Stock in focus - Sports Direct International (OTC:SDIPF)
Sports Direct is the U.K.'s largest sporting goods retailer, and operates in sports equipment, fitness, and fashion. Established in 1982 by Mike Ashley, Sports Direct has grown rapidly, both organically and through acquisition of other stores. The last decade has seen several other sports shop operators to close, yet Sports Direct has continued to flourish allowing it to becoming to most profitable and well known store in the industry. As well as building its empire of stores, Sports Direct has also acquired well known brands in a number of different sports, including Slazenger, Dunlop, Lonsdale and Karrimor, many of which are leading brands in their respective sport.
As Benjamin Graham said famously, "'In the short run, the market is a voting machine but in the long run, it is a weighing machine." In other words, in the long term, the value of a company will be fairly represented by its ability to earn future cash flows, but in the short run its price can fluctuate alarming based on current investor sentiment and popularity.
Sports Direct is currently going through a severely unpopular period. In the last year, its market price has dropped from a high of £7.41 to a current price of £3.03 per share (a near 60% drop). It doesn't take a long look read in the news to understand why this has occurred - Sports Direct has been in the public eye for a seemingly constant period over the last 12 months. These have been for a variety of reasons; I will attempt to name a few:
- A revelation that they pays thousands of temporary workers below the national minimum wage.
- A profit warning from poor sales during the Christmas period last year.
- An improper/informal statement from Mike Ashley (Chairman/Founder) during an interview that the company was "not trading very well".
- A government led investigation into the company causing an MP to suggest that their working were "similar to those of a Victorian workhouse".
- Revelations of cocaine use in warehouses.
- Pressure from individual and institutional investors for Chairman to resign.
- Statements that the company was not well hedged against the drop in Sterling following Britain's decision to leave the EU.
- Resignation of CEO (followed by Ashley stepping in to fill the position).
- A crystallized one-off loss of £15m due to a flash drop in the value of the Sterling.
Overall, this makes for quite unpleasant reading. Particularly in a period where a main competitor, JD Sports (OTC:JDSPY), has grown its share price by over 60%. However, this follows a long period of steady growth for Sports Direct, both in terms earnings, and also in share price. When a company has performed such a U turn after a long and steady history of success, it can often provide a good opportunity to investigate the company to understand why its decline has occurred and whether the reasons are warranted.
I would argue that in this case, the events of the last 12 months has not caused much to change for Sports Direct. The stores remain a very popular choice for customers, they are still the 'go to' place to buy sporting goods, and its future is as promising as ever. My view is that the current share price of £3.03 is not reflective of the company's intrinsic value, and that the market has become unduly pessimistic.
Its current share price of £3.03 represents a multiple of approximately 6.7 times earnings. This demonstrates a lack of investor confidence in the company; the markets does not have faith that it will be able to sustain its current earnings in the future. To draw your attention to two metrics from this year's financial reports, the Sports Direct group posted revenues that were broadly in line with the prior year (a marginal increase of 2.5%) and its underlying profit before tax decreased by 8.4% on the prior year. Whilst this drop in underlying profit is not insignificant, it strikes me as unlikely that this difference in one year's results could have any bearing on its future growth and consequently, this fact in isolation should not be a reason for such pessimism on the company's future and on its valuation. When viewed in conjunction with its earnings history, this pessimism seems to become more unjustified. Over the previous 9 years, the company has grown revenues from £1.3bn to £2.8bn (9% annual growth) and earnings per share from £0.08 to £0.39 (22% annual growth). Even if this impressive growth rate were to drop significantly, as is common for companies as they become much larger in size, its current valuation is very low.
Of course historical growth does not guarantee and it is important to consider whether there have been significant changes in the industry which may have caused this profit reversal. The last decade has seen numerous changes to the U.K. high street and even some of the biggest companies, such as Tesco, have seen their fortunes reverse. In this case, however, a number of simple observations can show the cause of its demise over the 5-10 years; from customer preferences changing to conveniences over choice (leading to the rise of Lidl and Aldi), to unsuccessful and unprofitable ventures abroad, to ever decreasing returns on capital employed. I would argue that Tesco was competing in a much more difficult environment than Sports Direct.
Due to its preceding growth, I am inclined to believe that the earnings figures alone are not the reason for the substantial drop in share price. More likely, the drop is either reflective of the perceived importance of the content covered by the constant media coverage, or perhaps due to the Outlook statement that was provided in the recent annual report. Let's first look at the media issues.
