Wait For A Bargain In Valuation For This Great Bargain Outlet Chain

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About: Ollie's Bargain Outlet Holdings, Inc. (OLLI)
by: Capital Compound
Summary

OLLI’s has substantial pricing power through the offering of name brand products that cost customers significantly less than mass market retailers.

OLLI’s is recession proof and will be able to compound earnings through store expansion.

The current share price is significantly above fair value and investors should wait for a decline.

Business Overview

Ollie’s Bargain Outlet, Inc (OLLI) is an extreme discount retailer. OLLI’s is a 300+ chain of retail stores that offer brand name products at deeply discounted and closeout prices. This is made evident by the slogan “Good Stuff Cheap.” Inventory is purchased on an opportunistic basis and not guaranteed to be available on an OLLI’s customer’s next visit. The limited inventory availability creates a sense of urgency and a treasure hunt shopping experience when visiting the store. OLLI’s assortment of merchandise includes houseware, food, books and stationery, bed and bath, health and beauty aids, and electronics and toys. OLLI’s buys its inventory from other manufactures, wholesalers, distributors, brokers, and other retailers. These businesses may be experiencing bankruptcy or have overstock, discontinued, or prior year products. In addition to the branded inventory, OLLI’s offers unbranded private label products. Brand name and closeout merchandise represents 70% of sales versus 30% for private label merchandise. Merchandise is sourced by an experienced 16-person merchant team. OLLI’s argues to have long standing relationships with hundreds of major suppliers. OLLI’s has been conducting business with their top 15 suppliers for an average of 13 years and no supplier accounted for more than 5% of purchases.

The first OLLI’s location was in Mechanicsburg, PA and opened in 1982. OLLI’s currently has 303 locations on the eastern half of the United States. Locations are in Alabama, Arkansas, Connecticut, Delaware, Florida, Georgia, Indiana, Kentucky, Louisiana, Maryland, Michigan, Mississippi, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Virginia, and West Virginia. OLLI’s will continually be opening more locations for the foreseeable future. OLLI’s internal estimates and a third-party research firm indicates the potential for up to 950 locations. Locations are warehouse style and described as “semi-lovely” by the company. Locations focus on second generation sites averaging in size of 32,500 square feet. Sports figures are invited to store grand openings.

Store metrics are attractive. Average sales per store fall between $3.9-$4.3 million, creating for about $130 in sales per square foot. OLLI’s sales per square foot is less than peers Target ($300), Walmart ($430), and Dollar-Store ($200). This reflects OLLI’s charging lower prices. However, OLLI’s is more profitable on a operating income basis. OLLI’s operating margin exceeds 13%, beating Walmart (4.1%), Target (6%), and Dollar General (8.6%). OLLI’s achieves higher margins on an inconsistent product basis, whereas its peers opt for consistent merchandise with lower margins. Each store cost $1 million to build and generates $585k in four wall EBITDA, representing a 59% return and 2 year pack back period.

OLLI’s has a customer loyalty program called Ollie’s Army. This program stands at 9 million members or approximately 30k per store. OLLI’s grew this base by 8.7% in 2018. In 2018, 70% of sales were generated from these members. Members spend approximately 40% more per shopping trip than non-members. OLLI’s broadly identifies their target customer as anyone between the ages of 25-70 seeking a bargain. The demographic skews toward the lower income portion of the market.

Economics/Financials

OLLI’s has demonstrated financial strength. Through 2018, OLLI’s had Y/Y revenue growth of 15.3% and three-year CAGR of 17.6%. Revenue growth has primarily been fueled by mid-teens store growth. Comparable store sales and ranged between 3.2 – 4.2% over the last three years. However, OLLI’s anticipates this will contract to 1-1.5% going forward. OLLI’s has maintained relatively high gross margins just above 40% for the trailing three years. This is higher than all the closest peers: Dollar Tree (36-37%), Dollar General Corporation (30-31%), and Five Below (35-37%) We attribute this to the very aggressive selection of low-cost inventory. OLLI’s grew free cash flow from $17 million in 2014 to $76 million in 2018 (30% 4 year CAGR). However, free cash flow declined to $51 million in 2018. The decline was largely driven by the purchase of former Toys “R” Us stores and construction of OLLI’s third distribution center. OLLI’s has a strong balance sheet with $51 million in cash and no long-term debt.

Management

Management is very aligned with shareholders. Mark Butler, Chairman, President, and CEO, co-founded OLLI’s in 1982. Starting work for OLLI’s at the age of 23, Mark is an OLLI’s lifer. Mark has led the organization through expansion and is the primary leader on the purchasing team. He lives and breathes this business. He currently owns 13% of the shares outstanding and has been greatly rewarded as a shareholder. His salary is made up of base and incentive. The incentive portion of his salary can easily double his base salary when the company performs well. The incentive portion of pay for executives such as Mark is determined by annual adjusted EBITDA (adjusted for stock comp) targets. We see this as an appropriate metric. If the company does not obtain a threshold of 85% of the targeted adjusted EBITDA, no bonus is paid out. The maximum bonus is received when 115% of the adjusted EBITDA target is met.

