Sports Direct has been written up once before on VIC by LTYC123 in February of 2016. The last 3 years have truly been a perfect storm for the business as just about everything that could have happened, happened. In 2016 there were a number of highly publicized corporate governance issues including (1) the then CEO Dave Forsey facing legal charges after improperly handling the collapse of a subsidiary, and subsequently quitting after 32 years at SPD (2) Sports Direct being charged with paying its workers less than minimum wage at the Shirebrook Warehouse, and finally (3) Brexit. Yet despite these stumbling, Sports Direct continues to grow and continues to generate a substantial amount of free cash flow.

Company Overview

Mike Ashley founded Sports Direct, a UK sports retailer, in 1982 with a 10,000 GBP loan from his family. Ashley quit school at age 16 to try his luck as a country-level squash player which eventually led him to sports retailing. By 1990, Sports Direct had over 100 stores, and today there are nearly 750 across the UK and Europe. The company went public at 300p a share in 2007, giving the company a valuation of 2.2B GBP. From 2007 to 2014 the stock tripled and the valuation reached a high of nearly 6B GBP. Today the company has nearly 3x as much sales as they did in 2007, and trades at an EV of 875M GBP.

Sports Direct Today

As Britain’s largest sporting goods retailer, SPD has been known for its low cost high sales density model. Sports Direct offered a wide assortment of entry level products from multinational vendors (Nike, Adidas, etc.), while also offering their own branded products (Karrimor, Everlast, etc.) for margins of up to 50%. The stores were borderline claustrophobic, covered with discount signs, and sold lots of product.

Over the last few years, Sports Direct announced that they were pivoting the business model and would focus on becoming the “Selfridges of Sport”, requiring many years of transition to elevate the brand of SPD and its offering. Those who were familiar with the Sports Direct story were thrown-off by the shift in focus, viewing the move as a desperate attempt to save a dying business.

In reality, Mike Ashely own 60% of the company (720M GBP), has built SPD from the ground up over the last 30 years, and has continuously evolved the business along the way. The shopping preference of today’s consumer coupled with the rise of ecommerce has forced Ashely to adapt. 10 years ago shoppers preferred to buy 3 entry level football kits with their money, and today shoppers prefer to buy 1 high end kit. Additionally, the rise of ecommerce is forcing many retailers to find a way to elevate the shopping experience for their customers, rendering the old SPD store format obsolete.

Sports Direct currently has ~36 new generation format stores, 20 of which are Flagship Stores of up to 100k sqft each. Over the coming years, SPD plans to continue building new generation stores as old leases expire, targeting 10-20 builds per year resulting in a store base that is half the count, but with stores that are twice the square footage, leaving the business with the same retail space. Given the dire retail environment on the UK high street, Ashley has opted to opportunistically buy properties as opposed to renting, taking advantage of distress and historically low interest rates. Today SPD has $700M GBP of Freehold Property and Buildings they own, which is offset by ~690M GBP in outstanding debt at ~2% interest. Importantly, the new generation stores are trading at higher profitability than the old format stores.

This snapshot shows the highest and lowest turnover new generation store compared to the average SPD UK store. You can see that the new generation format produces ~150-300bps more EBITDA per dollar of sales compared to the old model. Here are a few pictures that really highlights the difference visually in store format:

As of FY 2018, Sports Direct UK has 2.2B GBP of total sales, of which 400m GBP are online sales, and 293m GBP in EBITDA.

Premium Lifestyle / Flannels:

In 2012 SPD bought a 51% stake in Flannels, a chain of high end designer stores specializing in luxury fashion clothing. In 2017, SPD bought the remaining 49% of Flannels and have brought the store count from 8 in 2013 to 26 today. Luxury retail is increasingly becoming an important element to Sports Direct, and the Flannels business is taking advantage of the quickly growing UK luxury retail market. As of FY 2018, Flannels has 160m GBP in sales and 6.3m GBP in EBITDA.  In FY 2018, SPD spent 6m GBP in capex building out 8 new Flannels stores which generated an additional 2.5m GBP in EBITDA, or a 42% pre-tax cash on cash return. Here are a few pictures of the Flannels store in Leeds.

House of Fraser

On August 10th 2018, Sports Direct bought House of Fraser out of administration in an assets only deal for 90m GBP in cash. This was a monumental acquisition, and in a bold statement Mike Ashley expressed his desire to make House of Fraser the “Harrods of the High Street”. Here is some financial information about HOF which was released in a June 2018 turnaround plan by the former management.

When House of Fraser went into administration it had has 59 stores with a cumulative 3B GBP in minimum lease payments, 390m GBP in bank debt, and hundreds of millions of pounds owed to suppliers. However, because the business went into administration, Mike Ashley is now allowed to renegotiate or walk away from each of the 59 leases, operate a business that is now debt free, and is even able to sell down the inventory stock that he got for virtually nothing. And astoundingly, SPD paid only 90m GBP for a business that has historically done over 1B GBP in annual sales. To date, Mike Ashley has renegotiated ~25 of the 59 leases, and will likely shut down about 40-50% of the store locations that are not viable or where the landlord will not agree to significant rent reductions. Overall, while there is a significant amount of work to be done to elevate the luxury offering of HOF and to turn around the business, this deal seemed too good to be true. Here are pictures of the iconic HOF Glasgow location which SPD recently purchased from the landlord for 95m GBP.

