Big Lots: Switching To Hold After Run
- Big Lots had a knock-out quarter and meaningfully improved its liquidity.
- Despite economic challenges, sales have shown momentum.
- At 10x earnings, the valuation is no longer attractive.
- Switching shares to a HOLD.
Most retailers haven't had anything good to say about Q1 or Q2, except for the sliver of essential business retailers. That would include grocers, pharmacies, discount variety, dollar stores, and select big box retailers. Even though Big Lots' (NYSE:BIG) food sales actually only account for about 14-15% of total sales, the retailer was allowed to keep its stores open, unlike many others. Since my last write-up, multiple competitors to Big Lots have actually filed for bankruptcy; that includes Pier 1 Imports (OTCPK:PIRRQ), Tuesday Morning (TUES), Stage Stores (SSI), and others. Kirkland's (KIRK) could also be on the way out with its operating losses and limited liquidity, and while Bed Bath & Beyond (BBBY) is unlikely to file, its market positioning still continues to struggle. That's certainly not the case for Big Lots, which reported nearly 11% revenue growth year-over-year, mostly driven by organic sales improvement. That also led to $1.26 in EPS for the first quarter versus analyst consensus of only $0.45. I think most of that upside surprise was related to COVID-19, namely being low-bar expectations, as well as the considerable strategic investments management has made over the last two years, specifically being store remodels and improvements in digital infrastructure. In a few ways, Big Lots is certainly winning wallet-share and benefiting from its own strategic investments, competitor attrition, and oddly, due to covid-related forces.
The Right Moves
Interestingly, S&P Global downgraded Big Lots due to "changing merchandising strategies, inconsistent execution, and fiercer competition." While the latter may be true with online pure-plays seeking to gain market share and more companies increasing their omnichannel capabilities, I think management has made a lot of headway on its e-commerce platform and with store pick-up. The former two reasons, while relevant, seem like weaker arguments. Management has purposefully changed its inventory mix in the last few quarters in response to its largest growing categories and to provide an improved assortment, particularly in furniture and home goods. That's been reflected in recent comps performance that has been flattish to positive as well as the blow-out quarter for Q1. S&P's team continued with "potential store traffic loss from the outbreak of the coronavirus in the U.S." Well, if you perform a Google trends search on Big Lots, the company's traffic has shown the highest trending figures in its 10-year history. That's for both in 2019 pre-COVID as well as throughout COVID (as shown in the last two spikes running near record levels).
Granted the company did incur some debt to reinvest in the business, those decisions are providing immediate returns and management expects that it will continue to capitalize on what's driving growth and gain more momentum in the quarters ahead. Perhaps what's most exciting is that the company cleared so much merchandise in the first quarter that inventory was actually down 13% year-over-year. Most analysts were expecting that figure to be flat to down modestly.
On the balance sheet side, things were looking ugly up until early 2020 until the company closed on its sale leaseback, which turned out to be an excellent transaction. That deal encompassed selling its four distribution centers for $725 million (net proceeds totaling $550 million), or $73/per square foot, which is somewhat above the cost to build a new industrial warehouse. These proceeds were in part expected to be used to maintain liquidity and reduce its credit revolver balance.
That reduced the company's net debt of $406 million to only $125 million sequentially. Therefore, we observed that all key performance, leverage, and liquidity metrics all improved in one fell swoop. If it can keep these sales trends up and margins stable, it could rapidly deleverage. In the conference call, management stated that April sales continued strongly, but didn't prove any color on May. Perhaps the primary risk here is that as stimulus checks are starting to be exhaust, so we could see a potential slowdown in the back-half of the year.
Pertaining to returns, Big Lots has generated steady returns on invested capital and assets over the last five years. Retailers typically generate after-tax returns on invested capital in the ballpark in high-teens and in the mid-teens after adjusting for operating leases. Big Lots' returns of this caliber are characteristic of businesses that carry an existing moat albeit a narrow one.
Pertaining to return on assets, which includes all liabilities such as deferred taxes, accrued expenses, and other obligations, things are looking decent. Retailers typically generate ROAs of around 6%, so Big Lots is outperforming on that basis as well.
I've been a fan of Big Lots at $27/share and lower. Priced at 7x earnings, not much needs to go right for the stock to recover. In my previous analysis, my simple framework was the following: "If current margins can be maintained, the stock could support a valuation in the mid $30s. Although it may take a couple years to get there, the fair value of the company would be 30% higher." That story played out a lot faster than expected, but given the stock has effectively re-rated towards 10x, the upside really doesn't carry the margin of safety and juice that it once did.
Perhaps if trends continue as management seems to be supporting, "the customers are strong right now and I think we're really well positioned for now, next and later." over the course of the year, then that will certainly firm up earnings in the range of $4/per share. On a sustained basis, I could see the stock pushing into the mid-$40s, but that's not a bet I'm willing to take after the latest run-up. On balance, Big Lots' valuation doesn't necessarily warrant a buy rating, nor does it constitute an outright sell given how much steam is behind its recent performance. It seems more likely that shareholders would be more inclined to take profits especially with the stock trading near 52-week highs and running near its 10-year price average.
If you believe in management and the story, there's still room for upside that would validate owning the stock here, but I no longer hold a position.
Off-price, dollar stores, and discount retailers continue to perform well in this weaker economic environment. I think Big Lots will do okay over the long-run given it has learned to adapt, while many other retailers have fallen by the wayside in recent years and especially during the coronavirus pandemic. Despite such a magnificent balance sheet improvement for Big Lots, the valuation looks meaningfully less attractive near $40/share. I think we have to remind ourselves that retail is terribly competitive, and sometimes it just isn't worth buying (or perhaps even owning) a retailer at a so-so price. For that reason, I'm changing my rating from buy to hold. Thank you for reading and please comment below.
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