Today, I'm picking up with my ode to Dick's Sporting Goods
Why am I so high on a sporting good retailer, you ask (with understandable incredulity)? In a word, management. Browse through Dick's recent annual meeting presentation, and you'll see some rather convincing evidence for why Dick's is the best operator in its sector: highest return on invested capital (ROIC), best inventory turns, track record of self-funded growth, rising gross margins, and more.
Every aspect of the presentation reflects a management team that has its focus on and is succeeding in capital efficient growth -- precisely the type of growth that the stock market rewards. And that leads us to where I left off last week -- the second four (of eight) factors that position Dick's for what I believe will be significant shareholder value creation in the years ahead.
5. Sector-leading ROIC
In 2002, Dick's ROIC was 11.8%. In other words, per each dollar of capital that Dick's invested last year (in stuff like new stores, inventory, and information systems), the company earned profits of 11.8 cents. That's a decent ROIC for any industry, but especially good in the world of sporting goods retail. Average ROIC last year among the other major sporting goods retailers was only 9.5%. (For comparability, both figures include leases capitalized at 8x.)
Cut through all the numbers and you'll find that Dick's is simply a more efficient operator than the competition. ROIC, for all its finance-mumbo-jumbo complexity, is just a measure of productivity -- and greater productivity ultimately translates to greater cash generation. That's why, all other things being equal, a higher-ROIC company deserves to trade at a higher P/E multiple than a lower-ROIC counterpart.
But what's behind Dick's ROIC edge? Answer: Lean, mean inventory management. Last year, Dick's was far-and-away the most efficient inventory manager in its sector, as measured by inventory turnover (cost of goods sold / average inventory):
Inventory CompanyTurnoverDick's 3.83x Galyan's 2.84xSports Authority 2.75xBig Five 2.52xGart Sports 2.18xHibbett 2.16x
In retailing, the advantages of cycling through inventory as quickly as possible cannot be overstated. By keeping its inventories lean, Dick's ties up less cash in inventory -- and that means more cash in the bank (where we like to see it). Also, Dick's higher rate of inventory turnover helps it avoid every retailer's worst nightmare: being stuck with excess goods that have to be marked down and sold at a loss.
6. Rising gross margins
Part of Dick's ROIC success (on the numerator side of the equation) can be attributed to the company's fantastic work in expanding its gross margins. Check out this trend over the past six years:
Year
Gross Margin1997 21.1%1998 22.1%1999 22.5%2000 23.4%2001 24.5%2002 26.5%
This trend signifies an awesome increase in the raw profitability of Dick's sales. Not only are rising gross margins indicative of fundamental business strength, they also are the stuff of dramatic earnings growth.
Here's why: At Dick's 40% tax rate, each 100 basis point improvement on the gross margin line delivers a corresponding 60 basis point improvement to the net margin line (all other things remaining equal). Keep in mind, for a retailer with net margins of 3% (300 basis points), each additional 60 basis points on the bottom line is substantial. Even without any sales growth, the expansion of net margins from 3.0% to 3.6% translates to 20% earnings growth.
And when you combine expanding net margins with growing sales, the overall effect is explosive. Dick's is a case in point with its 97.6% annual growth in income from continuing operations over the past five years. That's 18.9% annual sales growth stirred in with the high-octane power of expanding gross margins.
But what's driving this gross margin improvement? The biggest factor is an increasing mix of private-label merchandise, which carries higher margins. Dick's exclusive private-label brands include, among others: Walter Hagen Golf, Northeast Outfitters, and Field & Stream. In 1999, these brands comprised only 1.3% of sales; today, they're at 7% of sales. By next year, the private-label segment will be Dick's largest vendor. And within a few years, management's goal is for the private-label mix to reach 15% of sales.
This bodes well for future gross margin expansion -- and you've already seen what that can do for earnings growth. In addition, management has suggested that by next year, it could begin to leverage the SG&A line -- that is, reduce sales, general, and administrative expenses as a percentage of sales, which would provide further fuel to net margins and, consequently, earnings growth.
7. Strong sales growth trajectory
Over the past five years, Dick's grew its store base by 18.2% annually, from 61 stores at year-end 1997 to 141 stores by the end of 2002. Most recently, Dick's had 149 stores in 26 states, with heavy concentration in the northeast. Top states include Pennsylvania (22 stores), Ohio (21 stores), and New York (20 stores). This strategy of regional clustering maximizes local economies of scale in advertising, promotion, distribution, and supervisory costs.
Consistent with this clustering strategy, Dick's is steadily pushing the outer limits of its current markets, particularly areas it considers "underserved." (Personally, I would consider any market currently dominated by Sports Authority
Obviously, growth will become more challenging as Dick's strays farther and farther from its northeast roots, but I don't expect the company to hit any serious roadblocks anytime soon. The sporting goods sector is wide open for a dominant category killer -- and I don't think Sports Authority is it, regardless of its merger with Gart Sports
I'll go out on a limb and predict a nationwide Dick's presence ten years from now. That would require 14% annual store growth, producing roughly the same penetration as Best Buy
8. Significant inside ownership
You can count on Dick's management to operate in the interest of shareholders -- because they are significant shareholders themselves. CEO Edward Stack, son of founder Dick Stack and chief executive since his father's retirement in 1984, owns roughly 33% of the outstanding stock. Other executives and directors own an additional 9% of the company. Combined, that's 42% inside ownership, or about $250 million of skin in the game (by market cap).
In sum, I think Dick's has all the makings of a great investment. And at Friday's close of $28.11, the stock trades for a reasonable 14.3 times this year's consensus EPS estimate of $1.97. Additionally, that's an estimate I believe could prove conservative if gross margins keep charging ahead the way they have been. Also, given Dick's sector-leading position and strong growth profile, I think the stock's P/E multiple belongs closer to 20 than 15.
Matt Richey ([email protected]) is a senior analyst for The Motley Fool. At the time of publication, he owned shares of Dick's Sporting Goods. For Matt's best stock ideas and exclusive in-depth analysis each month, check out our newsletter, The Motley Fool Select . The Motley Fool is investors writing for investors.
