Description

Discount retailer Big Lots is on sale. Shares of the chain, which sells furniture, home décor items, food and consumables at over 1,400 stores across the US, were hammered after two quarters of disappointing sales. The unplanned departure of a successful CEO David Campisi, who retired in April for health reasons, hasn’t helped either. Big Lots is now trading at more than 50% below its historical discount to its closest peers Dollar Tree and Dollar General and looks like a bargain on other metrics as well. At $41, it trades for 4.6.x EV/consensus forward EBITDA compared to a peer group average of 13.5x (including Dollar Tree, Dollarama, Dollar General, Five Below and Big Lots itself) and at a discount to its own historical multiple of 5.7x.

The reaction appears overdone. While top-line growth has stagnated, bottom line and EPS growth beat both guidance and consensus estimates. The experienced and shareholder friendly management team is taking necessary steps to rev up the topline down the road. Big Lots is in the beginning stages of a strategic transformation – its “Store of the Future” initiative, launched by Campisi before he left – that is showing remarkable early results If management, all of whom served with Campisi, can continue to deliver on its plan, comp sales growth should meaningfully accelerate, narrowing the discount to its peers and propelling the stock price higher by at least a 25%.

Business Description

Headquartered in Columbus, Ohio, Big Lots is a discount retailer with roots in the closeout business. It has over 1,400 stores in 47 states across the US. With annual revenues of approximately $5.2bn (FY 17) and a current market cap of $1.8bn, Big Lots is the third largest discount retailer in the US with 7% of the market, far behind market leaders Dollar Tree (40% market share) and Dollar General (35%).

While it is frequently compared to dollar stores, Big Lots carries a broader assortment of merchandise and targets a different customer. Big Lots sells a large variety of products, with an emphasis on the home: furniture (28.2% of sales in Q1 ’18); soft home (15.7%); hard home (6.9%); seasonal (13.8%) and electronics, toys & accessories (5.8%). Food and other consumables round out the rest, accounting for 14.9% and 14.7% of sales respectively.

Big Lots calls its core customer “Jennifer”, and describes her as someone who has a “love for deals” but struggles with home decor for a variety of reasons, including a lack of budget and time. Big Lots aims to help Jennifer overcome these barriers, forging a strong connection with its customer base as it does so.

The Jennifer concept was the brainchild of former CEO David Campisi, who took over in March 2013 and overhauled the company’s strategy. Besides Jennifer, the plan also focused on employees (Associates) and shareholders. He aimed to establish competitive prices, offer a wide range of quality products, and maintain a consistent supply of both general items and fresh food and groceries. Campisi also closed the Canadian and wholesale divisions in 2013. His efforts paid off for shareholders: The stock almost doubled under his watch, hitting $64 in January 2018 before the disappointing past two quarter results. In late 2017, Campisi was hospitalized and placed on medical leave; he retired for health reasons in April. Chief Financial Officer Tim Johnson and Chief Merchandising and Operating Officer Lisa Bachman, both brought on by Campisi in 2015, have taken over Campisi’s executive responsibilities on an interim basis while the board searches for his replacement.

·         Before he left, in 2016, Campisi and his management team launched the “Store of the Future” initiative, closing underperforming stores, remodeling others to have a larger format and selling more groceries, aiming to gain a bigger share of Jennifer’s wallet. Big Lots is also applying its “Edit to Amplify” strategy to existing stores, trimming the number of products in slow moving categories (stocking fewer toys, for example) and adding them to ones that sell well (such as adding more space for sofas, love seats and bedroom sets). By combining these two strategies, Big Lots aims to win market share from industry leaders Dollar Tree and Dollar General, while at the same time keeping Amazon at bay. There’s ample reason to believe it can succeed.

Investment Thesis

Stock is cheap on an EV/EBITDA metric

Big Lots is currently trading at 4.6x EV/EBITDA, below both its own historical average and its typical discount to the dollar stores.

Big Lots has always had lower top line and same store sales growth than its peers, thus the lower multiple, However, historically, the discount to the dollar stores has been between 2x and 4x. With the Q1 sales bomb, the gap jumped to 4.8x vs Dollar Tree and 7.1x vs Dollar General, an average difference of 6x.

If management can continue to execute on its strategic initiatives, both bottom and top line growth should reaccelerate, driving the EV/EBITDA peer discount back to historical norms. If the gap reverts even to the wider end of the spectrum - 4x - shares would be worth $59, 40% more than today.

