2023-09-29 03:22:50 ET
Summary
- DICK'S Sporting Goods' shares have continued to decline since reporting disappointing earnings in August.
- Margins have declined even as same-store sales rose, indicating a negative risk to earnings.
- The company's guidance for adjusted EPS has been cut, and concerns about declining consumer demand could lead to further cuts.
Shares of DICK’s Sporting Goods ( DKS ) have continued to decline since reporting disappointing earnings in August. Last October , I recommended selling DKS given my expectation for earnings to fall; since this recommendation, shares have fallen 4% while the S&P has risen by 16%. Given that degree of underperformance, now is an opportune time to determine whether the selling is overdone. Given the negative risk to earnings, I would still recommend selling shares.
In the company’s second quarter , adjusted EPS fell 23% to $2.82 amid margin pressure even as revenue rose 3.6% to $3.2 billion with same-store sales up 1.8%. This EPS result missed consensus by $0.99 . It is notable to me that margins declined meaningfully even as same-store sales rose, which is generally a sign of a relatively supportive demand environment. In fact, gross margins fell from 36% last year to 34.4% in the quarter. Management blamed theft for much of its gross margin decline. Additionally, it has taken “decisive action” to move excess product (namely outdoor goods) and freshen inventory by cutting price. Inventories were down $145 million to $2.85 billion in the quarter, suggesting some success in getting product out the door.
Unfortunately, there is no evidence to suggest that the attrition in gross margins is complete. In fact, alongside the earnings miss, DICK’s cut guidance for adjusted EPS to $11.50-$12.30 this year. It previously expected $12.90-$13.80. DICK’s has earned $6.57 in H1 earnings, so management is implying a ~10% sequential reduction in earnings, even as same-store sales are expected to be flat to up 2%. Given weakening margins, DICK’s announced alongside earnings it would begin a round of layoffs, which will lead to $25-50 million in one-time costs, excluded from the adjusted EPS range provided above.
Now, even using the annualized implied H2 guidance, DICK’s has ~$11 in earnings power, for a 9.5x, earnings multiple. That would seem like a reasonable multiple, particularly for a company with an excellent balance sheet. It has $1.9 billion of cash against $1.5 billion in debt, which has enabled it to buy back $260 million in stock year to date. However, particularly after its massive miss last quarter, I am skeptical earnings will hold around $11.
First, we know the theft issue is not going away, just this week, Target ( TGT ) announced it would be closing nine stores due to crime issues. Organized crime has become a persistent problem in the retail sector, and while its headwind may fluctuate quarter over quarter, we sadly do not have evidence the problem is being resolved in a meaningful way. Beyond this though, it is important to note that while margins have fallen, they are still robust. In its last quarter before COVID, gross margins were 28.1%. Last quarter, they were 34.4%. That is 630bp of improvement, even with increased loss from theft.
Now, the company has grown its own brand penetration by 200bp to 14%, and this generates 600-800bp higher margins than selling other brands, but this explains only about 20bp of the improvement in margins. If we were to assume that, factoring in own-brand growth, margins will retrace half of their post-COVID gains, they would decline to 31.4%. A further 3% reduction in margins would reduce profits by about $290 million or about $3.60 per share. That would leave run-rate earnings at $7.30-$7.80, leaving shares with a 14.5-15x earnings multiple.
The question for investors needs to be whether they believe margins will continue to shrink closer to pre-COVID levels or if they are permanently higher. Assuming just 50% retracement with increased theft in my view gives management credit for structural changes, increased scale, and a larger e-commerce presence. That said, we need to recognize DICK’s was a unique beneficiary of COVID, and as this fades and consumers face tighter budgets, demand may soften and force margins lower.
In the aftermath of COVID, we saw an incredible spike in sporting goods purchases. The data below is only updated annually, but from 2019-2022, sales rose by over 60%. Faced with lockdowns, people spent more time outside, or trying new hobbies, like golf. Some of this increase may be permanent as some consumers stick with hobbies they discovered, but there was likely a significant amount of one-time purchases that won’t repeat. With DICK’s having to cut prices to move outdoor goods last quarter, I would argue we are seeing signs of that.
Looking at monthly retail sales, we can see trends through August, though this series does include smaller categories like books and musical instruments, which do not apply to DICK’s. Still you can see the spike from 2020-2021, and sales have subsequently flatlined, at below-peak levels. This is also a nominal series, so adjusted for inflation, we are likely seeing volumes of product purchased declining.
While I do not expect a recession, which would reduce consumer spending across a whole range of goods and services, I still see DICK’s as vulnerable to falling consumer demand, given that it’s business functionally has seen a massive one-time benefit, allowing it to raise prices and widen margins, which is now slowly plateauing and turning down. Importantly, many consumers feel a significant pinch from inflation, and as they consider where to cut spending, this sporting sector is an area where they have been spending an “excess” amount and is ripe to be curtailed.
This process could also begin relatively soon. I would note the end of student loan forbearance will cost American consumers $70-$80 billion per year. That is about 0.4% of personal spending . When faced with this incremental expense, will consumers reduce their spending on some items, or will they save less? To answer that, we should consider that after surging during COVID due to government stimulus, the personal savings rate is now down to 3.5%, less than half of what it was pre-covid.
Personal savings are already quite low, so in my view, the risk is that increased costs, be it student loans, higher gasoline prices, or other inflationary forces will gradually be met with spending less on discretionary items. This process may not happen all at once, but that is the likely trajectory with student loans repayments likely hastening this. As consumers are forced to cut back, a category where they are already spending more than “normal” would seem particularly at risk of losing wallet share.
As such, investors should expect DICK’s customers to get more price-sensitive, and the increased promotion activity last quarter is more likely to be a trend than an aberration. We are likely to see prolonged margin pressure on the business, which weigh on EPS for the next 12-24 months. Moreover, my $7.25-7.50 EPS expectation assumes the current level of sales. If consumers pull back more aggressively, same-store sales could begin to decline, which would add to the earnings pressure. Prior to COVID, this company was earning about $3 per share , which is about $3.75 now, given share count reduction.
My bearish outlook actually still leaves earnings double what used to be “normal.” I accordingly view this outlook as giving management significant credit and assuming a fairly benign consumer environment. In other words, downside risk to earnings could be greater than what I have laid out. Given investors will face steadily deteriorating earnings and margins, I would be a seller at what is 14x my expected earnings level over the next year. I would want to see shares trade in the mid-80s or less than 12x earnings to consider buying shares, pointing to 20% of downside.
Perhaps, the consumer keeps spending as is, and DICK’s can sustain current margins, but it is hard for me to craft a case of margin expansion or prolonged earnings growth, and with investors seeing limited growth potential, and with the likely path being lower earnings. I expect to see multiple compression, which combined with a lower EPS level will send shares lower.
For further details see:
DICK's Sporting Goods' Stock: A Sell Due To Falling Margins