This Small-Town Retailer Is More Profitable Than the Big Boys

A niche market is typically efficiently served by one or a few incumbents, making it uneconomic for new competitors to enter. As a result, companies with dominant market share in a niche tend to be very profitable. Hibbett Sports (NASDAQ: HIBB  ) is a sporting-goods retailer with close to 900 stores in the Southeast, Southwest, Mid-Atlantic and lower Midwest regions of the U.S. The threat of competition is relatively benign for Hibbett primarily because of the size of the markets that it chooses to operate in.

The sweet spot
The sweet spot for Hibbett is typically a target market with a population between 25,000 and 75,000. This market size makes it unpalatable for big-box retailers and national sporting-goods retailers to compete. The size of the market does not justify the discounted offerings and overhead associated with these larger players' scale of operations.

Hibbett's main competitors are typically small and independent neighborhood stores, which are not a genuine threat as they cannot match up to Hibbett in terms of its broad-branded product assortment. If you are a small-town resident looking for the latest sports shoe from Nike, you will usually have no alternative to buying from Hibbett.

Also, the sporting goods retail is essentially a local and customer-focused business, for which Hibbett has an edge because of its small-market focus. By being intensely focused on serving the needs of a smaller customer base, Hibbett is able to localize its products to meet specific customer preferences.

It should not be a surprise that Hibbett has strong pricing power over customers, as evidenced by the 460 basis-point increase in gross margin from 31.9% in fiscal 2004 to 36.5% in fiscal 2013.

Costs matter
Being cost competitive also contributes to Hibbett's profitability.

Firstly, Hibbett's store-level costs are low. With an average store size of 5,000 square feet and relatively more subdued property demand in small towns compared to urban areas, Hibbett is able to secure retail space at much lower rental rates. Other expenses related to labor and store fitting also tend to be lower in such non-urban areas.

Secondly, the geographical concentration of Hibbett's store base results in cost efficiencies associated with distribution and management oversight. Hibbett currently only relies on one distribution center to support its logistics efforts, something only made possible with its store density. Furthermore, a national footprint would have made it difficult for management to monitor store operations closely without extensive travel.

Last but not least, Hibbett has a strong balance sheet with a negligible gearing of 1%, keeping interest expenses to a minimum. 

Future outlook
Hibbett reported a decent set of results for the second quarter of fiscal 2014, with net sales and earnings per share up by 13% and 33%, respectively. However, same-store sales growth was flat with an increase of a mere 0.3% in light of weak macro conditions. This led Hibbett to revise the lower end of its full-year diluted EPS guidance downward from $2.85 to $2.65.

While the near-term outlook for consumer-discretionary demand remains uncertain, Hibbett is well-positioned to take advantage of growth opportunities in the mid-to-long term. It sees the potential for eventually expanding its store count to at least 1,300, and started construction of a new distribution center in mid-2012 with the capacity to support more than 2,000 stores. The new 416,000 square-feet facility is expected to be completed and fully operational by fall 2014. It will replace the old 180,000-square-foot facility that Hibbett currently leases.

Peer comparison
Hibbett's peers include Dick's Sporting Goods (NYSE: DKS  ) and Foot Locker (NYSE: FL  ) .

Dick's is the largest full-line sporting goods retailer in the U.S. with about 9% market share of the U.S. retail-sporting-goods industry. Despite its size, Dick's trailing-12 months (TTM) operating margin of 9% pales in comparison to an operating margin of 14.3% for Hibbett.

In addition, Dick's is not spared from the effects of weak consumer sentiment, with same-store sales falling by 0.4% for the second quarter of fiscal 2013.

In a bid to improve sales and profitability, Dick's is focusing on e-commerce. Its online business grew by 50% year-on-year in 2012, but still only makes up about 5.6% of its total revenue. Dick's is targeting to triple the contribution from e-commerce by 2015 through increasing the depth of product offerings and providing options for buyers to pick up their online purchases in stores. 

Unlike Hibbett and Dick's, which are purely domestic players, Foot Locker, a specialty retailer of athletic shoes and apparel, has an international footprint with close to 3,500 stores in 23 countries. But size is rarely correlated with profitability. Similar to Dick's, Foot Locker's trailing-12 month operating margin of 10.3% lags that of Hibbett.

Compared with Hibbett and Dick's, Foot Locker delivered stronger same-store sales performance.  It grew same-store sales by 1.8% for the second quarter of fiscal 2013. Although Foot Locker does not disclose the geographical breakdown of revenue on a quarterly basis, I construe that its geographically diversified operations helped to offset the impact of weak consumer-discretionary demand in the U.S.

In May, Foot Locker announced its acquisition of Runners Point, a German specialty athletic store and online retailer. This is inline with its plans to expand internationally, particularly in Europe. Based on the purchase consideration of 72 million euros, Foot Locker probably took advantage of a difficult economic environment in Europe to acquire Runners Point at an attractive valuation of a price-to-sales ratio of 0.4.

Conclusion
I like Hibbett for its strong competitive position and advantageous cost structure. However, the market has factored Hibbett's superior profitability into its share price. Hibbett is expensive, currently trading at forward P/E of 17 and a PEG of 1.2. I will only consider taking a position in the stock at below 1.0 times PEG.

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