Why Dick's Sporting Goods Could Be Headed For A Sharp Decline

| About: Dick's Sporting (DKS)

In March, Dick's Sporting Goods (NYSE:DKS) CFO Timothy Kullman said the following about the effect of markdowns on the company's margins:

We believe the margin impact from clearance activity will be contained within the first quarter.

"Clearance activity" refers to the company's effort to work-off excess inventory. As of January 28, 2012 inventories at Dick's were $1.014 billion compared with about $897 million on the same day a year earlier, an increase of around 12%. This compares with an increase of .2% in fiscal 2010, an increase of 4.6% in fiscal 2009, and a decrease of 3.7% in 2008.

Without reading too much into Mr. Kullman's comments, it doesn't seem to be a stretch to say that his mention of "containing" clearance activity portended a notable decrease in margins as the company sold off excess inventory. Here is what the company's 10Q said about the effect of clearance activity on margins during the first quarter (emphasis mine):

Merchandise margin slightly decreased by 8 basis points due to the clearance of select cold weather related product and to a lesser degree, the clearance of fitness equipment

A "slight" decrease in margins doesn't seem at all like what Kullman would have meant by "containing" clearance activity. Eight basis points is just .08%, so one of two things must be true: either the clearance prices weren't that much less than the original prices or the company didn't sell many clearance items. Given inventory levels at the end of the first quarter, the latter seems far more likely.

Far from "cutting back on inventory" as the title of the above cited Reuters report suggested, inventories at Dick's increased by around 16% sequentially in the first quarter (from $1.014 billion to $1.201 billion). The company again cited warm weather as the culprit:

Inventories increased $28.8 million...which reflects the impact of higher levels of outerwear and cold weather merchandise due to the unseasonably warm winter season

While still feasible, keep in mind that the quarter in question ended on April 28. If excess winter inventory has not been sold off by then, it probably is not going to be sold.

There is an argument to be made that inventory generally always rises sequentially at Dick's in the first quarter. While true, the 16% increase in inventories in Q1 2012 was greater than the sequential increases in inventories in the previous years' first quarters (inventories rose 15% sequentially in Q1 2011 and 12% sequentially in Q1 Q1 2010), meaning that inventories rose faster than the historical rate during a first quarter where the company badly needed inventories to decline. The company noted that inventory should be back to normal by the fourth quarter of 2012. While I'm sure this wasn't meant to be a bad thing, what it means is that the company expects it will take until the winter season of this year to get rid of excess winter inventory from last year.

Given the lack of urgency here, it could be that there is another reason for the accumulation of inventory that the company is not going out of its way to emphasize. Consider the following quote from the company's 10K (emphasis mine):

inventory per square foot increased 6.2% resulting from higher levels of outerwear and cold weather merchandise due to an unseasonably warm winter season as well as the earlier receipt of spring merchandise and investments in e-commerce inventory levels

This makes more sense. As I noted in a previous article, Dick's e-commerce sales have become an increasingly important part of same store sales growth:

...during the fiscal year 2011, the 36.4% increase in e-commerce business contributed 100 basis points to the company's same store sales increase of 2%, meaning that, by my reading, gains in e-commerce went from accounting for 10% of same store sales growth in 2010 to 50% of same store sales growth in 2011. Translation: not as many people are going to the stores.

When online sales account for half of same-store sales growth, it certainly makes sense to stock up on e-commerce inventory. Of course this only works if the e-commerce business continues to thrive and the numbers are already slipping:

...the company's e-commerce business grew at 33.4% in the first quarter, compared to 36.4% in fiscal 2011 and 38% in 2010.

These sales could falter further should Amazon gain a foothold in the market. For its part, the company notes that as of now, Amazon doesn't have direct access to premium products. Nonetheless, Motley Fool contends that while

it's true that Nike and Under Armour don't sell to Amazon or its subsidiary footwear e-tailer Zappos.com, if Amazon uses its mighty force to pave the way for consumer demand within its channels -- particularly to another of its subsidiaries, Quidsi.com, which can create a more niche site to appease the premium brands -- would those companies resist? It's doubtful.

Another argument in favor of Dick's is that people don't mind purchasing books and DVDs online, but there is something about things like golf clubs and shoes that make the tangible, in-store experience especially valuable and thus, it will be difficult for Amazon to gain a substantial foothold in areas outside media. Apparently, somebody forgot to tell Amazon that, as sales of non-media items rose 72% year over year according to its most recent 10Q.

As a side note, Dick's made a $32 million dollar investment in U.K.-based JJB Sports during the first quarter. The investment consists of

...junior secured convertible notes in the principal amount of £18.75 million and 12.5 million ordinary shares of JJB for £1.25 million, for a total investment of $32.0 million.

Note that the company values this investment as follows (emphasis mine):

The Company's fair value of its investment in the Convertible Notes was determined using a binomial lattice model with level 2 inputs, including JJB's stock price, the expected stock price volatility, the interest rate on the convertible notes, the risk-free interest rate based upon appropriate government yield curves and option-adjusted spreads for comparable securities. As of April 28, 2012, the carrying value of the Convertible Notes was approximately $35.8 million, with an unrealized gain of $3.3 million recorded in accumulated other comprehensive income. Subsequent changes in the fair value of these investments will be recognized as unrealized gains or losses within other comprehensive income.

It is unclear why Dick's would count JJB's stock price as a Level 2 input. Typically, an exchange-traded equity would be a Level 1 asset; that is, its price is determinable by reference to an identical asset with a quoted price in a liquid market. This brings me to my next point: JJB's stock is down more than 50% since Dick's made the investment in April and its CEO resigned on Friday after failing to turn the company around. It will be interesting to see how Dick's values its investment in the company going forward.

In sum, investors should watch Dick's earnings report on August 13 to evaluate how effective it has been at reducing inventory, how it values its investment in JJB, and what the company says about its e-commerce business. Shorting the company or being long put options ahead of earnings is a risky bet, but I believe there is more downside to the stock than up. As such, I recommend shorting Dick's or getting long put options on the company's shares.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in DKS over the next 72 hours.