Dick’s Sporting Goods (DKS) reported third quarter results that handily exceeded consensus expectations driven by low expectations and strong online growth. Sales increased 7.4% y/y to $1.94 billion driven by an increase in online sales of 16% y/y offset by a soft same-store sales decline of 0.9%. Earnings per share declined significantly, falling from $0.48 per share in the prior year quarter to $0.30 per share in Q3’17. I think Dick’s is copying Best Buy’s (BBY) playbook, and 2018 looks like it will be the company’s bottoming out year. I am becoming constructive on shares, but I would wait for a slightly more attractive entry point because I do not love everything Dick’s is trying to do.
Strategically (Mostly) Strong Decision Making, but Secularly Challenged
From a strategy standpoint, I think Dick’s is making some great changes. For one, the company led a nationally televised advertising campaign to introduce its price matching guarantee program, which is exactly what Best Buy did in reaction to Amazon (AMZN). This playbook, though it can make price one of the most important buying factors, should stabilize the business from a traffic perspective. Price parity can make buying in-store or online at Dick’s Sporting Goods much more palatable.
Additionally, Dick’s Sporting Goods will allow its reward points to accrue on a trailing twelve-month basis. This rewards program can help augment cash back that buyers experience at other companies. Both of these decisions should help Dick’s Sporting Goods maintain shoppers in spite of the tough promotional environment.
Lastly, I think Dick’s is taking a very thoughtful approach to its real estate strategy. Management mentioned on the call that only a handful of stores are not profitable on an EBITDA basis and none are unprofitable on an EBITDAR (EBITDA + Rent) basis, so mass store closures are not coming. Additionally, management sees the price of non-A mall real estate declining (and the price of A mall real estate increasing), so Dick’s will open fewer stores than previously anticipated. I like this for two reasons: 1.) Dick’s can buy time and see how retail channels evolve and 2.) Dick’s can likely sign leases at much lower rates.
On the other hand, I do not love Dick’s decision to invest in private label brands. This is no new tactic. The likes of Kohl’s (KSS) and JC Penney (JCP) have had private label brands for years, and Dick’s is enjoying a higher margin profile and full control over distribution. Over the past two years, Dick’s has struck licensing deals with Umbro, adidas’ (OTCQX:ADDYY) Reebok for “RBK fitness,” Nike’s (NKE) ACG brand, among many others.
Unfortunately, I do not believe Dick’s will be able to have its brands resonate with customers nearly as strongly as traditional brands like Under Armour (UA) (NYSE:UAA), Nike, and adidas. I am not particularly sure how Dick’s will be able to position private label brands using anything other than price, and I don’t love the idea of inventory risk that will lack any return to vendor (“RTV”) credits.
On top of the private brands investment, I think the marketplace remains challenging. In Q3, gross margin fell over 300 basis points y/y to 27.5% of sales. Channel inventory is going to be an issue that leads to a soft Q4 in which comps decline in the low single digits and earnings per share fall up to 15%. 2018 will also be a brutal year for the retailer, as EPS is expected to decline at least 20% as the company gears up for e-commerce expansion in a flat retail environment.
What is Dick’s worth?
The sporting goods recession that has percolated in 2017 definitely caught me by surprise, but I think the worst is not over. Dick’s is likely to earn less than $2.40 per share in 2018, and I think an industry rebound may not occur until 2019.
In order to model the company, I’ve reduced my long-term operating margin to 5%, lower than my previous 6.5% long-term outlook. With EPS of $2.00-2.40 in 2018, shares trade around 10.6-12.8x next year’s earnings. Free cash flow should sustainably be in the $250-300 million range, so from a cash flow perspective, shares also trade at a relatively attractive multiple in the low teens.
With the uncertainty of this big box business model, my DCF yields a wide variety of outcomes, leading to a fair value range of $32-44. In the past, I definitely overestimated the durability of the Dick’s business model. That said, I am not particularly interested in shares at this level. I’d like a mid-single digits multiple before establishing a position. I would be fairly interested in the stock around $16-17, where I see a sufficient margin of safety.
Disclosure: I am/we are long UA, AMZN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.