Strategic turnaround underway that has shown great growth potential

With its Store of the Future strategy, Big Lots is transforming itself into a leaner, more profitable discount retailer, offering a differentiated shopping experience to its customers. It has already reformatted more than 5 markets in the US, with great results. Management says the renovated stores have seen “incremental lifts in business”, and in some markets the “Store of the Future comp is probably in the neighborhood of 20% to 25%”. For this initiative to pay off, Big Lots has said it needs comps at these new stores to increase in the mid- to high single digits. So far, they’ve met that mark and then some, with the remodeled stores “performing a little bit better” than that high hurdle, especially in the furniture, soft home and seasonal segments. These categories already accounted for the biggest source of revenue; in the reformatted stores, they have been moved to the front of the store. With these positive early results in hand, Big Lots is accelerating the number of remodeled stores, with another 20 planned this year, bringing the total for 2018 to 200 instead of 180 originally planned. It expects to open another 180-200 Stores of the future each in 2019 and 2020.

At the same time as it rolls out the “Store of the Future” Big Lots continues to apply its successful “Edit to Amplify” strategy. This consists of reducing the number of products in less successful categories while adding them to successful ones. Furniture, seasonal and soft home goods are all top performers, so Big Lots is increasing the number of SKUs in those categories and moving them to the front of the store in its reformatted stores. However, it still wants to grab as much of Jennifer’s wallet as possible, so it will continue to offer a variety of products and keep selling toys, electronics, groceries and other consumables.

Discount retailers are insulated from Amazon relative to other B&M retailers

The rise of online shopping has devastated much of retail, leaving a trail of bankruptcies and store closures in its wake. But dollar stores have proven somewhat immune, continuing to grow rapidly and attracting imitators. Walmart is converting more of its discount mass merchandise stores to supercenters, while at the same time both Target and Walmart are opening smaller format stores and promising to make “price investments” as part of their “everyday low” price strategies. But unlike Walmart or Target, dollar stores and Big Lots offer a value proposition that in its very nature is the anti-Amazon. Customers know that they will find the lowest price and therefore don’t look for it online (as they may for traditional retailers).

Big Lots is not taking its insulation from Amazon for granted. It was the first of the discount retailers to launch an online business in 2016. Its digital business is still tiny, but growing rapidly and on its way to profitability. In Q4 FY 17, the last time management offered hard numbers, e-commerce brought in net sales of $32m-$35m, with a net operating loss of $9m-$10m. By Q1 FY18 the business had its “best quarter to-date with the highest level of sales and our smallest operating loss”

Shareholder friendly management team with strong track record of execution

Big Lots’ management team has consistently rewarded shareholders through a variety of initiatives. It pays a higher dividend yields than its peers, (3-year average of 1.8% vs 1.2% for Dollar General; Dollar Tree doesn’t pay dividends) and on June 1^st, 2018 it announced a 20% increase in its dividend to $0.30 per share, up from $0.25. It has also recently announced an accelerated share repurchase program of $100m. This mirrors past efforts: The company returned $195m and $288m to its investors through buybacks and dividends in 2017 and 2016, respectively. In 2015, it completed a $239m share repurchase program.

Big Lots’ healthy balance sheet allows it to be generous. With net debt of only $110m, Big Lots has a net debt/market cap ratio of just over 6%, far below than that of Dollar Tree (~22%) and Dollar General (~10%). Most of this redistribution to shareholders is done through cash on hand or already-approved borrowings. It leases most of its stores, and its limited capex ($158m in FY17, $90m in FY16 and $126m in FY15) is linked only to its Stores of the Future project, helping keep debt levels low. It could take more debt to further increase buybacks or boost the dividend if needed.

Supporting DCF valuation with conservative assumptions also shows great potential upside

To further analyze Big Lots value, we conducted a DCF valuation that considers the number of stores remodeled per year (conservatively assuming the company opens only180 stores per year for 2018-2020, not the 200 planned), and assigns growth attributes to those new stores on the low end of what has been realized so far: comps of 8% for the first two years, 5% for the following two years and 2% afterwards. For the remaining non-renovated stores, we assume zero growth, well below historical performance. With a weighted average cost of capital of 8.6% (above the 7.1% calculated with current data) the DCF valuation results in a share price of $51.15 25% above current levels.

Risk Factors

·         Seasonality can impact all retailers; management blamed the most recent sales miss on weather, among other issues.

·         In March 2018, Amazon launched a “$10 & Under” category, which could potentially hit sales, though the dollar stores seem to be a more direct target.

·         The novelty factor of the Stores of the Future may wear off.

·         More management uncertainty, with a new CEO to be appointed in the coming months.

·         Competition, mark-downs and ecommerce alternatives could put pressure on margins and top line growth.

·         Trade war with China, which could push up the cost of goods sold.

Catalyst

Continued execution

M&A