BGFV - Big 5 Sporting Goods: A Hold Recommendation Amidst Challenging Economic Conditions

2023-11-28 20:25:26 ET

Summary

• Big 5 Sporting Goods is facing challenges from inflation, higher labor costs, and student debt payments, impacting revenue and profitability.
• Despite these challenges, the company has a strong financial position and is trading below its historical valuation, suggesting it may be undervalued.
• However, the lack of competitive advantages and the highly competitive market pose risks, and the economic slowdown could further impact sales and profitability. A 'Hold' recommendation is given.

Introduction

Big 5 Sporting Goods ( BGFV ) is a sporting goods retailer in the western United States facing a challenging macroeconomic environment. The company has taken steps to reduce expenses. Still, these efforts have not been enough to offset the headwinds from inflation, higher labor costs, and the renewal of federal student debt payments. Despite these challenges, Big 5 has a solid financial position and is trading at a valuation below its historical levels and its principal peers. This suggests that the company may be undervalued, and investors willing to take on some risk may want to consider buying shares of Big 5. However, there are also some risks to consider. The company has no competitive advantages that set it apart from its peers and is operating in a highly competitive market. Additionally, the economic slowdown could lead to further sales and profitability decline. For those reasons, I give it a ‘Hold’ recommendation.

Business Overview

Operating out of the western United States, Big 5 Sporting Goods has established itself as a leading sporting goods retailer, with roots stretching back to 1955. Renowned for its commitment to value and customer satisfaction, the company has successfully navigated the retail landscape through strategic growth, a value-driven operational philosophy, and a management team focused on execution. Big 5 Sporting Goods boasts a network of over 430 stores across the western United States, complemented by a robust e-commerce platform. The company caters to a wide range of sporting enthusiasts, offering an extensive selection of athletic footwear, apparel, accessories, and outdoor and athletic equipment. Partnering with renowned brands such as Adidas, Coleman, Columbia, Everlast, New Balance, Nike, Rawlings, Skechers, Spalding, Under Armour, and Wilson, Big 5 Sporting Goods consistently delivers quality products at competitive prices.

Turnaround Opportunity

Big 5 is involved in an adverse macroeconomic scenario with highly fixed SG&A expenses. The inflationary pressures, together with higher interest rates, depleted pandemic savings, increasing credit card delinquency rates, and the renewal of federal student debt payments, have created a challenging environment for companies in the discretionary consumer sector. Compared to 2021, 2022 and 2023 have experienced a decrease in US discretionary consumption, as shown by the Visa Spending Momentum Index .

The decrease in US discretionary spending aligns with the sharp reduction in the company’s revenue.

Nevertheless, even if revenue has plummeted, the SG&A increased in 2022 and remains flat in 2023. Thus, SG&A as a percentage of sales has grown considerably, deteriorating the company’s profitability.

The operating margin was compromised when SG&A represented over 30% of sales. In TTM, the SG&A is 32.55% of sales, even after all the management efforts to cut expenses and adapt inventory to adverse macroeconomic environment. These efforts include managing store opening hours to adapt to consumer patterns, reducing marketing expenses (already lower than half of pre-pandemic levels), and decreasing performance-based incentives accruals. In addition, the management has changed the product mix to be more appealing in current economic conditions, improving the merchandise gross margin and maintaining a gross margin higher than pre-pandemic levels.

I don’t think investors should worry about a further decrease in gross margin (currently at 32.9%) unless the macroeconomic conditions worsen more, as other competitors such as DICK’s Sporting Goods ( DKS ) or Sportman's ( SPWH ) held similar gross margins. Thus, Big 5 should be selling at prices comparable to competitors.

Despite management efforts, inflationary pressures have played a critical role in jeopardizing profitability. First, they created a more conscious consumer whose wallet is being squeezed by constant increments in living costs and higher interest rates. Second, they propelled politicians to raise the minimum wage to $15.5 per hour in California (where half of Big 5 stores are located), but in San Francisco and Los Angeles, the minimum wages are $18.07 and $16.78, respectively. Consequently, increased minimum wage and a tight labor market have partially offset labor expense reduction initiatives.

