March 14, 2018 1:11 am
Image Source: Company’s website
Dick’s Sporting Goods (DKS) hasn’t been helped much by the improving retail environment and the rebound seen in the past few quarters. The stock is still trading almost 50% below the top of $63 reached at the end of 2016 and is one of the few retail companies that experienced a deceleration in the past quarters, while most of the players reported a significant improvement. Same-store sales turned to a negative 2%, although the difficult comparison with Q4 2016 (5% comps growth) can explain part of the weakness. In any case, I continue to see the numerous and clear sources of margin pressure as the main problems for the business, and the stock still looks cheap for a reason.
E-Commerce Between Growth And Margin Pressures
One of the disappointments of Q4 2017 came from e-commerce growth. The e-commerce business increased approximately 9% and as a percent of total net sales, increased from 17.9% to 19%. This is a bit disappointing because it’s below the management’s guidance of a mid-teen increase and was not offset by a particular strength in the traditional segment since we have seen that overall comps declined 2%. Despite the weakness, the e-commerce channel’s performance is still better than what several peers have recently reported, with Foot Locker’s (NYSE:FL) DTC channel growing a more modest 4.3%. Anyway, this relative weakness should be only temporary, as the management explained that the company had some intermittent performance issues with the site during the quarter, while they have mitigated many of these issues and mentioned an acceleration in e-commerce growth in the first quarter.
The problem of e-commerce, as I explained in a few other articles, is that it’s dilutive to marginality for the majority of third-party retailers because it carries higher variable costs such as those related to free shipping, while e-commerce customers are more price-savvy and can easily and quickly compare prices across many platforms and pick the most convenient offer. In addition to that, Amazon (AMZN) and other e-commerce players that are moving along the lines of Bezos’ strategy have been particularly aggressive with their pricing strategies (“your margin is my opportunity” philosophy), which further reduces traditional retailers’ pricing power. There is no easy solution for this and we know the expansion of their own e-commerce platform is dilutive for margins, but it’s still better than losing market share to pure digital players.
It’s not easy to estimate the dilutive effect of e-commerce on margins, but retailers such as Kohl’s (NYSE:KSS) mentioned a 20-30bps yearly dilution from that channel. Estimates from other companies are not far from that range and I tend to use these assumptions when I model the effect of e-commerce growth on third-party retailers in the apparel/footwear industry.
Margin Trends Speak Clear – Higher Costs And Match Price Guarantee
The biggest issue I see in DKS’ fundamentals is the constant margin dilution shown year after year in spite of a solid revenue growth and not just as a result of the higher costs of the e-commerce channel. Actually, it’s quite clear that the size of these effects is not comparable to DKS’ margins decline. Adjusted EBIT margin contracted from 8.8% in 2012 to 5.6% in 2018 while revenue was 38% higher, showing a complete lack of operating leverage and significant margin pressures that don’t seem to soften much as time passes. In the same period, cost of goods sold increased 43%, which suggest the difference with revenue growth may be in large part explained by pricing pressures that affected revenue. SG&A expanded 43% as well, in part reflecting the significant costs needed for the e-commerce business.
In this context of constant margin dilution, last quarter’s performance didn’t show any particular good sign. Gross profit for the fourth quarter was $787.3 million or 29.55% of sales, which translates into a 130 basis points contraction versus last year. The management admitted that this decline was driven by lower merchandise margins in a promotional marketplace and by higher shipping and fulfillment costs as a percentage of sales in the e-commerce channel, which perfectly confirms our view about the main drivers of margin dilution in the industry. Non-GAAP SG&A expenses were $590.3 million for the quarter or 22.16% of sales and deleveraged 69 basis points from the same period last year, which further confirms the previous evidence of margin pressures on all fronts.
Just to make the state of margin trends more clear, the company has implemented a price match guarantee that intends to roll up as time passes, which contributes to limit margin expansion even in a scenario of improving costs.
Private Brands And The Unclear Benefits
One of the strategies that third-party retailers can implement to generate some margin expansion and offset the negative effects of all the factors mentioned above is to focus on their own private brands, which usually carry higher margins. Dick’s Sporting Goods is surely pushing that segment and has recently mentioned some good developments in that area. Moreover, they clearly stated that it’s a priority, showing the will to accelerate investments in that area and setting an ambitious $2 billion target for the segment:
That’s very interesting, considering the business is estimated to be worth around $1B now. Unfortunately, the management didn’t state what kind of benefit on margins they expect from the expansion of the private brands business, so we can’t have an idea of how much this factor will offset the dilutive effect of e-commerce growth and competitive pressures. My view is that if it was positive the management would have mentioned it. On the other side, it’s difficult to believe that private brands would be dilutive to profitability, so it’s reasonable to assume an overall neutral effect on margins in the worst case.
Not Only Negatives But The Trend Doesn’t Change
We have seen that the sources of margin pressure abound and the expansion of the private brands’ segment has uncertain effects on profitability. Nonetheless, there are some moderately positive signs coming from the industry, which is reporting a relative improvement in margins and a decline in promotional activity that suggests inventory levels may be under control. The management confirmed this when an analyst asked a question about the status of inventory in the industry, saying:
The improving state of inventory in the industry suggests softer pressures on sales and gross margins from this point but it seems clear that the trend remains firmly downward. In the management’s own words:
Margins are pressured on all fronts and will continue to be pressured for the foreseeable future, a factor that we need to take into account when we assess DKS’ attractiveness as a long-term investment.
At 12x EPS and with top-line growth in the mid- to high-single-digit area, DKS may look like cheap if we don’t understand the underlying margin trends. Moreover, the strong divergence between comps and revenue shows how DKS is still dependent on new store openings for growth, a risky model for a company of their size and in a retail industry that shows signs of overcapacity. The deep focus on taking advantage of displaced market share seems to be an unreliable source of long-term growth as well, considering the slower pace of store closures we have seen recently and the improving consumer spending environment, which is giving some relief to the less efficient players as well. In these conditions, I still prefer to remain on the sidelines until we will have more clarity on the future sources of margin stabilization, as in the current conditions the stock still looks like a probable value trap.
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