Description

This write-up is not intended as a standalone analysis.  BIG has been written-up on VIC three times.  The intent here is to provide color on the recent BIG fundamental underperformance and make a case that despite recent disappointments (and because of significant stock decline) BIG is an attractive investment.     

Two significant differences vs dollar stores: 

1. Consumables are 30% of its sales, dollar stores consumables are 60%
2. Half of its total merchandise and 70% of consumables are closeouts which are predictable in the short run

These two difference are responsible for the higher volatility of BIG's same store sales.  At the same time closeouts make BIG a unique retailer with no direct competitors.  About 15% of BIG's sales is seasonal merchandise which is bought directly from factories (not closeouts).  BIG buys it once for the season.  (In Q2 it seasonal merchandising was subpar, all good stuff sold out fast and the rest, less 3.good merchandise, had to be discounted).  Seasonal business could be a very good business but offers plenty of same store sales risk - weather impacts that business significantly, also merchandising screw ups (as happened in Q2 2012) make this business more volatile. 

In 2011 BIG bought a closeout retailer, Liquidators, out of bankruptcy, the idea was it is a cheap way to get into Canada at scale.  It is a significant turnaround, this Canadian business lost money for six years, the goal is for Canadian stores to reach break-even by Q3 2012 (so far it appears that it will achieve that goal).   In Q2 2012 BIG increased inventory and assortment in Canadian business, increase was intentional because stores lacked inventory.  

Inventories are up 13% for several reasons:  

1. Store count  increase - good reason
2. Increase in consumables in existing stores (they received more branded merchandise) - not worried (at least not yet).  Management says  increased consumables inventories level is not indicative of future higher inventories
3. Fireplaces - intentional seasonal build up  - not worried
4. Furniture - this is bad, it was driven by bad merchandising

 
Q2 2012 screw up

• Sales are up 1.7%, but same store sales are down 1.9% (total sales increase is driven by opening new stores)
• In previous quarter BIG struggled with merchandising in electronics and consumables, they fixed it in Q2.
• Sales weakness was driven by two categories: seasonal and furniture - completely driven by bad merchandising.  These businesses are not closeouts (for the most part), merchandise is purchased from factories directly.  
• COGS were up slightly to 60.8%, higher than annual average of 60% in 2011 and 59.4% in 2012
• SG&A expense as % of revenue was up a LOT - 33.8%, annual averages 2012 and 2011 are 31.6% and 31.8%.  In Q1 2012 this number was up as well, it was 32.3% - this is driven by sales de-leveraging.  BIG needs same store sales to go up for it to maintain its margins.   Per my conversation with management, there are no costs left to be cut at the store level (they are very efficient there already).   Management  is insistent that there are still costs left to be cut on the corporate, but I am not really sure where.  In 2012 BIG installed SAP's inventory and financial management software, in theory it should make them more efficient, Steve Fishman (CEO) usually doesn't commit capital to anything unless it meets his IRR. 
• Margins will be impacted further in Q3, possibly in Q4 by clearing inventory in furniture and seasonal (seasonal inventory is cleared faster and thus will impact mostly Q3). 
• Deficiencies in the quarter came from merchandising, the merchandising guy that was on the job for a little bit more than a year was fired.  Steve Fishman brought back John Martin who was in charge of merchandising from 2003 to 2011 and was very good at it.  In 2011 he was promoted to a more administrative, human resources and operations role.  John Martin will likely be able to right the ship; it doesn't seem that the problem here is structural.  However, this quarter highlighted an Achilles heel in BIG - merchandising, the business requires a constant merchandising touch.  We don't like that one person can really make such a significant difference in company's business on day to day basis.  BIG probably deserves a lower multiple than we previously thought.   

There are several ways to improve merchandising:

• Remember there are two distinct categories we are addressing here: closeouts and non-closeouts.  
• Closeouts - BIG needs (and it will) to broaden and deepen its relationship with manufacturers.  This is important because it will improve its assortment and will give a better lead time into what merchandise it will have. 
• On a non-close out front - it simply needs better merchandising; it needs to entice people to come into its stores. 

Coolers and freezers 

Steve Fishman mentioned that BIG will be experimenting with bringing coolers and freezers into its stores.   BIG needs to bring coolers and freezers so it can sell perishable items which will hurt its margins, but will help them on two fronts: first, will increase frequency of store visits and second will allow BIG to take food stamps (which are now called SNAP transactions).  Steve Fishman was against this for a long time, but things have changed.  Now a significantly larger portion of the population uses food stamps and company's registers are now able to take food stamps.  However, this is an experiment, BIG will try it out in five areas at first.  We don't know what capex will be if it decides to go with it.  

Balance sheet

Historically BIG was fairly debt averse, but this quarter its debt has increased to $240mm with around $50mm of cash.  BIG bought back $149mm stock in the quarter.  Company expects to exit the year with $140-150mm of debt on the credit line (did not indicate cash position).  Its cash flows for the year will be about $70mm lower than it expected going into second quarter.  

BIG has two methods of buying back stock, normal purchase which gives BIG roughly two week window during the quarter and 10 B5-1 plan – BIG tells broker to buy so many shares at certain price and there is nothing it can do afterwards.  So even as business deteriorated it could not put a stop on share repurchases.  Even though it has $50mm share buyback I suspect BIG will stop buying back stock for at least a few quarters until it pays off its line of credit (S&P possible downgrade is another motivator why BIG will do that).  

Guidance for 2012

• EPS 2.80-2.95, down from 3.25-3.45, $2.99 in 2011.  EPS in 2012 is benefited by 10% stock repurchase and but hurt by full year of ownership of Canadian business (vs. owning it 6 months last year).  It will have a loss of 0.22-0.26 share. 
• Same store sales decrease in low single digits, total 3-4% driven by US stores
• Gross margins US - gross margin low because of markdowns and mix
• Depreciation is impacting margins because of new store openings (but this is not the core reason for bad results.) 

Bottom line

• Is BIG structurally, fundamentally broken?   All wounds in Q1 and Q2 were self-inflicted by BIG not its competitors (and not Amazon).  It has a fairly unique business model and a competitive advantage.   Its currents problems are fixable.  Management has already made correct moves to fix them, but bad merchandising decisions take a few quarters (and lower margins) to fix.  I believe BIG has a first rate management that is capable, rational and honest.  
• What is its earnings power? Has its EPS been permanently impaired?  Next year's earnings are not linked to this year's reset number; once inventory is liquidated at lower margins new inventory (assuming merchandising is fixed) will have better margins.  Customer goodwill has not been damaged; just customers were not given good shopping choices (at the margin).  
• Is there more downside fundamental risk?  BIG is trading at about 10x lowered 2012 guidance.  If its operating margins revert to 6.5% (they were 6.6% in 2011, 7.2% in 2010, 6.9% in 2009), opens 4% of new stores and has flat sales then EPS will be $3.77 with 1% same store sales $3.82.  You put a P/E of 12 it is a $45 stock. 

Catalyst