Can Dick's Sporting Goods Run After A Rough Start To 2014?

| About: Dick's Sporting (DKS)
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Summary

Shares of Dick's Sporting Goods are down nearly 9% YTD.

Soft comps and margins defined FY13.

Nike and Under Armour are extracting value from retailers.

DKS is a little overpriced, but not worth shorting.

2013 was a great year for Dick's Sporting Goods' (NYSE:DKS) share price. The company paid out its quarterly dividend which amounted to a total payout of $0.50 per share, and it also saw its share price jump nearly 30%. At the same time, 2013 was a very ho-hum year fundamentally for the big box sporting goods giant. Can the firm put it together in 2014, or is the company destined for mediocre performance?

2013 Financials: Lackluster

2013 was certainly not the best year for Dick's Sporting Goods from a financial performance standpoint. While adding 40 new Dick's Sporting Goods stores and 1 new Golf Galaxy, total sales grew only 6.5% (up 7.8% on a like for like comparison). This mediocre growth resulted from an anemic 1.9% increase in same-store sales. Perhaps worse, gross margins fell year-over-year and SG&A increased as a percentage of sales, thus the firm's overall operating margin fell 40 basis points to 8.6% of sales. Inventory turns also slowed for the 3rd consecutive year, meaning it takes the company longer to sell product than it has in the past. Not surprisingly, inventory stood 12.4% higher than it did at the end of FY12.

On the positive side, the firm had some momentum in Q4. Comps were up 6.3% driven by the strong holiday and extremely cold winter weather. Cold and snowy weather during Q1 likely helped boost sales and help the company clear older inventory.

Another bright spot for shareholders was the slight downtick in the share count, as well as continued strong cash flow generation. As a result, Dick's Sporting Goods' balance sheet remains unlevered and clean.

A Shifting Tide in the Competitive Landscape?

Naturally, investors have attributed pretty much all retail weakness to bricks and mortars losing out to online competitors. Companies like Macy's (NYSE:M) and Nordstrom (NYSE:JWN) have done an exemplary job of creating omnichannel presences, while many mall-based retailers are under significant pressure from online competition. As for Dick's Sporting Goods, one of its most positive competitive advantages is that it does not necessarily lend itself to online selling in the same sense that clothing retailers do.

49% of Dick's Sporting Goods sales come from hardlines: sporting goods equipment, golf equipment, fitness equipment, and hunting and fishing gear. Due to prohibitively high shipping costs, it makes much more sense for consumers to purchase most of these goods in-person. Plus, several large equipment purchases are expensive and infrequent, making the consumer more interested in relying on sales associates and in-person visits for some degree of information gathering. It would be naïve to think consumers will eschew online research; however, I think there is a good chance purchases will remain predominantly in-person.

Nevertheless, Dick's Sporting Goods hardline sales have been soft for the past few years, and management has been working to reduce square footage exposure to fitness equipment and golf. The square footage will shift towards higher growth categories like youth and women's apparel. Though Dick's Sporting Goods has some competition in the hardlines category, I do not think The Sports Authority or smaller competitors are stealing market share. The weakness is likely secular, and it could persist going forward as gym membership increases across the United States.

Ultimately, the hardline business should maintain some resiliency. Dick's Sporting Goods' other large categories, apparel and footwear, indeed face some competitive pressures. Athletic footwear has been a hot item for the past few years, and companies like Foot Locker (NYSE:FL) and Finish Line (NASDAQ:FINL) are improving their stores and selling great products from Nike (NYSE:NKE), adidas, and Under Armour (NYSE:UA). While these competitors do not sell cleats - an important business for Dick's and The Sports Authority - young end-users may be interested in the larger variety of SKUs available for basketball, casual, and running at Foot Locker and Finish Line.

Luckily for Dick's Sporting Goods, its core consumer differs from the core Foot Locker consumer. However, I would like to see the firm acquire a larger variety of SKUs in basketball in areas where it makes sense. Because of the strong Dick's Sporting Goods online business, I think the company will be able to mitigate the negative risks associated with expanding SKUs. Adding a wider selection of footwear would help drive incremental foot traffic and likely additional sales.

As for apparel, Dick's Sporting Goods does not hold many competitive advantages. Fortunately, the firm remains one of the best retail partners for the fast-growing Under Armour. As long as Under Armour continues to see revenue growth in excess of 20%, Dick's will be a beneficiary. At the same time, Under Armour is increasing its distribution network. UA apparel can now be found in places like Macy's and Nordstrom - two retailers that are sure to have some overlap with the Dick's customer base. Margin dollars could tilt in favor of Under Armour on future orders. Nike and North Face (NYSE:VFC) remain the other important retail partners of Dick's Sporting Goods. Nike continues to expand its store within a store presence at Dick's while simultaneously increasing its own retail penetration. Dick's shareholders should be worried about the shifting value towards a concentration of brands. Both UA and Nike are probably going to keep grabbing gross margin dollars as long as both exhibit high degrees of brand loyalty and repeat purchases.

The Outlook Going Forward

At this point in time, I think Nike and Under Armour, which account for a large portion of Dick's apparel sales, are looking like more valuable portions of the sales chain. Though the top line should continue to expand in FY14, I think Dick's will almost undoubtedly see some gross margin compression in the coming years.

Nevertheless, the company forecasts FY14 EPS of $3.09 - an increase of 15%. Same-store sales are expected to grow 3-4%. Both of these figures are solid, in my view, though I think shares will see some weakness in response to capex numbers. Dick's plans to open 50 new stores, relocate 6, and remodel 5. The firm predicts capex spending of $360m, though I think it could push north of $400m. 50 new stores is a lot to manage, and 11 other projects on top of the 50 could spell trouble, in my opinion. The company tends to seldom launch more than 40 stores in a single year.

The other issue I see going forward is saturation. Though lease terms will be friendly for Dick's as big box retailers like JC Penney (NYSE:JCP) and Sears (NASDAQ:SHLD) close locations, I think the firm is nearing saturation in many markets. Midwestern states like Ohio, Pennsylvania, Michigan, and Illinois already hold 20+ stores, and I am not sure if the firm needs to expand its retail footprint so aggressively. In fact, additional stores could spell weak comps in FY14 and another headwind for the stock.

What Should You Pay for Dick's Sporting Goods?

Clearly, Dick's Sporting Goods is one of the last remaining big box sporting goods retailers, along with The Sports Authority. Other competitors like Big 5 (NASDAQ:BGFV) and to a lesser extent Hibbett (NASDAQ:HIBB) have much smaller stores and target customer bases. 15x forward earnings of $3.09 yields a target price of $46.35 per share. Given the company's solid record of producing free cash flow and rewarding shareholders, I think this number is a pretty reasonable price to pay for Dick's Sporting Goods, even if it does experience a gross margin headwind in FY15 and beyond. That being said, shares are still a little expensive right now, so I'm waiting to see if a broader market pullback can sink Dick's to a multiple that is cheap enough (say 11-12x FY14 EPS) to make some real money.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.