Description

Short Thesis

â–  BGFV is a dying business with high operating leverage trading at 20x earnings

â–  Recent results (and the stock price) have benefited from the recent bankruptcy of competitors which will not repeat

â–  Fair value is well below the current price even in a best case scenario

Business Overview

Big 5 Sporting Goods (BGFV) is operates a chain of 432 sporting goods stores in the western United states. 51% of stores are in California, 12% are in Washington and the remainder are located in other western markets. Approximately 52% of sales are hard goods, 20% are apparel and 28% are footwear. Store count appears to have peaked in 2014 with 439 units and now looks to be slowly declining. Big 5 did not have an e-commerce offering until late 2014 (which management admitted was about 10 years too late) and company’s online sales are not material.

Big 5 is Dying Business

Sporting goods are discretionary purchase. So it is reasonable to expect Big 5’s sales to grow when the economy is expanding and fall during recessions. While historically this was indeed the pattern at Big 5, it was not the case in the most recent cycle. From 2009 to 2015 sales per square foot actually decreased slightly while EBIT margins fell 37% from 2010 to today.  Given the deteriorating sales and margins in an improving economy it is correct to view BGFV as a declining business.

Figure 1: BGFV Change in Same Store Sales and EBIT Margin

Like so many other retailers, the reason for BGFV’s decline is competition from Amazon and other e-commerce platforms. While all of Big 5’s product categories are subject to online competition, hard goods seem particularly vulnerable given that these are standardized products where it is simple to compare prices and that these items can ship easily.  Indeed, hard goods have declined from 54.9% of total sales in 2010 to 52.2% in 2015 and sales of hard good per square foot have been falling for the last 10 years.

Figure 2: Hard Goods Sales Per Sq Ft

BGFV is Benefiting from the Liquidation of Competitors

Earlier this year both Sports Authority and Sports Chalet declared bankruptcy and closed all their locations.  Management estimates that about 250 of their stores were impacted by about competitor closings. This sudden decrease in competition has clearly benefited BGFV. As shown in Figure 3 below same store sales were slightly negative prior to the exit of these competitors but suddenly turned strongly positive last quarter. This caused the stock price to rally 45% from the end of 3Q.  However, this benefit is one time in nature and next year when these closures anniversary the business should continue its decline.  Longer-term, the liquidation of competitors with a very similar business model in a strong economy suggests that BGFV’s model is itself vulnerable.

Figure 3: Near-Term Same Store Sales

Fair Value is Much Lower than the Current Stock Price

Let’s assume we are wrong about Big 5 being a declining business. In that case we could view next year’s earnings as representative of the mid-cycle earnings power in the business. If you capitalize these earnings at 8% you get a fair value of approximately $12.80 or 35% below the current price (calculations shown below). Given significant evidence that BGFV is secularly declining as well as over-earning due to the overall all business cycle this valuation would represent a best case scenario.

It would be more realistic to assume normalized earnings are below current earnings and will likely decline over the long-term. In this realistic valuation scenario we first assume mid-cycle sales are 4% lower than 2017E sales.  This appears conservative given that sporting good are a highly discretionary purchase and the average sales per square foot this cycle is 15% below the prior cycle peak. Next we’ve assume that continued online competition causes profits to fall 2% over the long run. This too seems conservative since due to the operative leverage in this business a 2% long-run earnings decline implies a long-term sales decline of <1%. Under these assumptions the fair value of the stock is about $6.35 or 70% below the current price.

 Figure 4: Valuation

Key Risks

Near-Term Results Could be Stronger than Expected – BGFV has only reported one quarter of results since Sports Authority and Sports Chalet closed their locations. Even though these closures weren’t fully completed until the end of July, analyst models I’ve seen have comps decelerating for the next 3 quarters. As such, it is possible that the impact of store closures is greater than the market expects. However, some of the positive impact should be offset by lower firearm / ammunition sales post-election and by Dick’s reopening 15 of the closed locations.  We are comfortable with this risk because even if these store closures increase sales 50% more than expectations fair value is still at least 50% below the current price.

General Consumer Strength – We’ve assumed that general levels of consumer spending look similar to previous business cycles. However if consumer spending in this cycle or the next cycle is much stronger than the past our short may not work.  Given that consumer spending cycles have been fairly constant over many cycles and there is no reason to expect this to change, we are comfortable with this risk.

Lower Corporate Tax Rate – Currently BGFV is a full tax payer with about a 37% cash tax rate. If corporate taxes fall, this would benefit the company.  However, as shown in the appendix, shares are still significantly over-valued even if the tax rate falls to 20%. As such we are comfortable with this risk. 

Catalyst

Lower sales and earnings over time