In the interim earnings statement which was released today, HOF had 122m GBP in sales over a tumultuous period of 2.5 months. On an annualized basis this is roughly 700m GBP across the 59 stores that are trading. SPD also announced that they dismissed the former HOF management, have fired XPO logistics and hired clipper logistics, and invested a further 70m GBP in the HOF supply chain. Over the next year, Ashley will reduce the store base, elevate the product offering and make sure the stores are operated efficiently. Something that will be extremely helpful to SPD in this effort is that they already have the supplier relationships with the multinational luxury brands (Prada, Gucci, Fendi, etc.) through their Flannels stores.

One point worth mentioning about Harrods, which is unquestionably the most iconic UK luxury retailer, is that there is only one Harrods location in Knightsbridge. In addition, Selfridges, who is very much like Harrods, only has 4 location. The UK luxury retail market is large and growing quickly, and Sports Direct plans to use the Flannels and HOF brands to bring the same type of ultra-high-end luxury to high streets across the UK.

Valuation

Now for the fun part, what’s the business worth? Understanding the different segments of the business will help to highlight how mispriced this business is. Here is the segment breakdown from the FY 2018 annual report (which doesn’t include HOF).

We can see that the core UK Sports Retail segment is very profitable, the wholesale & licensing business is very profitable, the Premium Lifestyle segment is just reaching profitability, and European Sports Retail and Rest of World Retail is unprofitable. Some noise to clarify here, the 120m GBP investment cost was a write off of a 30% position in Debenhams Plc, and the Finance Costs of 40 GBP includes currency hedges, debt interest, and finance leases.

As of today’s interim statement, there were 520m shares outstanding at 235.4 pence per share, or 1,224m GBP market cap. There is 164m GBP in Investments, 181m GBP in Cash, 689m GBP in Freehold Property, and 687m GBP in Debt. This brings us to an EV of ~875m GBP, compared to ~157m GBP of after tax earnings in the core UK sports retail business alone, or 5.5x earnings. However, it’s also helpful to consider the valuation on an EBITDA basis. For tax reasons, SPD is incredibly aggressive in recording depreciation. Here is the depreciation schedule of Sports Direct vs. Dick’s Sporting Goods.

SPD:

DKS:

You can see the dramatic differences for exactly the same business model. For FY 2018 the core UK sports retail business had 96m GBP of D&A, giving us 293m GBP in EBITDA. In other words, SPD today trades at 3x EBITDA of the core business. Importantly, in today’s trading statement, EBITDA grew 1.5% in the core UK Sports business, 257% in the Premium Lifestyle business, 42% in the European Sports business, and improved to nearly break even in the Rest of World business. Here is an estimate of valuation which I think is very conservative:

The context underpinning the valuation --> Historically, the UK retail sector has traded at ~8x EV/EBITDA, and at its peak in 2014 Sports Direct traded at ~14x EV/EBITDA. Just earlier this year JD Sports traded at 13x EV/EBITDA. The European Sports Retail business is going through a turnaround, with EBITDA increasing 42% year over year, which in my opinion easily justifies the 12x multiple on current EBITDA. The Premium Lifestyle segment grew EBITDA 257% year over year, and SPD continues to roll out Flannels stores at a brisk pace as they have seen pre-tax cash on cash returns of 40%+.  I believe this also justifies a 12x multiple. House of Fraser was a monumental acquisition done at an incredibly cheap price. Given the store level economics of Flannels, and the scale of HOF, I would not be surprised if the business is worth much more than 2x cost down the road.

Perceived Risks

1. Mike Ashley destroys capital with cowboy style capital allocation.

• With the “Strategic Investments”, Mike certainly has had a number of mistakes, including a ~175m GBP write off of Debenhams Plc over the last 18 months. However, there have been a number of fantastic acquisitions including Flannels and HOF, and while Mike will make mistakes, he has a vast majority of his net worth in Sports Direct giving me confidence that he will continue to act rationally. It’s also worth noting that over the past 2 years, amid the collapse in the share price, Mike has repurchased 250m GBP of Sports Direct Shares. Mike also pays himself zero salary, not even a penny, so his return will truly come from the results of the business.

2. Poor Corporate Governance

• This has been flagged as a problem since the IPO in 2007. If one takes time to really understand the missteps made by the company, instead of reading the media headlines, it’s pretty easy to understand that what happened were honest mistakes. There are two 2hr+ videos of Mike Ashley meeting with the House of Commons in 2016 and just a few weeks ago. They do a wonderful job highlighting Mike’s character, which is animated at times, but certainly honest about the situation.

3. Brexit

• I don’t think anyone has anything intelligent to say until the final outcome of the negotiations are determined. Whatever may happen, the business will sort itself out. In the short term, if the pound devalues significantly against the dollar that would be bad for the business, and if it rallies, it would help the business.