On Dick’s Sporting Goods Inc. (NYSE: DKS) and raising our price target to $70 from $63.
The company has been very proactive in responding to the COVID pandemic. In April, it issued more than $500 million of convertible bonds. The company also announced plans to cut spending, negotiate with suppliers and landlords, and suspend its dividend and share repurchase plan.
It also brought employees back from furlough, restored salaries, and repaid associates for lost wages.
Our precrisis store visits showed that the management team has been adapting well to competition and changing product preferences. On the 2Q conference call, CEO Edward Stack expressed his belief that the importance of health and fitness has accelerated. There has been a shift towards athletic apparel as people spend more time working and exercising at home.
We believe that Dick’s has the potential to gain additional market share thanks to its focus on exclusive and innovative merchandise that improves athletic performance; its unique store environment comprised of specialty ‘shops’ within the store; and its comprehensive customer service. Post-recovery margin enhancement is likely to be aided by increased sales of exclusive merchandise, a shift in the merchandise mix to higher-margin apparel and footwear, a shift away from lower-margin guns, the expanded use of technology in inventory management, and efforts to tailor stores to regional markets and improve vendor relationships.
We believe that management has been very effective in allocating space to the most productive categories. The company has launched a line of women’s athletic apparel, called CALIA, with the popular singer and actress Carrie Underwood. It is already the second-largest women’s brand that Dick’s sells, behind only Nike, and the third-largest component of the company’s private brand portfolio, which has potential for future growth.
On September 16, the Commerce Department reported Advance Retail sales for August 2020. Sales in the sporting goods, hobby, musical instrument, & book store category were up. This is a strong performance. Overall retail trade sales were up 5.1% year-over-year, boosted by the sporting goods category, a 15% increase in building materials, a 22.4% increase at nonstore (mostly internet) retailers, and a 9% increase at grocery stores. Department store sales were down 16.9%.
While there could be headwinds from a muted back-to-school season, a reduction in some organized sports, and the possibility of less attention on professional and college sports, demand for athleisure products and home fitness equipment should remain strong. We are seeing a growing interest in camping amid concerns about virus transmission at hotels and resorts. It is also possible that the legions that have been out walking will turn to DKS for boots, gloves, fleece, and other cold-weather gear.
There has been other favorable news in the sector. After the close on September 22, Nike reported fiscal 1Q21 revenue and EPS that topped estimates by wide margins. In FY21, management expects revenue to increase at a high single-digit to low double-digit pace as sporting events resume and e-commerce sales remain robust. While the strength in online sales could be a risk for DKS, we think the strong demand for athletic gear is a good sign. Nike is the biggest vendor, representing 21% of Dick’s merchandise purchases.
On October 2, Academy Sports, a DKS competitor we have discussed in previous notes, began trading as a public company. One of the interesting data points in Academy’s prospectus was that a market research firm expects sporting goods categories, including outdoor, team sports, apparel, and footwear to grow about 6% per year from 2019 through 2027. The growth rate is consistent with our long-term growth rate for DKS.
EARNINGS & GROWTH ANALYSIS
This compares with a GAAP profit of $3.34 in FY20. The FY21 consensus is $4.00. We were conservative coming out of 2Q. We are making a small increase in our full-year sales forecast. Our estimate is now $8.95 billion. We also made a small increase in our gross margin estimate, reflecting more comfort with our sales forecast and management’s comment, on the 2Q call, that it was seeing continued margin expansion. We project operating income of $485 million.
We expect sales to surpass prepandemic FY20 levels on strong demand for fitness gear. We are modeling $795 million in full-year EBITDA, including $275 million of depreciation and amortization, up from a prior estimate of $750 million.
We recently reduced our EPS growth rate for the next five years to 6% from 10%. We are thinking of this as the rate that the company might grow after the COVID crisis ends. We remain optimistic about the company’s opportunity to grow the private-label business and reposition stores with categories that are faster growing and more profitable than firearms.
FINANCIAL STRENGTH & DIVIDEND
The company’s debt is subject to covenants that could limit its financial flexibility. Our bias is for raising our assessment back to Medium.
The company has been very proactive in responding to the COVID pandemic. In March, DKS increased its borrowing capacity under its revolving credit facility. In April, the company issued $575 million of convertible bonds. The company also announced plans to cut spending, negotiate with suppliers and landlords, and suspend its dividend and share repurchase plan.
