Is there any group more hated right now than retail? Lukewarm consumer spending has caused Wall Street to flee from this sector, allowing a number of quality retailers to drift down to very cheap prices. Among the best of these, although not a victim of a swooning stock price, is Sportsman's Guide (Nasdaq: SGDE).
This is the tiny outdoor gear specialist that I first presented here last May. Sportsman's Guide is a formerly struggling catalog retailer that has seen its entire business model transformed for the better by shifting sales to the Internet, thereby allowing for much greater profitability. Back in May, shares were trading hands at $6.06 with a P/E of only 7.9. Now, after three quarters of solid execution, the stock is up nicely to $7.88, but still offering solid value at 9.7 times 2002 earnings.
But there's more value here than meets the eye. Unlike most brick-and-mortar retailers, Sportsman's Guide's catalog and Internet operations require very little in the way of capital expenditures. That's the advantage of selling out of a massive warehouse versus costly individual retail outlets. As a result, the company actually generates free cash flow well in excess of net income. By my conservative estimates, free cash flow for 2002 amounted to $4.9 million, or $0.98 per share. On that basis, the stock is priced at only eight times free cash flow.
Not to sound like a Ginsu knife commercial, but there's even more. Strong free cash flow over the past year allowed Sportsman's Guide to close the year with $17.9 million in cash and no debt. That's $3.43 per share in net cash. When you subtract that amount from the stock price, the enterprise value per share is only $4.45. So, on an EV-to-FCF basis, the stock trades at an astoundingly low multiple of 4.5. That, dear Fools, is fire-sale cheap.
Of course, that's just a quick valuation summary. To give you a fuller picture of this company and its investment potential, I want to return to this column's roots and put Sportsman's Guide through the paces of the Foolish 8 investment criteria. Remember those? They're the eight criteria for small-cap growth stocks that David and Tom Gardner presented in their first book, The Motley Fool Investment Guide. Let's see how Sportsman's Guide fares on these criteria, and then we'll try to draw some conclusions.
1. Annual revenue less than $500 million. This may seem like an arbitrary criterion (and it is), but the Foolish 8's $500 million revenue requirement is used to delineate small companies from large ones. The idea here is to focus on small businesses, not just small caps. Indeed, Sportsman's Guide is a small company, having produced 2002 revenue of $180.3 million.
2. Earnings and sales growth of at least 25%. Obviously, the goal here is to target fast-growing companies. That Sportsman's Guide is not. Sales for 2002 grew only 6.3%. The company is, however, becoming much more profitable. Earnings per share for 2002, on a tax-equivalent basis, grew by 63%. The catalyst for this growth was a lower mix of high-overhead catalog sales and a higher mix of Internet sales, which increased to 30% of the business, up from 21% in 2001. So given the high rate of earnings growth, Sportsman's Guide technically meets half of this criterion; but from the perspective of whether the company is truly a fast-growing enterprise, it falls short.
3. Net profit margin of at least 7%. All things being equal, a high net margin is better than a low one; hence the value of this criterion. But all things are not equal when it comes to business models. Sportsman's Guide, with its 2.2% net margin in 2002, fails on this test -- even while actually being a strongly profitable company. The secret here is that what Sportsman's Guide lacks in profit margins, it makes up for in capital efficiency. In 2002, the company required only $10.7 million in average invested capital, on which it earned $4 million in net income. That's a return on invested capital of 37.4%.
4. Daily dollar volume of $1 million to $25 million. This range of daily dollar volume is high enough to support decent liquidity, while low enough to indicate a stock that hasn't been widely discovered. As it turns out, Sportsman's Guide is still too small to qualify on this criterion. Multiplying its average daily volume of 26,545 shares times the current stock price of $7.78 results in an average daily dollar volume of just over $200,000. There are pros and cons with a stock this thinly traded: While it can occasionally trade with volatility akin to a gnat in the wind, it also represents a unique opportunity that's available only to private investors and small hedge funds.
5. Insider holdings of at least 10% ownership. Management and shareholders don't naturally have the same agendas, a problem known as "agency risk." But this risk can be vastly reduced when management has meaningful share ownership. On this measure, Sportsman's Guide qualifies. Even after a good bit of selling by management this past year (understandable given the stock's huge run since 2000), insiders still own about 10.5% of outstanding shares, by my estimates.
6. Share price of no less than $7. A stock price below $5 is almost a universal sign of financial distress. (Not in every case, but very often it is.) This screen's purpose is to set a bar comfortably above that $5 threshold. After a strong year in 2002, Sportsman's Guide now qualifies with its $7.78 price tag.
7. Relative strength of 90 or higher. Stocks can gyrate to and fro in the short term, but a return measured over a year or more is typically a good indication of improving or declining fundamentals. This screen is designed to target companies that are in the top decile of stock market performance over the past 52 weeks. In the case of Sportsman's Guide, its 54% return over the past year qualifies it, with a relative strength of 95.
8. Positive operating cash flow. As is so often hailed in Motley Fool articles, we believe cash is king, and that starts with positive cash flow from operations. Sportsman's Guide has no problem in this department, having spun out about $8.6 million in cash from operations in 2002 (my estimate; no cash flow statement is yet available).
Drawing conclusions
Add 'em up, and Sportsman's Guide meets only five of the eight criteria. Does this mean the stock isn't as much of an opportunity as I portrayed at the outset? No, it just goes to show the weakness of any static set of investment criteria. The Foolish 8 comprises a great tool for finding small, high-quality growth companies; it's a much less effective tool for evaluating any and every small company.
That the Foolish 8 is just one out of many tools for finding and evaluating small caps brings me to an important point. Over the past year, regular readers have probably noticed that this weekly "Small Cap Foolish 8" article is very rarely on the strict subject of Foolish 8 investing. That's because the Foolish 8 criteria are a formula for finding a very specific type of small-cap growth stock, whereas I and the other writers for this feature are typically writing from a broader value perspective in which growth may or may not be part of the equation.
That's why today's column will be the last one under the "Small Cap Foolish 8" banner. But before you shed any tears, I have some good news: In place of the weekly Foolish 8 column, we're starting something totally new (part of the larger programming changes announced last week). Beginning next week, The Motley Fool will be rolling out writer-based columns, including that of yours truly. That means next Monday I'll be back to begin a weekly column devoted to the hunt for value. This will be a broad-based search for stock market value -- be it small or large cap, fast or slow growth, long or short. Under this new format, you can count on all Fool columnists to live up all the more to our goal of being investors writing for investors.
Matt Richey ([email protected]) is a senior investment analyst for The Motley Fool. At time of publication, he owned shares of The Sportsman's Guide. For Matt's best Foolish stock ideas and in-depth analysis that you won't find anywhere else each month, check out our newsletter, The Motley Fool Select. The Motley Fool is investors writing for investors.
