a brick wall.

What is the biggest driver of OLLI’s long term value?

OLLI’s ultimate value depends on a single question: At what level of domestic penetration will it reach saturation, such that further growth would come only at the expense of store economics? OLLI’s business model won’t give it a chance for a “second act” once its current growth strategy reaches maturity. An international growth story won’t emerge due to the regionalized nature of closeout products and supply chains (E.g. BIG’s attempt at Canadian expansion failed). eCommerce for closeouts is a non-starter. Pivoting to non-closeout categories wouldn’t work because closeout specialization is the only reason anyone intentionally drives to an OLLI store (this is a major reason for why BIG’s pivot failed).

What governs OLLI’s saturation point?

The key to understanding why OLLI’s saturation point is closer than you think is understanding why BIG decided to exit the business. I was part of an LBO team which nearly took BIG private a decade ago and had a pretty good window onto management’s thought process on the closeout business. The domestic hardline closeout market is finite, unpredictable, and somewhat regional. Therefore, it cannot support steady growth at national scale. BIG abandoned closeouts because at its size and footprint it couldn’t consistently source enough deal depth to maintain a compelling customer proposition in every store. In all of our conversations with folks in the closeout space there is no indication that anything has structurally changed about that business in the past 10 years except that it has grown in dollar terms over the past decade due to simple inflation. Therefore, it’s reasonable to assume that OLLI will face the same challenges that BIG did once it reaches roughly the same level of closeout sales, adjusted for inflation, that BIG abandoned a decade ago. This level is ~$2.0B, equivalent to ~$2.85B total OLLI sales. This math suggests saturation is 3-4 years away if OLLI continues to grow top line on its “mid-teens” algorithm.

As the saturation point approaches, we expect to see increasing levels of traffic/comp volatility. Given the unpredictable nature of closeout supply, we are likely to continue to see periods of false dawns, punctuated by more frequent struggles to “comp the comp.” Prior to COVID, we already saw one such cycle with toys closeouts and management blaming temporary headwinds. We’ve also already seen some regionalization red flags (e.g. OLLI selling closeout space heaters in Florida).

Valuation framework

If you believe our prior assertion that OLLI is unlikely to find 2^nd order growth drivers once it reaches saturation, we suggest valuing it by estimating earnings power at saturation and how many years saturation will take to reach. Then, apply a “low/no growth with volatile comps retailer multiple” like ~10x earnings (still higher than what BIG gets!) and discount to today at a ~10% WACC. For the sake of simplicity, you can give OLLI credit for its long-term growth algorithm in your projection of annual ~14% store growth, ~15% top line growth, and ~20% EPS growth.

-          Our case (~3 years away): Saturation at ~625 stores / ~$2.85B total sales / ~$2.0B closeout sales 

o   Inflation-adjusted closeout sales level equal to where BIG stalled

o   ~$4.5 EPS * 10x PE = $45 per share = $34 per share value today

-          Management case (~7 years away): Saturation at ~1,050 stores / ~$5.0B total sales / ~$3.5B closeout sales

o   Inflation-adjusted closeout sales level ~75% above where BIG stalled

o   ~$9.3 EPS * 10x PE = $94 per share = $49 per share value today

-          Bull case (~9 years away): Saturation at ~1,400 stores (where BIG topped out domestically) / ~$6.8B total sales / ~$4.8B closeout sales

o   Inflation-adjusted closeout sales level 2.4x above where BIG stalled

o   ~$13.8 EPS * 10x PE = $138 per share = $59 per share value today

Please note: This valuation approach assumes management will recognize when saturation is reached and avoid destroying value via inefficient growth and/or other dubious initiatives, but there is a good chance OLLI will instead flail around like BIG has in order to maintain the hope of a growth story.

Trading the stock in light of its recent selloff

The key to trading OLLI is understanding why bulls own it. There is “scarcity value” for multi-year store growth stories with good unit economics, so multiples for these stories remain high until the story actually breaks down regardless of how obvious the ultimate destination is. In our experience, OLLI longs fall into 3 categories:

-          Those who don’t believe that it will hit closeout saturation or will find a way to grow past it

-          Those who believe it will hit saturation but sufficiently far into the future to ride the interim growth and sell to a greater fool

-          A surprising number of lazy longs who don’t even know that an OLLI store today is a near carbon copy of a BIG store circa the 2000s, except even more dependent on closeouts

The good news is that you don’t need to open excel to predict their behavior; you can do it on one side of a napkin. As long as they feel like “the story” remains “on” and maturity is sufficiently distant, they will model growth ~5 years out and slap an ongoing high-growth multiple on it. This approach justifies the $80-$100 valuation range OLLI has been stuck in since the aforementioned “temporary headwinds” started to crop up. We’ve been merrily short OLLI for most of the past 3 years within that range because no credible case exists for either the store growth rate or unit economics to get better than that valuation already implies. Meanwhile, the growing volatility of OLLI’s business ensures occasional dips below this range prior to an eventual crash.

Shorting the stock below this range is a much more tactical game and we would recommend that only those who can track at least traffic, sales, and closeout activity with precision play it (unless you really have 5yr capital!). We are still short the stock today because we think results for at least the rest of this year will be so bad that the longs are going to be hesitant to step in (if you wonder about our ability to track KPIs in this space refer to our BIG writeup and our commentary on buggs1815’s OLLI writeup). However, we’re tracking trends closely and acknowledge that a time may come to politely step aside so that our bullish friends can bid the stock back up. Rinse & repeat.

Risks

-        Improved execution and a favorable closeout cycle puts the bull case back “on track,” at least temporarily, pulling the stock back to the $80-$100 range. Beware that this can happen quickly as there are longs who are eager to call “the bottom” as they perceive it.

Catalyst

-          Ongoing cyclical traffic comp volatility

-          Inability to lap strong quarters

-          More frequent need to blame “temporary” headwinds for volatile performance

-          In the longer term, capitulation on either store growth or comps/margins

-          In the near term, further negative revisions