Hibbett: Strong Execution Makes It A Surprising Gem

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About: Hibbett Sports, Inc. (HIBB), Includes: FL
by: Detroit Bear
Summary

Hibbett stands out as the company continues to perform against a tough retail backdrop.

Comps were up in Q1 and management sees comp growth positive for the balance of the year.

Integrating City Gear and closing underperforming stores should change the operating margin profile.

Shares are worth $22-27.

Shares of Hibbett Sports (HIBB) have performed well in 2019, rallying from $15 at the start of the year to just over $21 at the time of writing, good for a return of nearly 40%, even though shares are off 12% from their 2019 high. With the company’s plan to reduce its store count combined with cleaning up poor inventory from its City Gear acquisition and leveraging fixed costs, earnings per share should grow at least 15%, especially as comp store sales growth remains solid. After evaluating Q1 results, I am upgrading my fair value range to $22-27 per share. Let’s take a look at Hibbett’s recent results and why I believe its strategy will result in value creation.

Q1 – Comps Great, Margins Solid, E-Commerce Potent and Growing

Q1 comp store sales growth at Hibbett was solid, up 5.1% y/y, which helped drive total sales growth of 25% y/y (mostly a result of the City Gear Acquisition) to $343 million. The 5.1% comp comes on top of a 0.3% decline in Q1’19, moving the 2-year stack to 4.8%, better than rival Foot Locker’s (FL) 1.8% 2-year trend.

Although I did not love the deal when I read the 8-K detailing the financial performance of City Gear, I do believe that it improved the positioning of its company in the eyes of Nike (NKE) and adidas (OTCQX:ADDYY), making it a more critical retail partner for both dominant brands. Hibbett continues to receive solid allocations of new products like the Air Max 270, 720, and legacy platforms like the Air Force 1 and Air Max 95 and 97.

With good comps and good product allocation, Hibbett was able to mostly mitigate gross margin pressure. Though GAAP gross margin declined 70 basis points y/y due to a $950 thousand City Gear charge, non-GAAP gross margin fell just 40 basis points y/y driven by an increase in freight charges associated with a mix shift towards e-commerce. Overall, GAAP gross margin came in at a solid 34.5% of sales. Inventory was up only 8% y/y versus a 25% increase in sales, and I believe this healthy inventory position is why management guided to adjust gross margin to compress only 35-45 basis points y/y for FY2020, translating to a full-year gross margin of roughly 32.3-32.4%.

While e-commerce sales tend to carry a lower gross margin profile, I believe positive e-commerce growth will help offset store closures while helping the company adapt to new retailing conditions. E-commerce sales represented 8.3% of total sales in Q1 or about $28.5 million, up from 7% of sales in Q1’19 of about $19.2 million. This equates to e-commerce growth of about 48% y/y. Management did not do a great job of highlighting this on the call or during the earnings release, especially considering how the incremental $59.4 million in City Gear sales obscures the penetration of Hibbett’s online business. City Gear has a very limited online presence, so in terms of penetration, Hibbett itself likely jumped from 7% in Q1’19 to 10% in Q1’20. This trails rival Foot Locker’s 15.4% penetration as well as Finish Line’s 18% penetration, meaning Hibbett’s core business retains significant e-commerce runway, without including the meaningful uplift potential from turning on the e-commerce spigot for City Gear.

Driven by solid sales growth, Hibbett leveraged fixed costs by about 80 basis points, leading SG&A to fall to 21.7% of sales in spite of industry-wide labor cost headwinds. Excluding impairment charges and integration costs for City Gear, SG&A fell even more sharply to 21.1% of sales. This performance, however, is not sustainable. Hibbett also experienced a $1 million drop in stock-based compensation after its CFO left to join Dave and Buster’s (DAVE). As a result, management expects SG&A to be flat to down 10 basis points y/y for the full-year, excluding non-recurring costs.

All told, operating margin for the quarter registered a robust 10.7% of sales, up 30 basis points on a reported basis. If you adjust out one-time costs, operating margin was 11.6% of sales, an increase of 120 basis points y/y for Q1. Ultimately, this operating margin strength will not carry through for the rest of the year, but Hibbett should come in around 4%, which is down only slightly y/y. 4% is not a great operating margin in many industries, but in a retail structure where Hibbett does not own the brands it sells, 4% seems tolerable, especially if the company is able to extract additional integration savings from the City Gear deal.

Store Closures Will Improve Operating Margin and Highlight Strong Stores

Hibbett announced the decision to close 95 underperforming stores that, on average, are 50% as productive as the typical Hibbett store. Interestingly, Hibbett’s store strategy limits cannibalization and geographic closeness, so Hibbett only expects to capture some sales from online growth, with the rest likely to go to competitors. However, I suspect these underproductive stores contribute minimal, if any, EBIT, so closing such stores should highlight the underlying profitability of existing Hibbett stores.

On a consolidated basis, I believe Hibbett’s operating margin will improve, all things equal, in FY21 with a smaller but more productive store base. As counterintuitive as it may seem, shrinking is the right move for over penetrated retailers, and I think this strategy will yield long-term value creation as lower spending on capex mitigates margin pressure to keep cash flow growing.

Management Team Still Undecided, but Should Continue Strategy

Earlier in 2019, Hibbett suffered two blows to its senior management team, as former CFO Scott Bowman, left to become CFO of Dave and Buster’s. Prior to his departure, CEO Jeff Rosenthal announced his retirement after 21 years at Hibbett. I doubt Rosenthal’s departure signals anything beyond normal course retirement, as he is 61 years old, and he offered to stay on until a replacement is found.

A new management team has not been announced, but I do not envision a major shift in strategy. However, I will note that the existing management team has done a wonderful job of running a conservative balance sheet and allocating capital. Finding a team with the same exact vision may be difficult.

Increasing Valuation Amidst Execution

Overall, considering the financial performance of Hibbett in FY19/Q1’20 and the company’s solid operational execution driving comp growth, I am increasing my fair value range to $22-27. The company managed cost exceptionally well in Q1’20, and I am interested to see the profitability picture unfold throughout the rest FY20 and FY21 as the company extracts synergies from City Gear and reduces its footprint of poorly performing stores.

At the current share price of $21, I would remain patient and wait for the stock to drop to the $17-18 level before considering a position.

Disclosure: I am/we are long FL, NKE. 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.