Should You Join the Bulls in Big Lots?

Source: Big Lots.

Shareholders in deep discount retailer Big Lots (NYSE: BIG  ) have endured an up-and-down stock price performance over the past couple of years, as the company has struggled with lackluster per-store sales growth and a failed expansion into Canada, since abandoned. Part of the company's problem has been a rise in competition in the deep discount retail sector, including the continued expansion of the so-called dollar store chains, like Dollar General (NYSE: DG  ) and Dollar Tree  (NASDAQ: DLTR  ) .

However, Big Lots' share price has been getting a lift in 2014, up more than 30%, thanks primarily to better than expected profitability. Big Lots' latest bit of good news was a solid performance in its fiscal first quarter, highlighted by positive comparable store-sales growth, which led management to increase its financial outlook for the year. So, should investors bet on more upside for Big Lots?

What's the value?
Big Lots is a major player in the deep discount retail sector, operating a network of roughly 1,500 stores across the country. While the company made its name as a seller of closeout merchandise, a lack of inventory in key areas, like home décor and seasonal categories, has led to relatively weak customer traffic and comparable-store sales growth lately, hurting Big Lots' operating profitability.

Case in point was the company's performance in its latest fiscal year, highlighted by a 1.2% top-line decline that was mainly a function of lower comparable store sales. More notably, a need to engage in heavy promotional activity in order to drive sales led to a steep drop in operating income, down 36.1% for the period. The net result for Big Lots was a decline in operating cash flow, hurting its ability to invest in growth initiatives, like the addition of freezers to a majority of its store base that will allow it to participate to a greater extent in government assistance programs.

On the upside, though, Big Lots' comparable-store sales growth turned positive in its latest fiscal quarter, up 0.9%, a data point that led management to forecast positive comps for the current fiscal year. However, those sales seem to have come at a cost, evidenced by lower gross and operating margins during the period compared to the prior-year period.

Looking into the crystal ball
Much of Big Lots' positive recent stock price momentum seems to be based on a belief that profit growth is just around the corner, thereby providing a solid foundation for a higher price level.  Unfortunately, higher operating profit seems somewhat unlikely given the company's recent results, as well as the heavy competition in the discount retail sector, especially from the so-called dollar stores that seem to be operating from the same playbook as Big Lots.

While it started out as a dollar store concept, Dollar General has transformed itself into more of a seller of deeply discounted items, with only one-quarter of its overall inventory selling for less than $1. Like Big Lots, Dollar General has made a big push recently to increase sales of food consumables, adding coolers to a large subset of its store base over the past year. While the food consumables area, including tobacco and candy categories, has a low gross margin, it has allowed Dollar General to continue attracting larger volumes of customers to its stores, a trend that helped the company post its 24th consecutive year of positive comparable-store sales growth in 2013.

Likewise, Dollar Tree has been adding freezers to its base of stores over the past few years, covering a majority of its network as of December 2013. Dollar Tree's initiative has helped it continue attracting greater volumes of customers to its stores, a key factor in its ability to post consistent annual increases in comparable-store sales. Not surprisingly, the improved average store productivity has generated solid profitability for Dollar Tree, evidenced by an operating margin in its latest fiscal year that sat at a five-year high.

The bottom line
Mr. Market seems to have liked the recent financial results at Big Lots, pushing the company's share price up sharply after each of its last two financial updates. That being said, Big Lots' operating profitability is still stuck in decline, and the company needs to find a way to match the superior operating efficiency of competitors, like Dollar General and Dollar Tree. As such, Big Lots still looks like a work in process, and investors are best to watch the action from the sidelines.

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