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A Top Notch Quarter From Dick's Sporting Goods Puts The Stock At Fair Price

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About: DICK'S Sporting Goods, Inc. (DKS)
by: Detroit Bear
Detroit Bear
Deep Value, special situations, long-term horizon, value
Summary

Shares of Dick's Sporting Goods rallied significantly after the company easily exceeded Q3 estimates and increased guidance.

Still, results are about flat to the year ago period.

Further, I think the company needs to have a larger cash cushion.

Shares look about fairly valued, with my fair value estimate at $40-50.

Shares of Dick’s Sporting Goods (DKS) ripped higher after the company posted significantly better than anticipated Q3 results. After such robust results, it would be awfully tempting to purchase shares of the sporting goods giant; however, I believe the company offers only modest upside from its current price. Let’s take a look at Q3 results and why I think the risk/reward from the current price is unimpressive.

Q3 – Robust Same Store Sales Growth Drives Results

Net sales jumped 5.6% y/y to $2 billion driven by a robust 6% same store sales growth rate. The ~6% gain laps a 3.9% decline in Q3’18 that was the result of the company intentionally pulling back on wearable technology monitoring as well as the company significantly reducing its presence in firearms. Prognosticators suggesting the decision to pullback on assault rifles would lead to material blowback appear to be wrong. Although the 2-year stacked comp sits at just 2.1%, I believe Dick’s Sporting Goods enjoys a strong position as the last major sporting goods chain standing.

Online sales also grew nicely in the quarter, up 13% y/y and now accounting for 13% of sales. Interestingly, management commented on the increasing trend of orders occurring online that are later picked up at the store, with President Lauren Hobart saying:

During the quarter we continued to see growth in the number of orders our athletes ordered online and picked up in store significantly outpacing the double-digit sales growth we saw in our overall e-commerce business.

Interestingly, the omnichannel presence appears to be an undervalued source of competitive advantage for the company. It looks like this may be driving some of the comp growth while also explaining why online growth looks relatively average.

Adding to the positive sales results, gross margin increased 140 basis points y/y to 29.6% of sales thanks to 87 basis points of occupancy leverage and a 60 basis point uptick in merchandise margin. Dick’s Sporting Goods will continue to benefit from this mix shift towards apparel for the foreseeable future, and the decision to reduce exposure to the hunting category going forward should also help margin productivity.

On the SG&A line, management noted that they are on-track to take out $30 million in annual costs, which have allowed the company to offset the increased costs from its investments. Overall, SG&A jumped 100 basis points y/y to 26.3% of sales. I consider this P&L management relatively strong, and I think the company looks well positioned to maintain its margin profile going forward.

Capital Allocation Strategy Remains Risky

The one area where I do find some fault with the company is on the capital allocation front. Inventory jumped 17% y/y versus the 5.6% sales growth rate. Management noted that they ran inventory too lean in 2018, which is consistent with messaging from the prior call. Management also noted that growth in inventory would be robust in Q4, suggesting that the new floor space allocation requires relatively significant investments. We will see how this dynamic plays out going forward. I remain somewhat cautious on this front, but I have been proven wrong about inventory growth thus far.

In addition, management repurchased a significant amount of stock in the quarter, reducing the share count by 2.8 million shares at an average price of $35.07 for a total expenditure of $99.5 million. The price paid in Q3 looks attractive, building on the momentum of the $107 million buyback in Q2 that occurred at an average price of $36.15. Management has demonstrated a strong grasp of value in recent quarters, though I ultimately think the company’s balance sheet management remains a bit too aggressive.

Admittedly, Dick’s Sporting Goods has demonstrated the ability to management its leverage. Typically, management pays off its revolver at year-end, leaving the company with no net financial debt (excluding leases). The strategy has had little impact on the company thus far, and the company has ended the last two years with roughly $100-115 million in cash. In theory, this should be acceptable. However, I think that retailers can inflect negatively at a faster pace than many analysts anticipate, and I would prefer the company have a cash cushion closer to $500 million given its current cost structure.

The Stock Looks About Fairly Valued

Without question, the market should have been excited about Dick’s third quarter numbers. However, some context for the full-year is necessary. Management guided to full-year same store sales growth of 2.5-3%, which compares to a decline of 3.1% in FY18. So, on a 2-year stack basis, store productivity should be flat to down. EPS should grow nicely on a full-year basis, up 8-11% y/y to $3.50-3.60. Again, about 9% of that gain is driven by a reduction in share count, so operating earnings growth will be relatively subdued.

Overall, I am keeping my valuation unchanged at $40-50, putting the company roughly in the middle of my fair value range. I do not agree with the leverage profile of the business, and as a result, I would mostly been interested in buying the stock at a sizeable discount to fair value, which simply is not the case at the current price.

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.