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Big 5 (“BGFV”) has approximately 100% appreciation potential as the market works to correct extremely negative sentiment which put lots of pressure on the price of the stock due to current challenging Sporting Goods Retail environment.
There is no doubt that traditional retailers have experienced the squeeze from e-commerce nowadays. For quite a long time, department stores or chain retail stores have been considered as an industry that have relative stable revenue and earning power, partly due to the diversified portfolio they have, and partly due to the “consumerism” in United States. 67% of the GDP is from consumption of various kind, that is almost the back-bone of USA’s GDP growth.
As a result, various retailers were taken over in the past through deals in the form of “Leveraged Buy-outs” where private equity firms bought the company from founding families and then apply a high level of debts to its capital structure, hoping that they can improve the operating efficiency and relying on the fact that the revenue and earnings are stable enough to afford high level of debt load. That was the major mistake they made (for their clients, not themselves of course) and the driver behind so many bankruptcies from retails with unsafe capital structure. It almost worked as a perfect storm: on the market share side, traditional retailers lose ground to e-commerce, showing negative same store sales growth number, tighter margin (because their e-commerce competitors don’t care profitability); on the capital structure/balance sheet side, if this traditional retailer is highly levered, they will start facing tighter cash flow, getting closer to loan covenants breach and if they need to re-finance a large debt in such market, they will pay much higher spreads if there are any lender out there at all. The tighter cash flow will also limit their ability to re-invest and improve their own businesses, which will further reinforce lots of consumers’ impression from main stream media that “traditional retailers are dead”. Such vicious cycle will self – feed and create a downward spiral in such industry.
Within Retail industry, sporting goods retailers were particularly hit with a few specific negative developments in the past year: change of consumer taste to sports/leisure apparels and footwear, lack of new innovations from major players like Nike and Under Armor, new Republican President and Congress’ negative impact to gun sales, different weather patterns that causing some inventory issues etc.
That’s where you can find value.
Big 5 Sporting Goods Corporation (“BGFV”) is a leading sporting goods retailer in the western United States, operating 432 stores and an ecommerce platform as of October 1, 2017. The Company provides a full-line product offering in a traditional sporting goods store format that averages approximately 11,000 square feet. The Company’s product mix includes athletic shoes, apparel and accessories, as well as a broad selection of outdoor and athletic equipment for team sports, fitness, camping, hunting, fishing, tennis, golf, winter and summer recreation and roller sports.
The Quantitative Factor
BGFV’s stock price as of Feb 14, 2018 was $5.7, this pricing implies a price/book ratio of 0.62 and a P/E multiple of approximately 11. The company experienced revenue growth of -0.8% in 2016, and estimated revenue growth of -1.1% in 2017, which will be reported at end of February. The reasons behind such revenue decline are partly due to e-commerce’ challenge in this space, but also partly due to unusually warm and dry winter in 2017 that caused lots of winter sports goods stuck in the inventory.
Revenue and Earnings – Income Factor
Note that the past 7-year period, their revenue growth was 0.6% (2011), 4.3% (2012), 5.6% (2013), -1.6% (2014), 5.2% (2015), -0.8% (2016) and -1.1% (2017 E) respectively. There is no clear trend which give me certain belief that it is not a steady decline (e-commerce has existed for a long time). Same store sales growth showed similar pattern, which will eliminate the concerns that their growth in revenue was due to new store openings.
More impressively, their operating profit were positive for the past 16 years, no any single year you saw a negative operating profit, even during the great finance crisis time. Same can be said for their net income number. These are not small achievements to dismiss. It tells me something great about the management team.
In the past 7 years, their return on equity has been averaging 8.7%, not extremely impressive, but not something poor as well. Their Free Cash Flow has been decent over years. The Free Cash Flow Yield on Equity averaged around 6.5% in the past 7 years, again, not eye-popping but quite decent. It provides some confidences to their ability to pay out dividends after serving the debt interest expenses.
Capital Structure – Balance Sheet Factor
Historically their price/book went as high as 2 at the end of 2009 and now at the lowest point of 0.62. Note that this company did not do a lot of acquisitions so the intangibles and good wills on balance sheet is only about $0.2/share. So, the tangible book is very similar to actual book value.
Long term debt as of Oct 1, 2017 is about $46.4m, against a total asset of $441.4m. The interest expense was covered roughly 11 times – 20 times by Net Income in 2016 and 2017. And that coverage was relatively stable over the years in the past.
We believe the capital structure is sound and safe and should be able to sustain a prolonged decline and challenging environment in Retail sector.
Currently the company pays roughly $.6/share dividend, a more than 10% dividend yield based on $5.7/share price. Although the dividend yield is high, it is not the primary considerations for us to recommend this stock because if you buy into the business as a business owner, what you care is how the free cash gets deployed to earning a better return on equity or distribute back if there is lack of opportunity to grow the business. We think the dividend may stop grow or be cut in future should the capital expenditure requirement heightens which demands more investment into the business than sending out checks to shareholders as dividend. If there is a dividend cut announcement, I am confident that it will create another round of selling off in the market, which, if the reason for dividend cut is to focus on growth rather than liquidity problem, will present another excellent opportunity to buy more shares at a better price. However, in our base case underwriting, we do not invest due to the high dividend yield or we will not bail out if there is a dividend cut.
The Qualitative Factor
Enough has been said in the media or other channels about the challenges faced by traditional retailers. We think that it is a headwind for now, but it won’t last forever. Sooner or later, e-commerce companies need to make a profit to sustain their business. And sooner or later, traditional retailers will finish adapting to new competitive landscape and have a balanced strategy in physical store and e-commerce channels.
Management team is led by Steve Miller, who managed the company from 2002. We like long term management team that shows dedication, prudent, conservative style and shareholder mentality. Steve has a good track record over the 16-year period as the CEO of the company and based on the return on capital, capital structure and dividend policy, we think he is capable and shareholder-minded executive. He draws a total compensation about $800K per year, including 30% from bonus and 70% from salary. I think it is a fair number in today’s environment.
Reputation wise, we spoke to some customers of BGFV, we believe they carry a very positive image within their customer community as fair, knowledge and attentive.
Ben Graham said the stock market is a voting machine in the near term and weighing machine in the long term. This company is doing roughly $1 billion in sales with a market cap of a little over $110million. We think that given their profitability record, capable management team, they don’t deserve such a significant discount to book value.
I believe given the amount of pessimism priced into the stock, any slightly beat in revenue or margin or earning or dividend will make the stock price pop significantly in near term. But frankly speaking we don’t see it become a growth machine near term given the shifting landscape in the industry. I would rather patiently hold a good stake in this company and wait for the market to correct its bias and give it a fair pricing, which should be around 1.2 to 1.5 book value. That implies at least a 100% to 300% appreciation over next 5 years.
Not all retail stocks that are sold cheaply are good ones to own. To pick the right one, we have stringent rules built in to make sure we have margin of safety. They are (but not limited to): consistent earning ability over past decade or longer, reasonable return on equity over the long term, safe capital structure and strong coverage of debt service, shareholder minded dividend policy, reasonable and health free cash flow, stable, capable and honest management team etc.
BGFV operates mostly in west coast markets and in a store format around 11,000 sqft, not in a direct competitive against another favorite stock-DKS, its business fulfills smaller neighborhood needs and it can be nimble in such dynamic time of retail industry. We want to recommend it as a strong buy and it should provide satisfactory return at this price point for next 5 to 10 years.
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