Much of the press coverage has been very damning of Sports Directs employment practices, such as those mentioned previously. Whilst a company's reputation is of utmost importance, I find it hard to believe that such coverage will prevent previously enthusiastic customers from visiting their stores when in search of sporting goods. I am also of the opinion that the practices employed by the company are unlikely to be as severe as being portrayed by the media to the public. Along with the stories of BHS's closure and subsequent pension scandal, 2016 has been a busy year for shaming company malpractice. Whilst I do not condone such practices being deployed, I state this merely to illustrate that an unusual amount of emphasis and possibly scapegoating may have been placed on Sports Direct. Indeed, I believe that the coverage is important eye opener for the public, and in the long term may be beneficial for the company as it has forced them to address their employee relations. Already they have scrapped zero hour contracts and they are seeking ways to further improve their practices. As an aside, the Sports Direct board recently issued a statement which says that their workers "expressed their dissatisfaction with how the Company was portrayed by the Committee and the media", in reference to the Business, Innovation and Skills (BIS) Committee that recently made visit the Sports Direct's warehouse. This strengthens my affirmation that the media and government committee have been overplaying the severity of certain issues.
Now onto the issue of its recent Outlook statement. The company statement made a fairly unsure (and perhaps slightly downcast) predication to its near term forecast, making reference to "potential weakness with the U.K.'s short to medium term economic outlook…likely to act as a continuing drag on consumer confidence. When combined with the structural difficulties for U.K. retailers, including high street footfall, and our exposure to the weakness of the pound against the U.S. Dollar (as announced on 24 June 2016), these factors make the current outlook for FY17 somewhat uncertain and therefore hard to predict." This type of outlook statement, whilst not positive, is not unusual for high street retailers. Unfortunately for the analyst and investor, it can be difficult if not impossible to make a precise calculation on how each of these issues will impact future cash flows. Particularly, it is difficult to understand how exposed the company will be to the weakness of the Pound, whether other companies are less exposed and may be able to gain a competitive advantage, and whether they will be able to mitigate this cost by passing the price increase to the consumer.
Despite the difficulties in calculating these costs precisely, it is prudent to make any forecasts of future earnings more conservative. However, I take comfort in the knowledge that this is not the first time Sports Direct has overcome times of economic uncertainty and instability. The company has a strong management team, led by the man who turned it from a one shop business into the United Kingdom's largest sports-goods retailer with roughly 670 stores worldwide. Like it has done numerous times since its inception in 1982, Sports Direct will continue to make the changes required to maintain its position as the number one U.K. sporting goods retailer, and to provide an excellent customer experience. The company has developed what Warren Buffett would describe as an 'economic moat', or sustainable competitive advantage over its competitors which will be difficult to replicate or overcome. They have developed a perceptions in the eyes of the customer that they are the lowest cost and have the broadest range of branded sporting goods, compared to any U.K. high street shop It would now be very difficult for a competitor to beat them at this game. This advantage has not changed over the last 12 months and will stand them in great stead in the future.
A further signal of strength and confidence is that Sports Direct has itself been snapping up shares on several occasions over the last few months, purchasing its own shares in the £2.80 - £3.15 price range. The company has now holds a total of 47,475,931 treasury shares out of the 593,126,438 ordinary shares outstanding, which includes 3,193,264 shares (worth just under £10m) that it has acquired since September 19th of this year. As well as returning surplus cash to holders, this demonstrates confidence from the management in the long term future of the company, believing that the purchase, at the current price, will provide a superior return on capital than other ventures. Certainly, it seems that CEO and Chairman Mike Ashley maintains confidence in the company he started, with a large portion of his wealth still invested in the company. Ashley is the majority shareholder with 330,000,000 shares held (55% of total), and has given no indication of plans to loosen his grip on the company.
To conclude, even though management will surely consider 2016 a year to forget, it may well prove to be a great year for investors who can use this opportunity to purchase the company's shares at its lowest price for four years. I believe that the struggles faced by the company over the last 12 months are not indicative on the future of Sports Direct, but rather a minor speedbump following a history of great success. Whilst 2017 may prove to be another difficult year for the retailer following the currency impact and uncertainty created from the Brexit decision, I think the strength in the company and its brands will allow Sports Direct to overcome these short term obstacles and continue to flourish for years to come.
Disclosure: I am/we are long SDIPF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Note: the ticker for Sports Direct on London Stock Exchange is SPD not SDIPF
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.