Big Lots: Cheap For Customers, Expensive for Investors

Big Lots (BIG) released some fairly decent numbers in the most recent quarter that would appear, on the surface, to be very appealing. The largest improvement area was the company’s operating and net margins. The minor increase in margins accounted for a very nice increase in earnings per share. This was also the case for the fiscal year of 2006.

Operating improvement, not sales growth

What has caused such a drastic improvement in operating margins and net margins?

In 2000, BIG shed KB Toys in bankruptcy. This was creating a drag on working capital and earnings. As recently as 2005, the company began looking within for improvement. They eliminated underperforming stores, shut down their furniture outlets, exited the frozen food business, and began taking measures to increase margins by evaluating their existing stores from top to bottom. This proactive decision has benefited the bottom line greatly. I like that management is focused on this. They have trimmed the fat by ridding themselves of poor prior decisions. They are now focused on their BIG Lot stores and their "treasure hunter" customers, as they were called in the recent annual report. What I don’t like is how investors have misinterpreted the growth in earnings per share via increased operating improvements, with real growth via increased sales. Same store sales growth is around 4-5% and not 30% as some investors would seem to believe.

Coming up with a value for BIG

Owner earnings for 2007 are expected to be around $190M. With an enterprise value [EV] of around $3.5B, BIG is trading at approximately 19X owner earnings. I personally don’t find it prudent to pay 19X 2007 OE when sales growth is in the range of 4-5%. Especially now that the operating improvements have been for the most part completed, and from here forward we'll be focusing on margins and sales growth. I would be much more comfortable with 10X OE, which would be an enterprise value of $1.9B (10x $190M = $1.9B). To obtain a market cap figure, I have to add in cash on hand which is around $200M. I end up with a comfortable market cap of $2.1B. To come up with a current share price, I take the $2.1B and divide by the number of outstanding shares. This would be 2.1B/110M, which equals approximately $19/share.

If I want to add a margin of safety, I can trim 30% off of the $2.1B market cap figure, which yields $1.5B. With my $1.5B margin of safety figure, I end up with approximately $14/share.

For a retailer that identifies their customers as "treasure hunters", BIG is much too rich for me and is certainly no treasure find.

BIG 1-yr chart

Disclosure: none