Buying Big 5 Sports Stock Aggressively

Summary

• I think the market is too pessimistic about the expected drop in sales and earnings from the record highs of 2021. I want to try to take advantage of that.
• I think the dividend is well covered, and the recently announced buyback will be supportive of price. I think shares are objectively cheap, even compared to an inevitable downturn.
• Thankfully, the market's pessimism means that it's possible to earn a 10% yield on deep out of the money puts. If exercised, the dividend yield jumps to 12.5%.

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It’s been about three and a half months since I started looking at Big 5 Sporting Goods (NASDAQ:BGFV), and in that time, the shares have been virtually cut in half, down 48.2% against a loss of about 8% for the S&P 500. In my previous missive on this name, I suggested avoiding the shares at the then price of $29, but sold a number of puts with a strike of $24 that expire next month. The company has just reported fourth quarter and full year results, so I thought I’d look at the business to see if it’s still worth holding for the long term. I’ll decide whether to hold or take my lumps and go home by reviewing the earnings just released and by looking at the stock as a thing quite distinct from the underlying business. I’ll also comment on the options trade I entered into, and may surprise readers with a new trade. Stay tuned.

In case you skipped past the title above, and in case you missed the three bullet points above, and find yourself in uncharted territory, distressed by the fact that you don’t yet know my perspective on this stock, fret no further, dear reader. I’ll lay out my arguments in broad strokes in this “thesis statement” paragraph. I think 2021 was a great year for the company, and I think anyone who was surprised by that might also be surprised to learn that the sun rises every morning, and that water is wet. What’s more relevant is the fact that this cyclical company is likely going to cycle lower. Thankfully, the shares are cheap even under the most harsh assumptions about future growth, and for that reason I’ll be buying stock. In addition, I recommend another short put trade that creates what I consider to be another ‘win-win’ trade.

Financial Snapshot

The company just announced what I consider to be fairly decent results. To sum up, revenue was up about 12% relative to 2020, and net income was about 83% higher than it was in 2020. Additionally, interest expenses dropped to virtual non-existence, down to $893 thousand. This happened in spite of the fact that 2021 had one less week in the fiscal year, unseasonably warm weather, and, of course, the ubiquitous supply chain problems. At the same time, the company remains debt free, and the cash hoard grew even higher in 2021, to $97.4 million. To put that cash figure in context, in 2020, the company spent about $5.5 million on dividend payments, and forecasts CAPEX of $15-$20 million.

In my previous work on this name, I reviewed the dividend more thoroughly, and decided that it’s very well covered. If you’re interested in reviewing why I think this, I’d suggest checking out the previous article. The bottom line is that I consider it to be well covered.

BGFV Forecasts

The company is very clearly talking down expectations. For example, for the month of January 2022, sales are down about 20% relative to the excellent results of 2021.

From the company’s press release:

First Quarter Guidance

For the fiscal 2022 first quarter, the Company expects same store sales to decrease 10% to 13% compared to the fiscal 2021 first quarter, with earnings per diluted share in the range of $0.30 to $0.40. This compares to a same store sales increase of 31.8% and record first quarter earnings per diluted share of $0.96 in the first quarter of fiscal 2021, which included a previously reported net benefit of $0.06 per diluted share.

The Company’s sales and earnings guidance for the fiscal 2022 first quarter assumes that any new conditions relating to the COVID-19 pandemic, including any regulations that may be issued in response to the pandemic, will not materially impact the Company’s operations during the period.

Mr. Miller commented, “Our outlook for the 2022 first quarter reflects very difficult comparisons to our record 2021 first quarter. Additionally, guidance reflects challenged quarter-to-date winter product sales resulting from unseasonably warm and dry winter weather in our western markets, along with headwinds related to the Omicron variant and ongoing supply chain disruptions. Despite these challenges, we believe we are positioned to deliver first quarter earnings near or above any pre-pandemic first quarter earnings in our history. Looking beyond the current quarter, while comparisons to the prior year will continue to be challenging, our outlook remains very positive, and we are confident in the flexibility of our business model and diverse product mix.”

Thus, I think it's reasonable to expect a drop, perhaps a significant drop, in sales in 2022. For my part, I’m modeling a relative collapse in EPS, as the company returns to a kind of normal. Specifically, I’m modeling EPS of $2 for the year, but I’ll admit that this is as much a guess as informed by analysis. This is why I rarely reveal my EPS forecasts. They’re notoriously unreliable.

That said, I think the dividend is very safe, and I think the recently announced share buyback will be somewhat supportive of price. Thus, I’d be very happy to actually start buying shares at the right price.

Big 5 Financial History (Big 5 Investor Relations)

The Stock

Some of you who follow me regularly know that it’s at this point in the article where I turn into a real killjoy because I start yammering on about how a great company can be a terrible investment at the wrong price. I know it’s tough to hear, but the price you pay really matters because the more you pay for a perpetually sustainable dividend, for instance, the lower will be your subsequent returns. Rather than try to demonstrate this point abstractly, I'll use Big 5 itself to demonstrate the principle. If you bought this stock on February 15, you’re sitting on a 15.5% loss. If you bought eight days later, you’re up slightly. Not much changed at the firm over these eight days to warrant a 15%+ swing in returns. The investors who bought virtually identical shares more cheaply did relatively better. This is why I try to avoid overpaying for stocks.

