Dick's Sporting Goods: Long-Term Investment Thesis Remains After Solid 2018 Results

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About: Dick's Sporting Goods, Inc. (DKS)
by: Cameron Smith
Summary

Overreaction to 2018 results leaves Dick's Sporting Goods shares at 11.0x P/E based on both the $3.25 EPS mid-point of management's forward 2019 guidance and TTM $3.24 2018 EPS.

2018 EPS increased 7.6% to $3.24 driven by the repurchase of 9.6 million shares which represented approximately 9.3% of Dick's Sporting Goods shares outstanding at the end of FY 2017.

While net income has been flat in recent years, I have no problem investing in a no-growth company as long as I am not paying for growth in the valuation.

Dick's Sporting Goods (DKS) released Q4 and fiscal year 2018 results on March 12 which did not meet analyst estimates sending its shares plunging over 10%. However, the year was in no means terrible, in my opinion, and my investment thesis from previous articles on Dick's Sporting Goods remains intact. The company once again looks like a solid buying opportunity for value investors trading around 11.0x P/E based on both the $3.25 EPS mid-point of management's forward 2019 guidance and 2018's TTM $3.24 diluted EPS. After the 22% dividend increase, Dick's dividend yield is now around 3.1% and the company still has approximately $433M remaining under its authorization for share repurchases which can be used to return even more cash to shareholders.

Chart Data by YCharts

How Did Dick's Sporting Goods Perform in FY 2018?

Driving the initial slump in Dick's Sporting Goods shares following the earnings release was probably the fact that same-store sales decreased 3.1% on an adjusted 52-week comparable basis. Also, not helping sentiment was net sales for the 52-week period decreasing 1.8% from last year's 53-week period to be approximately $8.4B. The all-important retail metric of gross margins was weak for the quarter at 27.87% which was down 125bps compared to gross margins of 29.12% in Q4 2017. Also discussed on the earnings call which might have given some analysts a scare was the 6.6% increase in inventory levels that management tried to explain as a strategic investment to support key growth categories.

However, there were also some bright spots to be found in Dick's Sporting Goods results. While FY 2018 net income across Dick's Sporting Goods was relatively flat at $319.9M compared to $323.4M in FY 2017, diluted EPS increased 7.6% to $3.24 from $3.01 in 2017. This EPS increase was the result of Dick's Sporting Goods repurchasing approximately 9.6 million shares of its common stock for $323.4M. These repurchases represented approximately 9.3% of Dick's Sporting Goods 103.0 million shares outstanding at the end of FY 2017. Also, on a full-year basis, gross margins were relatively flat at 28.90% compared to 28.97% for FY 2017. This full-year gross margin figure paints a far brighter picture than Q4's large decrease.

The company also increased its quarterly dividend by a whopping 22% to $1.10 as management continues to return cash to shareholders through dividends and share repurchases. Lastly, management also gave guidance for FY 2019 at $3.15-3.35 diluted EPS which would leave Dick's Sporting Goods shares trading at 11.0x forward P/E based on the mid-point of $3.25.

A Profitable Company

Being a national retailer and a household go-to name has allowed Dick's Sporting Goods to be nicely profitable with a return on equity (ROE) averaging 12.3% over the past decade. While this level of profitability is slightly below my rule of thumb of 15% ROE, when taken together with the fact that Dick's Sporting Goods has only had one unprofitable year in 2008 (during the financial crisis) over the past 12 years, these figures give me some confidence that the company should be able to maintain its intrinsic value. On the growth side, book value per share has grown from $8.16 in 2007 to $20.39 in 2018, which when combined with the dividends paid out from equity has averaged growth of 11.9% annually.

Source: data from Morningstar and company financials

Growth in net income at the company has tapered off in the past 5 years to average only around 2.2% with EPS growth averaging 5.4% supported by share buybacks. While the flat EPS guidance for 2019 of $3.15-3.35 might have disappointed some investors, I have no problem investing in a no-growth company as long as I am not paying for growth in the valuation. If share buybacks are able to continue to drive EPS growth, that would be a bonus on top of the 9.1% earnings yield an investor is getting when purchasing Dick's Sporting Goods at 11.0x P/E. The company still has approximately $433M remaining under its authorization for share repurchases that extends through 2021.

Risks from High Operating Leverage

Retail is a fiercely competitive business with rivals like Amazon (AMZN) always competing to grow market share. The bankruptcy of Sports Authority in 2016 is a good reminder to potential investors of how a retail business can go under. Like a lot of retailers, Dick's Sporting Goods leases most of its stores, which keeps capital invested in the business low and directly related to selling goods (not owning real estate) as well as allowing for a degree of flexibility in its operations.

Because of store leases, however, retail businesses look less financially levered than they actually are as they, in fact, have plenty of contractual obligations they are held to beside interest payments. To get an idea of how well operating income covers these fixed obligations, we can add lease expenses back to operating income and then divide it into the combination of interest and lease expenses.

Source: data from company financials

As you can see in the above table that outlines FY 2012 - FY 2017 of this adjusted coverage ratio, Dick's Sporting Goods operating income before lease expenses only covered fixed obligations 1.87x in 2018 and has decreased in recent years. A lot of retailers operate highly levered and Dick's Sporting Goods is no exception. That being said, the company ended the quarter with approximately $114M in cash and equivalents on the balance sheet and no borrowing on its revolving credit facility.

Due to FASB issues ASU 2016-02, Leases (Topic 842) coming into effect for the 2019 year, Dick's Sporting Goods has guided that they will need to capitalize lease assets and liabilities of approximately $2.3B on the balance sheet which were previously treated as operating leases. Management also stated on the conference call that the new accounting standard will have no material impact on their 2019 net income.

Risks from E-Commerce Competition

While retailers like Dick's Sporting Goods might have some in-house brands, they mainly rely on selling the products of major branded consumer companies. The rise of e-commerce is a threat not only from the likes of Amazon but also because it allows consumers to go straight to the online source of their preferred brand in order to buy their product directly. In fact, I bought my last pair of shoes straight from my favorite brand's website (Nike.com). These structural changes will be a headwind for retailers in the years to come.

Take Away

Dick's Sporting Goods is a highly profitable company which continues to be tossed aside by a market embroiled with fears of Amazon's entrenchment into every corner of retail. The 2018 results show that the company is running steadily, in my opinion, and I have no problem investing in a no-growth company as long as I am not paying for growth in the valuation. As long-term value investors wait for sentiment around the company to change, they can sit on a great company at 11.0x P/E for a 9.1% earnings yield and collect their 3.1% dividend.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DKS over 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.

Additional disclosure: Disclaimer: While the information and data presented in my articles are obtained from company documents and/or sources believed to be reliable, they have not been independently verified. The material is intended only as general information for your convenience and should not in any way be construed as investment advice. I advise readers to conduct their own independent research to build their own independent opinions and/or consult a qualified investment advisor before making any investment decisions. I explicitly disclaim any liability that may arise from investment decisions you make based on my articles.