Description

I wanted to shoot a thesis out for Sports Direct (LSE: SPD), a UK sports retailer whose stock has collapsed over 50% in the past few months following a string of negative press releases and weak earning guidance. With the shares massively re-rating from 13x EV/EBITDA in September to 6x today, I believe SPD offers a unique opportunity to invest in a dominant UK retailer benefiting from secular growth trends at a highly attractive valuation. I have stayed up to sketch my thoughts here, but it’s a messy story and would anticipate some debate in the comment section.

Company Background

Sports Direct is a UK sports retailer founded in 1982 by entrepreneur Mike Ashley. Over the next 30 years, SPD grew rapidly, consolidating a highly fragmented market through acquisitions and aggressive organic growth, and has emerged today as the leading sports retailer in the UK, with £2.8B of turnover and £298.7M of operating profit. With a focus on serving value-oriented customers, SPD has differentiated itself by offering the lowest prices on an extensive range of products from third party brands (principally Nike, Adidas, Under Armour), as well own brands including Everlast, Slazenger, and Danaher.

Situation Background / Market Mispricing

While the Company went public in 2007, Mike Ashley still owns 55% of the shares and exerts a significant degree of control over the business. Ashley is a shy individual who pursed a public offering simply to allow the company to capitalize on its global ambitions. He does not revel being in the spotlight, and he is often poor at communicating his vision and ambition with the Street.  When planning to IPO the business, the FT reported, “that the whole prospect of going public was really rather daunting [for Ashley],” and noted during press conferences that he “oozed discomfort.” His unwillingness to manage public perception, combined with abrupt decision making, has caused significant tension in the City.

Since the IPO, however, revenue and operating profit have doubled. In the face of such results, investors’ governance concerns were cast aside; the valuation discount attributed to Mike Ashley’s unique management approach turned into a premium, and shares rose to 916 GBp at the peak with valuations climbing from 8x EV/EBITDA to 20x. Indeed, throughout 2015 SPD continued to trade at a premium valuation despite rising risk: signs began to emerge that Continental expansion plans were faltering; Management stopped disclosing financial results by geography; and, Mike Ashley continued allocating capital to strategies with little transparency.

Then in quick succession, the Company’s CEO was charged with a criminal offense in October, the Company released 1H financials which highlighted slowing growth in December, and, just 4 weeks later, released a press release in which Management noted they were no longer confident in meeting their adjusted full year EBITDA target laid out the prior month. The stock slumped 50% percent.

The reaction reminds me of comments mad recently by Howard Mark’s comments: “One of the most notable behavioral traits among investors is their tendency to overlook negatives or understate their significance for a while, and then eventually to capitulate and overreact to them on the downside…As negatives accumulate – whether they surface for the first time or just are finally recognized as significant – eventually a time comes when they can no longer be ignored, and instead they come to be treated as being of overwhelming importance.” So this is true of the Sports Direct.

Thesis

Following the carnage, Sports Direct presents an interesting investment opportunity with compelling risk return characteristics. At 6.2x LTM EBITDA, investors can purchase shares in the leading UK sports retailer which has built a meaningful economic moat through its scale, sophisticated supply chain logistics, strong in-house brand portfolio, and an extensive real estate portfolio. These unique capabilities, combined with a cost-conscious culture, enable the Firm to command best-in-class margins while also offering consumers a strong value proposition. Mike Ashley, whilst not forthcoming, has been an innovator within the retail space, and consistently made investments which have driven robust returns for shareholders. Furthermore, the Company is well positioned to continue benefiting from strong secular growth trends within the sports retail space, and will enjoy near-term demand boosts from the Brazil Olympics as well as the EUFA championships. Furthermore, while there are clearly questions regarding the success of SPD's Continental expansion, disappointing growth is unlikely to impair one’s principle given shares trade at meaningful discount to European retail peers XXL (20x EBITDA) and JD (13x).

Detailed Thesis

Dominant UK Sports Retailer with Attractive Economics and Wide Economic Moat

Sports Direct's dominance in UK retail stems principally from their expertise in maximizing sales density. The Company tactfully utilizes attractively priced third party brands (footwear most often) to drive footfall in stores but offers additional heavily discounted SPD-owned brands to drive incremental purchases. Their focus on maximizing sales volumes, combined with their significant market share in the UK, have made them an incredibly important relationship for major brands such as Nike and Adidas, providing them strong negotiating leverage when purchasing their products. This angle, combined with their active supplier relationships and sophisticated supply chain logistics, allow the firm to source products at significantly better prices than competitors. Furthermore, by utilizing a broad portfolio of Sports Direct-owned brands, the Company is able to offer products at a meaningful discount to competitors without comprising on margin while also capturing additional revenue from the global licensing of brands. In fact, the Company is able to achieve margins of ~40-50% on SPD-owned branded products versus third party branded products which yield a ~30% gross margin.