We believe the board of directors adds value as well. Although we imagine Mark has the final say on decisions as he is the CEO and chair, the board is very independent. The board is very strong with leadership from executives with considerable retail experience. Many directors also hold considerable portions of shares.

Competitive Advantage

OLLI’s primary competitive advantage stems from its pricing power. However, normal pricing power is usually dictated by a company’s ability to continually raise pricing. OLLI’s exhibits pricing power in its ability to offer branded goods at heavily discounted prices. OLLI’s boasts its prices are up to 70% below department and fancy stores and up to 20-50% below mass-market retailers. Consistent with the claim, a KeyBanc analyst tested this theory across 32 items and discovered prices were on average 42% cheaper than Amazon. We view this as a major value add for a brick-and-mortar retailer in the modern age. OLLI’s has also demonstrated the ability to acquire customer loyalty. We think the success of Ollie’s Army shows the businesses ability to obtain recurring revenues. This group not only spends more per ticket but will drive further distances to visit the store.

Sustainability

We view this business as mostly sustainable. In many ways Ollie’s is at the mercy of its partners. If its partners become more efficient with inventory, this would mean less opportunity for overstock, discontinued, and prior year products for purchase. Jim Cramer expressed a similar concern to the Ollie’s CEO Mark Butler on Mad Money. Mark Butler advised manufacturers are always making changes. This would include package changes, last year’s models, and discontinued items. We believe the 37-year operating history proves this to be true. We believe this business is shielded from the popularity of online sales. The CEO indicated manufacturers do not desire to sell their closeouts on the web because it would draw traditional customers away from full-priced items. However, we view this business model as very susceptible to long term competition because it can easily be replicated. In fact, the first Ollie’s concept was copied after a closeout retailer based in Massachusetts called Building 19. Modern competition for inventory could stem from other purchasers such as Ross, TJ Max, Marshalls, and Home Goods for starters.

Valuation

OLLI’s is currently trading above fair value. The current price for OLLI’s is driven by overall market levels and/or the market anticipating OLLI’s will eventually open more locations than guided. We would wait for a decline in share price before initiating a position. Shares traded as low as $61 on the last major market decline in December 2018.

On a DCF basis, we estimate a fair value is between $50-$70 per share. Although this is not a precise exercise, we think the current market price is nowhere near fair value. Our forecast is based on a 10-year period and primarily driven by company guidance. We assume OLLI’s will open stores at a mid-teens rate until 1,000 stores is finally opened in 2027. We then assume no additional stores will be added in final year 2028. For all years, we assume same-store-sales (SSS) growth of 1.5% (long term guidance from OLLI’s). We then multiply the revenue estimate for SSS by the average of the stores open at the beginning of the period and stores open at the end of the period. We chose this method to roughly guess what revenues will be as stores are open throughout the store.

OLLI’s has gradually improved its operating income margin over time. It was 9.8% in FY 2014 and recently ended at 13.1% in FY 2018. We assume the margin will expand to 13.2% and stay flat for all following years. OLLI’s guided capex of about $77 million for FY 2019. We then used the historical average of 2.7% of revenue for all remaining years. OLLI’s guided D&A of $17 million in FY 2019. We then used the historical average of 64% of capex for the remaining years. Changes in working capital are in line with historical averages. We assume a discount rate of 10% for all DCF scenarios. In our growth in perpetuity model, we exit with terminal growth of 1.5%(set to match long term SSS growth guided by the company). In our exit EBITDA model, we exit at a multiple of 10x EBITDA (long term average of most stocks).

OLLI’s is also expensive relative to its closest peers.

OLLI’s is currently trading significantly higher than its average FCF multiple this year. CapIQ indicates the average TEV/ Unlevered FCF multiple for 2019 has been 164x. OLLI’s recently closed (May 14, 2019) at 196x. This suggests at least 16% in mean reversion. This could present a nice buying opportunity for investors.

Thesis

We believe OLLI’s has a unique value proposition compared to its closest peers. OLLI’s offers branded or quality products at drastically discounted prices versus peers who offer lower quality non branded products at low prices. These peers include The Dollar Store, Five Below, etc. We also view OLLI’s as attractive because we believe sales are insulated from Amazon and Walmart. OLLI’s prices are lower than its largest rivals. We view OLLI’s as insulated from an economic slowdown. Every OLLI’s location has maintained positive EBITDA on a trailing 12-month basis through boom and bust cycles. The board recently authorized repurchase of up to $100 million shares and will only purchase shares on an opportunistic basis if they get undervalued. OLLI’s will also be able to continually compound earnings as additional stores are built out. However, we still rate OLLI’s with a HOLD based on valuation concerns explained above.

Risks

Store model is not successful as OLLI’s expands into the west.

OLLI’s faces growing competition for closeout inventory and cannot acquire merchandise at the same attractive prices. This also relates to the business model being easily replicated.

OLLI’s opens significantly more than between 950-1000 stores as guided.

The CEO is 60 and closing in on retirement age. He has led the company since inception. A change in management could be a concern for us.

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.