Shares of Dick's Sporting Goods (NYSE:DKS), one of the fastest-growing sports retailers, went on a tear immediately following its October 2002 IPO. Things cooled off somewhat after the company announced its acquisition of competitor Galyan's in July 2004, and investors have been working overtime since then to determine whether the large acquisition will spoil what has otherwise been an impressive performance record. Recent results shed some light on this subject, and I have some concerns about the current valuation.
Earlier this week, Dick's announced Q4 and 2005 results. Earnings per share, according to generally accepted accounting principles, increased by an impressive 27%, while net sales grew 8% and same-store sales (an important metric for retail stocks) climbed by 4.1%. For the year, the company stated that pro forma EPS increased 50% to $1.75 year over year, excluding merger and store-closing costs. On a GAAP basis, EPS increased by only 4%, however. Results were not exactly straightforward because of the acquisition, but they should become more visible as former Galyan's stores enter the comparable-sales base starting in the second quarter of fiscal 2006.
Management also offered 2006 guidance; it expects EPS of $1.77-$1.81, inclusive of stock-option expenses. Based on where the stock is currently trading -- it closed at $37.82 on Wednesday -- this represents a forward P/E of about 21.
Recent results indicate that merger-integration efforts are going well. Store comps from Galyan's have finally started to improve, and organic growth came in ahead of expectations. Monday's Foolish Forecast for Dick's highlighted that net margins have been under some duress over the past 18 months and that the stock is currently a bit pricey with little free cash flow. But if the trend for store comps continues to improve, then margins should recover accordingly.
Let's look at FCF in a bit more detail. For Dick's, operating cash flow has been strong, but as is the case for companies aggressively expanding their operations, FCF is minimal at present. In Dick's case, it's facing high capital expenditures in the form of opening new stores.
According to my estimations, FCF at Dick's was about $43 million for 2005 and about nil for 2004. But Dick's does have strong operating cash flow and appears to be prudently growing the company's store base. Indeed, management has a strong track record of profitable growth and explicitly focuses on return on capital (another important Foolish metric), which it lists at about 10%-12%.
What type of growth is the market expecting from Dick's? Based off a two-stage earnings discount model -- major inputs include a 13% cost of capital and a 3% terminal growth rate -- I currently estimate that the company must grow approximately 14% for the next 10 years to justify the current stock price. Of course, any present value earnings model is quite sensitive to estimates of cost of capital and the terminal growth, so it's important to consider a reasonable range of values.
Overall, I believe that growth expectations are within reason but are somewhat aggressive right now. Because of the acquisition of Galyan's, results for 2005-2006 are a bit less visible in terms of comps, indebtedness, and overall profitability. Accordingly, the stock has been on a bit of a wild ride as investors work through all of the details.
Based on where the stock trades now, I'd wait a couple of more quarters to ensure that Galyan's has been successfully integrated. I'd also like to see the company pay down its debt a bit and get the debt-to-capital ratio well below 50%. That would also improve return on capital.
I'd be much more interested in the stock in the low $30s, so I'll sit on the sidelines for now. I'm hopeful for the future, though, given that Dick's is one of the better-run sporting retailers, compared with pure-play competitors such as Cabela's (NYSE:CAB), Sports Authority (NYSE:TSA), and Gander Mountain (NASDAQ:GMTN).
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Fool contributor Ryan Fuhrmann has no financial interest in any stocks mentioned (that means he's neither long nor short the shares). Feel free to email him for further discussion.