The Retailer’s strategy of maximizing sales density at peak gross margins has been complemented by a vigorous focus on managing costs. This strategy has been supported by an entrepreneurial culture which encourages employees to prioritize profit growth. Leading by example, Mike Ashley and his four key executives all work out of the same office room, have no assistants, earn small fixed salaries with no bonuses (David Forsey only receives a fixed £150,000 p.s.), and have no additional benefits (e.g. car allowance, etc.). Executives do not receive an annual bonus, instead they are awarded a large upfront equity award at the end of 6 years that is only vest if significant and consistent EBITDA targets are reached (risks of this equity plan are discussed in more detail below). Interestingly, all full-time employees participate in the same share compensation plan as executives with 25 million shares being award to over 2,000 full-time employees. As Management mentioned in the latest Annual, “The culture of the Group is payment as reward and the team is awarded large bonuses for outstanding achievements.” These measures have led to a highly motivated employee base which collectively works to maintain costs. This has been supported by Mike Ashley’s significant investments in the supply chain, such as the Shirebrook National Distribution Centre, which is well positioned to efficiently deliver goods with minimal moves. As a result, SPD commands superior gross margin: EBIT margin ratios. The Company’s dominance in brick and mortar retailing has been extended to online shopping. SPD was quick to invest in its online offering in the mid-2000s, and have since scaled internet purchases to nearly ~15%  of total sales despite their patient approach which balances growth with ROIC.

Sports Direct offers consumers a very strong value proposition by consistently providing a broad array of attractively priced products across numerous channels. Because of its scale, unique entrepreneurial culture, and differentiated supply chain, the Company has developed a wide economic moat which has allowed the company to generate robust top and bottom-line growth over the last 10 years.

Skilled Owner-Operator Focused on Long-Term Wealth Creation

Complaints about poor corporate governance have been present since SPD first IPOd, but they have risen to a fever pitch in the last month. Indeed strategic decision making has always been a black box at SPD, for which the market assigns a premium when performance is strong or a significant discount when the business moves sideways. The fundamental issue is that the controlling owner, Mike Ashley, is also the manager, and exerts significant control over how the business is run. The board is comprised of: Dr. Keith Hellawell, the prior Chief Constable of two British police forces; Matt Pearson, the acting CFO who only graduated from uni in 2004; Simon Bentley, a retail sports businessman; Dave Singleton, a prior executive at Reebock; Claire Jenkings, a prior corporate affairs exec at a leading global beverage can maker; Dave Forsey, the CEO who has been at SPD for over 30 years; and, Mike Ashley, the executive deputy chairman. Given few members of the board are independent or have substantial sports retail experience, Mike Ashley has considerable sway in making decisions. With little control over the strategic direction of the Company, shareholders have grown increasingly anxious as growth slows and Mike Ashley continues to do seemingly random acts (purchasing shares in competitors, “wasting” any excess EBITDA achieved above 16 FY16E targets on ecommerce experiments, fighting publicly with Rangers Football Club).  

These concerns are valid; however, it is important to appreciate the value that Mike Ashley brings to the table as a savvy entrepreneur who is actively involved in building the business. Many of Sports Direct’s most important decisions can be linked back to his strategic decision making: building an in-house brand portfolio in the mid-90’s; ramping the ecommerce offering in 2007; investing aggressively to advance supply chain technology; expanding sourcing networks in the east; and, encouraging all employees to act like owners. Furthermore, he remains highly motivated and involved in the business. With an equity stake valued at over £1.3 billion, Mike Ashley remains highly ambition with hopes to create a global sports retail business. Indeed, Keith Hellawell told the Scottish Affairs Committee that Mike Ashley spends 50-60 hours per week running the business at headquarters, and can often be seen on the distribution center floor. For all his shortcomings, Mr. Ashley is dedicated to growing Sports Direct, and has shown tremendous skill in navigating difficult retail environments over his 30 years building the Company. Some decisions might be confusing or even counterproductive in the long-term, but ultimately, Mr. Ashley adds tremendous value and is aligned with shareholders in his desire to build a highly profitable discount retailer. This is an owner-operator I am willing to back.