I measure the cheapness (or not) of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value like sales, earnings, free cash flow, and the like. Ideally, I want to see a stock trading at a discount to both its own history and the overall market. In my previous missive, I suggested that I’d become excited about Big 5 if and when it reached a valuation of ~1.9-2 times book. It was trading at the time for 3.3 times book, which I couldn’t get excited about. It’s currently well below my 1.9 level, per the following:

Data by YCharts

Additionally, the shares were trading at the time at a price to sales of ~0.6. It’s now trading at about half that valuation, per the following:

Data by YCharts

Now, it’s obvious that the company’s performance will revert to a more normal level, and so I think it would be wise to assume that, holding everything else constant, a price to sales of 0.29 today will be a price to sales of perhaps 1.0 at some time in the future. Even with a significant drop of various valuation denominators (earnings, free cash flow, sales etc.), the shares remain much cheaper than the overall market.

In addition to simple ratios, I want to try to understand what the market is currently "assuming" about the future of this company. In order to do this, I turn to the work of Professor Stephen Penman and his book "Accounting for Value." In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in a fairly standard finance formula. Applying this approach to Big 5 at the moment suggests the market is assuming that this company will be bankrupt in about seven years, which I consider to be nicely pessimistic. Given all of the above, I’m very comfortable buying shares at current prices. Even if sales collapse, I think the shares will remain objectively cheap, and the dividend will remain secure.

But Wait, There's More...

As the share price collapsed, the puts that I wrote when they were 17% out of the money are now very much in the money. You might think that this would make me gun-shy about selling more puts on this dividend machine, but if you think that, dear reader, wrong you are. In addition to buying shares as the stock market swoons, I’m also willing to sell deep out of the money puts. I’ve written it before, and I’ll write it again. I think deep out of the money short puts offer an excellent way to open a "win-win" trade. If the shares remain above the strike price, I'll simply pocket the premium. If the shares drop, I'll be obliged to buy, but will do so at a price that I find attractive, and at a price that is much superior to the already cheap price.

In terms of specifics, I would recommend selling the January 2023 puts with a strike of $8. These are currently bid at $0.80 which is a reasonable enough premium at this strike price. If the shares remain above $8 over the next eleven months, I'll simply pocket the premium, and add it to the $2.65 I’ve earned from selling puts on this name already. If they fall another 48% from their current level, I'll be obliged to buy, but will do so at an approximate 33% discount to book value, and a dividend yield north of 12%.

It’s time to talk about the risk of short put options, dear readers. I know I characterise them as “win-win”, but you might be forgiven for suggesting that’s a bit of hyperbole. The fact is that short put options, like everything in life, come with risk. The short puts that I consider to be ‘win-win” are a subset of all short puts. I consider a short put to be a “win-win” when it’s written on a company that I would be happy to own at a price at which I’d be happy to buy. So, not all puts are “win-win” trades. If the strike price is a terrible entry price, for instance, that’s a very bad trade in my view.

I should also state that I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.

Some put writers don't want to actually buy the stock - they simply want to collect premia. Such investors care more about maximizing their income and will be less discriminating about which stock they sell puts on. To be very clear, I am not such an investor. I like my sleep far too much to sell puts based only on the income I can generate. I'm so much of a coward that I’m only willing to sell puts on companies I'm willing to buy at prices I'm willing to pay. I wasn’t always so disciplined, but after painful losses, I decided to only ever sell puts on quality companies at prices I was willing to pay.

I should also write that I think put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling out of the money puts on a given day to be far lower than the risks associated with simply buying the stock on that day.

I'll conclude this rather long discussion of risks by looking again at the specifics of the trade I'm recommending. If Big 5 Sports shares remain above $8 over the next eleven months, I'll simply pocket the premium and move on. If the shares fall in price, I'll be obliged to buy, but will do so at a price that lines up with a magnificent dividend yield. All outcomes are very acceptable in my view, so I consider this trade to be the definition of "risk reducing." Weird of me to end a discussion of risk by writing about how these things can reduce risk. It’s true. I can be weird. Please contain your shock and alarm.

Conclusion

There’s much to like about the company, obviously. I think the buyback, sustainable dividend, and cash hoard are all supportive of price. I like that the market seems to be irrationally “freaked out” by the cyclical nature of this business. We can take advantage of that faintheartedness by buying aggressively (when others are selling). In addition, I think the deep out of the money puts I recommended above enhance yields nicely. I like buying cheap stocks because they are less risky. How much further can shares drop? They also offer great potential returns. What will happen when buybacks take effect, or when the stock becomes cheap enough to be a buyout candidate? I think investors who can stomach a bit of volatility would be wise to buy these shares at current prices. The dividend yield is generous, well covered, and the chance of capital gain from current levels is high in my estimation.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of BGFV either through stock ownership, options, or other derivatives. 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.

In addition to buying 800 shares, I just sold 10 of the puts described in this article for $.90.