Furthermore, the renewal of federal student debt impacted October sales as they fell 10% , worse than the whole quarter, which only fell 8.2% . Consequently, I expect further weak sales as payments squeeze the already-reduced disposable income of young adults, the population segment that exercises more . However, Big 5 is unlikely to suffer as much as other retailers in other states, as California has one of the lower ratios of student debt-to-personal income.

Taking a forward-looking perspective, the management expects further revenue shrinking (by a high single-digit to a low double-digit), along with a net loss per share of around $0.2-$0.35 , so assuming the number of shares ( 22,444,422 ) won’t change considerably, investors could expect a net loss of approximately $4,489-$7,856 thousand, giving an annual net loss per share of $0.12-$0.27. From my point of view, the future seems a little dark as the management initiatives to reduce SG&A expenses haven’t been enough to reduce them significantly; California expects to keep increasing the minimum wage in 2024; the renewal of student debt will keep decreasing disposable income; and lower marketing expenses may weaken future sales.

Nonetheless, some positive signals point out a recovery of the economy from inflation. First, both CPI and PPI indicate a general economic slowdown, as both rates have decreased considerably in 2023. In addition, although the labor market remains tight, it is showing a deceleration. Consequently, the bond market has lowered the US 10-year bond rate .

However, along with a less inverted yield curve, these indicators warn of the possibility of a recession in the US economy, which, even if it is soft, could cause a further reduction in sales, threatening the sustainability of Big 5, as it could experience heavy losses. Thus, I think the economic slowdown that financial markets “celebrate” won’t be good for a company that cannot reduce its SG&A as fast as its revenue falls.

Even so, I believe the company has the financial strength to endure heavy losses as it has no financial debt other than leasing and a stockholders’ equity equivalent to $255 million . Of course, the inventory is the largest asset in the company’s balance sheet, representing 43.21% of total assets. So, even if the equity doesn’t rely on intangible assets, inventory could be hard to sell quickly without substantial markdowns in the current situation. Nevertheless, analysts don’t expect Big 5 to experience heavy losses that compromise its financial position. Analysts expect the company to lose only $2 million in operating income the following year, less than 1% of current equity. Moreover, the company has a current market capitalization of $128 million . Hence, the company trades with a P/B of around 0.5, even if future expected net losses are subtracted, representing a value opportunity as, historically, the company has traded with a higher P/B. Furthermore, Big 5 is cheap compared to some of its peers by a large margin:

Nonetheless, when analyzing other multiples like P/E or P/FCF, Big 5 seems more expensive than its peers due to the variability of returns in the current challenging environment; whereas companies such as Dick's Sporting Goods and Academy Sports and Outdoors are enduring the crisis relatively well, Big 5 and Sportsman's have been experiencing difficulties. Therefore, the bad performance explains partially the low multiples of Big 5 and Sportman's.

Lastly, even if it could be a value opportunity, I don’t think holding these shares for an extended period will benefit investors as the company doesn’t have any competitive advantage that sets it apart. The former can be seen in the low ROIC and revenue growth in the last ten years. In this sense, revenue growth was zero, and the median ROIC was 5.9% . Moreover, the company relies on operating leverage to be profitable, adding volatility to future profits, and it competes in a highly competitive market based mainly on pricing competition.

Conclusion

Big 5 Sporting Goods is facing a challenging macroeconomic environment that has led to a decrease in revenue and a deterioration in profitability. The company has taken steps to reduce expenses. Still, these efforts have not been enough to offset the headwinds from inflation, higher labor costs, and the renewal of federal student debt payments.

Despite these challenges, Big 5 has a robust financial position and is trading at a valuation below its historical levels. This suggests that the company may be undervalued, and investors willing to take on some risk may want to consider buying shares of Big 5.

However, there are also some risks to consider. The company has no competitive advantages that set it apart from its peers and is operating in a highly competitive market. Additionally, the economic slowdown could lead to further sales and profitability decline. Consequently, weighting the above-mentioned factors, I think Big 5 is a ‘Hold’ while waiting for an economic signal that points out an improvement in increasing demand.

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