Secular Growth Trends within Core UK Market         

Sports Direct is well-positioned to benefit from strong secular growth trends in sports retail. Since 2010, major brands have seen tremendous growth in sportswear throughout Western Europe with Nike, Adidas Group (which includes Adidas, Reebock, and TaylorMade), and VF Corporation recording top-line CAGRs of 8%, 5.4%, and 17%, respectively. Since 2014, Nike and Adidas have reported a blended average sales growth rate of 16%. Such robust growth is driven principally by an increasingly active population which recognizes the role regular physical activity has in lowering the risk of heart disease, diabetes, stroke, and some cancers (NHS). Given the potential to shed healthcare costs through active exercise, governments and businesses have been actively promoting wellness programs, which successfully boost exercise, as well as initiating  (Workplace Wellness Programs Study – US DoL; UK Department of Health; UK Department of Culture). These trends have been propelled recently as the private sector boosts investments in the industry, make exercise increasingly accessible, affordable, and fun. According to LDC Reports, the UK health and fitness club market (as calculated by the total annual membership revenue of all clubs in the UK) has grown from £3.6 billion in 2007 to £4.3 million in 2015 (2.2% through-cycle CAGR) with the number of private gym members rising from 4.4 million to 5.5 million since 2011 (6% CAGR) driven by the expansion of new clubs, particularly new low-cost gyms which have grown at a 53% CAGR since 2011. The proliferation of new gym concepts have been matched with a variety of other products and services which encourage active lifestyles, including group fitness classes (Zumba), web-streaming products (FitFusion), wearable technology (Fitbit / Apple Watch), and community health platforms (Nike+GPS / Fitocracy / RunKeeper).  Sport retailers have been further benefited by the overlapping trend of sports fashion, which makes it increasingly acceptable to wear running shoes, sweatshirts, and leggings outside of the gym. This has been boosted by the emergence of an “athletic trend” in high fashion with even high-end designers such as Marc Jacobs introducing athletic lines.

http://www.vogue.com/12721967/chic-new-workout-clothes-best-brands/

http://www.vogue.co.uk/news/favourites-of-vogue/2013/05/exercise-fashion

http://www.vogue.co.uk/fashion/trends/2014-spring-summer/the-sporting-life

Yet despite these secular trends, many analysts are downbeat on Sport Direct’s market prospects. Concerns over recent top-line weakness have been compounded after its closest peer, JD Sports, posting strong sales growth of 26% (UK + Euro) with 10% LFL growth while Sports Direct’s UK sales seem to be up 2-3% (directional given lack of disclosure), making many worry that Sports Direct is losing significant market share to a competitor.  Some of this has to do with JD’s business model, which targets the Sports Fashion market with style being prioritized above price. In an environment where the sports retail market is being supercharged by the emergence of high-end sports fashion, JD is better positioned given it stocks newer, more on-fashion products with the support of major brands such as Nike and Adidas.

JD Sports is disproportionately benefiting from this trend in the short-term, but it is unwise to overlook the power of the discount business model. These retailers might not be sexy, but they offer a compelling value proposition, especially in Europe where it is increasingly acceptable for consumers to shop at the likes of Jawohl, Poundland, B&M, Aldi, and Lidle. By relentlessly focusing on cost, Sports Direct has ensured that they will consistently be the preferred retailer for a growing population of value-oriented consumers adopting active lifestyles and comfortable sportswear. Furthermore, Management has more room to boost growth than many recognize. The Firm has been focused predominately on growing margins, which might have had an impact on their capacity to sustain top-line growth. In e-commerce, for example, the Firm been built out the technology, but has been reluctant to drive further penetration unless it is highly profitable. Perhaps most important, the Company has focused on boosting its gross margins by allocating more space to its own brand products: while this has boosted GM% by 500bps, it might also have moved too fast and isolated certain customers looking for third party brands. By tweaking its e-commerce offering or changing space in its existing stores, SPD might be able to resume growth. It is important, however, to not place too much emphasis on one fiscal year, especially as 2014 has been a tough comp with the 2014 World Cup as well as the acquisition of Ebyl and Sig. In 2016, these trends will reverse, with the build-up to Euro 2016 and the Olympics which have historically provided a boost to revenues.