By the time of the 2Q earnings release, the company had repaid the balance on the revolver and reinstated the dividend. That is near the bottom of the 10-step investment grade category.
The retail industry is highly competitive, in normal times, with an expanding array of vendors expanding their offering of ‘athleisure’ products. Margins are low and getting lower. Dick’s is a destination for sporting goods, and is striving to raise its operating margin, but competitive pressure is intense.
Many of the company’s products, or at least products in the same categories, are also available at Wal-Mart, Target, Amazon, other sporting goods stores, athletic shoe stores, and even department stores. Dick’s can combat online competition by providing a compelling store environment, using its private brands and vendor relationships to deliver exclusive merchandise, and expanding its own e-commerce business with options for in-store pick-up and returns. We believe that more and more vendors will consider selling directly on Amazon, because it is an increasingly important marketplace. We are pleased to see Dick’s expand its offering of high-quality basics with the new DSG brand. This is something that competitor Academy Sports, which became a public company and started trading on October 2, does very well with its Magellan Brand. Academy had sales of $4.9 billion last year, compared to $8.8 billion at DKS.
At the end of 2Q, Dick’s had $1.06 billion of cash and cash equivalents. DKS had $405 million of convertible notes, $2.4 billion of long-term leasing obligations, and $475 million of current operating lease liabilities at the end of 2Q. The company ended 2Q with no borrowing under the $1.855 billion revolver. At the end of 2Q, it had $1.45 billion of borrowing capacity on the revolver after subtracting letters of credit.
FY20 dividends were $1.10. The company initially suspended the dividend as a result store closings and the negative COVID-19 effects.Before the suspension, then reinstated the payout with a payment on June 30 and a declared payment for September 25. After the 2Q earnings release, we raised our FY21 dividend estimate to $1.25 from $0.3125. We also raised our FY22 estimate from zero to $1.30.
The company suspended its share repurchase plan and did not repurchase shares in 2Q. Management said in the 2Q earnings release that it might resume opportunistic share repurchases under its existing $1 billion authorization. We would like to see the company reduce debt significantly before resuming buybacks. The 10-Q for the second quarter says that the company believes that it has sufficient cash flows from operations to operate the business for the next 12 months, supplemented by funds from the credit facility if necessary. DKS said that it may require additional funding if it makes acquisitions, repurchases shares, or opens stores at historical levels.
It also planned to consider opportunistic acquisitions.
MANAGEMENT & RISKS
COVID-19 created a scare for Dick’s. The company had to borrow in the convertible bond market, which suggests that it may have had difficulty getting reasonable terms on straight debt. The company had to increase borrowing under its revolving facility and furlough employees. While sales did rebound in 2Q, consumer spending could be crimped by elevated unemployment, the absence of government stimulus, the need to pay off consumer debt incurred during the crisis, and lower confidence in spending rather than saving. We may see a shift in spending patterns to Amazon and Walmart. It is also possible that DKS will see a continuing benefit from a growing affinity for ‘athleisure’ apparel, from concerns about crowded fitness classes and sweaty gym machines, and from the distress of weaker retailers.
Edward W. Stack has been chairman and CEO since the retirement of his father, founder Richard ‘Dick’ Stack, in 1984. Before becoming CEO, he served as the company’s president, and as a store manager and merchandise manager.
Lee Belitsky became the company’s CFO in September of 2016.
Lauren Hobart appears to be on the rise. She has been promoted to president of Dick’s. She will continue to run the e-commerce business. One of her notable successes has been launching the CALIA brand.
Retailing is a very economically sensitive business and demand for sporting goods can decline in a weak economy. Dick’s has grown its top line, augmented by store openings, but comparable sales were negative in FY09, FY10, FY16, FY18 and FY19. Comps were up 3.5% in FY17. Comps were up a very solid 3.7% in FY20. In addition to being cyclical, the business is also seasonal, with approximately 30% of sales and 40% of EPS coming in the fourth quarter. A particular risk is that warm weather may dampen sales of cold-weather merchandise during this important period. Another risk is that cold or rainy weather may dampen sales in the spring. Dicks has also been hurt by the declining popularity of golf, by the declining popularity of Lance Armstrong, whose Live Strong brand was on a lot of big-ticket exercise equipment, and by swings in the market for guns and ammunition.
