It's Time To Sell Big 5 Sporting Goods

Summary

• Big 5 looked like a decent risk/reward net-net in September of 2017.
• The trade has worked out well, but I think it is time to exit.
• Big 5 has revenue and cost challenges and a rapidly declining balance sheet.
• Big 5 is a sell.

One of the key attributes to success in distressed equity investing is to know when to sell. After horrible quarterly results last week, I believe Big 5 Sporting Goods (NASDAQ:BGFV) should be sold after a nice run.

Ultimately, Big 5 has delivered about a 10% return, including dividends, since I recommended the stock as a net-net play in September of 2017, good for an IRR of roughly 13%. However, I believe the fundamental scenario has worsened, but more importantly, I think the stock currently reflects an optimistic valuation. Big 5 is likely doomed in the long-term, and it appears that short-term headwinds could accelerate the process. Let's look at the results in the latest quarter, and I'll explain why I've exited the stock.

Revenue Trends are Terrible

Big 5's revenue trends in Q1 were horrible across all categories. Total same-store sales declined 7.5% y/y, driving a total decline of 7.3% y/y to $234.2 million. This puts the two-year stacked comp at 0.4%. This trend demonstrates that Big 5's underlying business is basically flattish, with some annual volatility driven by weather and gun fundamentals.

At the category level, hard goods sales declined 5.7% y/y to $104.5 million. This segment represented roughly 45% of total revenue in the quarter, underlying the durability of the hard goods category relative to other categories where online buying is more prevalent. Athletic apparel declined a whopping 10.3% y/y to $58.4 million, and though management blamed weather, I believe Big 5 is likely losing share in this category to online retailers. Footwear revenue also declined significantly, dropping 6.5% y/y to $69.4 million. I think this segment will continue erode, especially if consumers start to trade-up to nicer Nike (NKE) and adidas (OTCQX:ADDYY) footwear or continue to shift to Skechers (SKX) on the low-end.

With sales declining significantly, gross margin dropped 200 basis points y/y driven by comp deleverage and lower merchandise margins. The combination is even more troubling, as it indicates that sales at Big 5 are dropping in spite of promotional efforts.

Labor Costs Hitting the P&L

Paramount to my long-term bear thesis on Big 5 is the impact of minimum wage increases, particularly in California. Essentially, Big 5 is going to increase its SG&A spending significantly or risk understaffing stores. Now, one could argue that higher wages will raise all tides, boosting discretionary spending at the low-end, and thus propelling Big 5's sales higher. I think that view is quite risky given the increasing penetration of online selling, particularly in the apparel and footwear segments, as well as the risk that consumers actually trade-up to higher-value products.

SG&A for the first quarter declined by $1.1 million due to a $1 million cut in newspaper advertising expenses and $0.1 million of lower store hours. In the 10-Q report, Big 5 mentions that the impact of the California minimum wage increase was $0.3 million. This should lead to an annualized impact of around $1.4-1.8 million with labor costs coming in at a higher rate during busier quarters. It will be harder to quantify the total impact, but I am guessing the overall labor expense, given flat labor staffing, would be about $20-25 million lower than my original estimate, but negative nonetheless. The amount of employees impacted by the wage increase will grow every year as more employees hit the thresholds for increases.

Unfortunately, I have not been able to visit a Big 5 during the most recent quarter, but I will seek one out next time I am on the West Coast to look at store labor levels. If you have insight here, please chime in.

Balance Sheet Degradation: The Main Sell Signal

The main reason why Big 5 is a sell is the horrible condition of its balance sheet. Inventory increased 8.4% y/y to $321.5 million, representing an absolute jump of ~$25 million. This is a drain on working capital and importantly could portend a future write-off or high level of discounting. Big 5 likes to spin a story that its inventory is evergreen, but style changes, even at the low end of the market.

Cash fell to just $4.9 million while Big 5 increased its borrowings to $68.9 million, up from $45 million at the start of the quarter. Big 5 can't meet its current working capital needs with its cash flow, and I am quite worried about debt that's increased by about $45 million over the past year. The Big 5 business is falling apart, and I have less confidence in its book value given the huge jump in inventory over the past year.

With the balance sheet suggesting a possible credit crunch in the next 6-12 months, it is time to put out the last puff of this cigar butt. The quarterly dividend will sap another $3.3 million of cash, since the company refused to reduce it. Additionally, Big 5 will be closing on the parking lot next to its building for a total of $4.5 million. $0.3 million already sits in escrow, so Big 5 will see another ~$4.2 million leave the balance sheet before or on November 27th of this year.

The company is running out of cash, fundamentals are not looking great, and the labor cost bear case remains intact. I have exited my position, and I suggest that investors consider doing the same.

Analyst’s Disclosure: I/we 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.