Furthermore, Sport Direct’s value-oriented business model will likely be more resilient in the long-term as global brands aggressively scale their direct-to-consumer businesses. Nike and Adidas will find it much more difficult to capture value-conscious consumers because a roll-out of a highly promotional ecommerce platform could impair their long-term brand equity. Sports Direct more effectively serves value-oriented customers, and allows global brands to push high volumes of lower-ticket goods without compromising their most important asset.

Valuation

Sports Direct trades at a meaningful discount to European sport retailers, discounters, apparel retailers, and sporting brands. Prior to the January re-rating, Sports Direct was trading at 13x EBITDA, a valuation which required investors to be highly comfortable with the Firm’s capacity to grow internationally while continually capturing share in its core UK market. Today, with share trading at 400GBp (6x EBITDA) the bull thesis has changed drastically. To be a buyer at today’s level, you need to believe that Sports Direct remains a dominant UK discount retailer which can moderately grow organic cash flow through ecommerce, new store roll-outs, and LFL gains. A rapid turnaround of the European business or successful M&A (which I have not discussed here but we can talk about more in comments), is gravy. Assuming the Company can generate £390M of EBITDA (at the lower end of estimates) and trades in-line with UK retailers at 8.3x, the p.s. equity value is ~530 GBp. 

Risks

Negative Press Regarding Poor Treatment of Staff

Sports Direct has increasingly made the press over the last couple years given their poor treatment of staff and extensive use of zero hour contracts (75% of UK employees), which effectively mean that workers have no guaranteed minimum shifts. Continued coverage could result in damaged brand equity, while a change in labor laws could reduce the Firm’s capacity to manage costs.

·         Mitigating Factor: The success of the Conservatives in last year’s election effectively ensures that there will not be a change in zero hour contracts.

·         Mitigating Factor: SPD is attempting to improve relations with the government and the broader public. As of December 31, 2015, the Company committed to paying all casual workers more than the National Minimum Wage from the 1^st of January 2016, and they have invited MPs to their distribution center in Shirebrook. Following a lawsuit from a former employee, Zahera Gabriel Abraham, the Company has also revised their contract to make it more clear the responsibilities and rewards for zero hour workers.  

·         Mitigating Factor: Data from AlphaWise suggests that ethical treatment is one of the least important reasons for consumers deciding where to shop for apparel. Furthermore, while Sports Direct more extensively uses zero hour workers, there are numerous other retailers which rely upon similar labor policies to maintain margins.

Brands Moving to Closer to Consumer

Brands are expected to aggressively move into the direct-to-consumer retail market with Adidas and Nike projected sales to jump 4x and 7x, respectively by 2020.

·         Mitigating factor: Sports Directs’ dual brand focus helps insulate them from third party brands increasing their penetration of the market.

·         Mitigating factor: Given their value orientation it will be more difficult for Nike/Adidas to capture share given their capacity to sell high volumes of off-season goods.

·         Mitigating factor: Global brands will largely be growing their share of the retail market through e-commerce, which Sports Direct has been investing heavily in over the last few years. Their capacity to have a digital interface that complements their brick and mortar offering should help them maintain share in a tough market.

CEO faces criminal proceedings

The Department of Business charged David Forsey, CEO, with “consent to connive at or neglect to prevent the failure by West Coast Capital (USC)… to comply with section 193(2) of the Trade Union and Labour Relations Act 1992 in that they failed to notify the secretary of state at least 30 days before the first dismissal took place on 14 January”. As background, David Forsey took a wholly owned subsidiary into pre-pack administration, purchased the business back immediately from another SPD subsidiary, and left behind a warehouse which was liquidated by the administrators. Some workers in the warehouse were allegedly only giving 15 minutes of notice before they were fired, which has prompted public backlash and now a criminal filing. Typically the penalty would be £5,000, but criminal charges can be upheld if connivance can be proven.

·         Mitigating Factor: A judge in a similar trial regarding City Links liquidation, exonerated executives of similar charges. Can give more detail on this in the comments.

·         Mitigating Factor: David Forsey, while important to the organization, is not a CEO in the traditional sense. Mike Ashley is far more involved in capital allocation and daily decision making, and sits right alongside of David. In the worst case scenario in which David has to step-down as director, SPD will not be leaderless.

Catalyst

Management turning focus on improving core UK business; roll-off of negative news cycle; closing of owner-operator valuation gap