We think the company showed leadership in discontinuing sales of military-style rifles and high-capacity magazines, which allow a shooter to fire more rounds without having to reload. DKS has also stopped sales of guns to anyone under 21, and removed hunting merchandise from approximately 135 stores through FY20. The company plans to eliminate hunting departments from an additional 440 stores in the current FY21. CEO Stack recently said that the company had destroyed more than $5 million of military-style guns. The company’s actions also have critics.
Mr. Stack recently responded to criticism that the chain’s actions would not solve the problem of gun violence. His response was that the company’s actions were worth it if they saved even one life. Mr. Stack has also said that Americans are looking for ‘common sense gun reform’ and are not getting solutions from officials in Washington.
The company’s actions minimize the potential for a public relations disaster that could be far more damaging than lost gun sales. DKS sold a weapon to the Parkland shooter, but it was not the gun or even the type of gun that was used in the 17 murders and 17 attempted murders. If Dick’s did not act to restrict the sale of military-style weapons and accessories, it could be very vulnerable to backlash if a gun it sold was used in a mass shooting.
DKS has also seen sales pressure because Under Armour is distributing merchandise to a wider range of retailers, including Kohl’s, to drive sales. They could also see pressure from weaker sales at Armour.
Regionally, Dick’s stores are more concentrated in the eastern U.S. and could be disproportionally affected by weather and economic conditions. The company currently has five distribution centers and a problem at any of these locations could disrupt operations.
The company faces intense competition from a wide range of players, including Wal-Mart and Target, which have more stores, wider brand recognition, and deeper pockets. Specialty stores that sell shoes and clothing; hunting, fishing and camping shops, golf-and-tennis pro shops, bike stores, running shops; and catalog and internet-based retailers. Cabela’s and REI are two very good competitors in the outdoor, and hiking categories. Academy is more regionally focused in the south, but it is a tough competitor. It may become a tougher competitor now that it is a public company. The stores appear to have more merchandise at opening price points than Dick’s. We have heard some favorable comments about Academy’s private-label merchandise as a good alternative for hikers and campers who are cost conscious. Pressure from competitors is leading Dick’s to reduce its prices or increase spending on advertising and promotions. The company could also lose market share as competitors adopt more innovative store formats, more aggressive pricing strategies, and more effective e-commerce platforms.
Online sellers are probably the most worrisome source of competition because Amazon, in particular, has a well-developed infrastructure and has historically been more concerned with driving sales than gross margins. We don’t expect the pressure from Amazon to ease.
We are currently seeing that some of the manufacturers of sporting goods are facing competitive pressure.
The company’s sales could suffer if successful brands elect to sell through their own channels rather than through Dick’s. Lululemon has, to its credit, maintained control of its distribution. DKS could also be hurt if it can’t get significant allocations of hot basketball shoes or if other retailers do a better job of getting exclusive merchandise.
Under Armour has been below 10% for a couple of years now. A disruption from a major supplier or distributor could hurt sales. The importance of the Nike relationship is a risk which will require additional attention.
Merchandise costs could be affected by commodity prices, labor costs and transportation expense. Margins could be hurt if the company isn’t able to pass these costs on to customers and sales could be hurt if shoppers trade down to lower-priced merchandise or purchase fewer items. The company sells products under private brands. While these products offer higher gross margins than national brands, the company could be subject to product liability claims if there are problems with its products.
The company has two classes of stock. The common shares have one vote and the class B shares have 10 votes per share. Mr. Stack and his relatives control the majority of the combined votes of the two share classes and could control the outcome of any item submitted for shareholder approval.
Dick’s Sporting Goods Inc. Total FY20 sales were $8.75 billion, with about 35% from apparel, 21% from footwear, and 42% from hard lines such as sporting goods, fitness, and golf equipment.
The extra week boosted sales by about $105 million and EPS by $0.09.
DKS shares have risen about 25% this year. We now expect DKS to earn $3.90 per share in the current FY21, up from $3.20 previously.
We will keep our valuation analysis simple. If the company earns $4.50 per share in FY22 and reaches $4.75. A terminal multiple of 18 equates to an additional three years of 6% growth with a 40% dividend payout and a 8% cost of equity, followed by steady-state growth at 3% with an 80% payout and a 7.75% cost of equity.