Judging the Players

Most of us here at the Fool are sports fans. The office is littered with bikes, footballs, bats, and athletic shoes. Following the recent World Series, gloating Sox fans wandered through HQ in full Boston uniforms -- yeah, a little weird -- while St. Louis mourner Rex Moore simply put a Cardinals paperweight next to his mouse pad.

As you might expect from a group that repeats Peter Lynch's advice of buying what you know and love, the Foolish affection for the sweaty arts leads us to consider whether or not there's a buck to be made for prospective shareholders in the sports biz. Short of trading billboard British footballers Arsenal, Manchester United, or Newcastle United, we're forced to live more vicariously through those who sell the gear.

Among equipment manufacturers, Nike (NYSE:NKE), Reebok (NYSE:RBK), and K2 have caught our eye, while lesser-known foot fitter Saucony (NASDAQ:SCNYB) has given investors a 173% gain since it was a Hidden Gems pick.

The big game
But today, I want to take a look at a few of the major retailers, the ones who sell the dream to the rest of us. Shoes, jerseys, bats, gloves, blades, and clubs -- there are plenty of places for us to get this stuff. The Sports Authority (NYSE:TSA), Dick's Sporting Goods (NYSE:DKS), Finish Line Sports (NASDAQ:FINL), and shoe specialist Foot Locker (NYSE:FL) are the biggest and the brightest. First off, three of the four have beaten the broader market handily so far this year. They capitalize on our hankering for competition, so how do they stack up as investments when compared to each other? Lest you think it a bit facile of me to set these firms up and race 'em, I got the idea directly from an employee of one of the firms. In a bit of quality electronic trash talk, he told me, "We are eating Foot Locker's lunch."

Let's start by getting acquainted. While we're all familiar with The Sports Authority and Foot Locker, Dick's is -- for the time being -- an East Coast phenomenon. Finish Line is another mall-based retailer with a strategy of trying to provide the big sports-store experience inside the shopping center. With its large stores and blob-like penchant for consuming the competition -- including Sportmart and a merger with Gart Sports -- Sports Authority might seem like the gorilla of the group, but those honors actually go to mall-based Foot Locker, with its $3.6 billion market cap and $5 billion in sales.

On the face of things, there's quite a difference in the valuations. Dick's trades at a premium to its peers, owing, in large part, to the excellent execution that we've discussed in these pages several times. The Sports Authority is the other stranger in the bunch. It seems ludicrously cheap from a price-to-sales standpoint yet far more expensive in relation to earnings. Regular readers here will remember that I've had harsh words for the company and its habit of providing less information than necessary for investors to get a handle on its prospects. It's no secret that the company has stumbled more than a little bit in its efforts to complete the recent merger, which begins to explain the schizophrenia in those ratios. A closer look at operations sheds a little more light on the playing field.

Answers in the margins?
The amount of money these firms bring down to the bottom line is a good measure of what matters to shareholders. From that standpoint, we have some definite winners and losers in this bunch. Make that three winners and a loser. Care to guess which is the loser? Hint: It rhymes -- kind of -- with "Mork's Seniority." Seems that in the sporting goods biz, as in the major leagues, some teams improve, and others continue to flounder.

The tale of current net margins does a lot to explain why The Sports Authority looks both so expensive and so cheap. It's inability to leverage acceptable gross margins into competitive earnings means that investors get very little from the huge revenue base.

The other thing to eyeball here is the trend. While the top three here have all made strong moves toward increased profitability over the past few years, The Sports Authority remains all over the map.

Marginal trends
Take a closer look at the numbers above. Dick's margin growth, while robust, seems to have leveled off, while Finish Line and Foot Locker continue to contain costs and bring more to the bottom line. Given their advantages here, why don't they command the kind of premium we see at Dick's? The reasons for big discrepancies in valuation between companies that look similar on the surface can often be traced to key metrics such as those in the table below. Let's get the last column out of the way right off. Enterprise value-to-free cash flow (EV/FCF) is a Foolish measuring tool that puts a premium on real, cash earnings available for stockholders. (Remember, earnings are an accounting opinion. Cash is tougher to fake.) FCF is often slim -- or entirely absent -- from companies that are expanding rapidly, as cash from operations is consumed by capital expenditures in order to fund yet more growth.

By this standard, none of these companies is exactly generating excess cash, meaning shareholders are banking on growth for now and cash, perhaps, in the future. Do note that it's not impossible for fast-growing retailers to still generate excess cash. Chico's FAS comes to mind. And Dick's itself did better a few years back.

Reaching for the tape
It looks like Dick's valuation is mostly an artifact of greater hopes, given its solid performance in the past and growth estimates that outrun the competition by a good four percentage points. But the second column in that table, the PEG, attempts to reconcile price-to-earnings-to-growth. Even considering the higher expectations, Dick's is still more richly valued than any of the other players. This may be owed to the firm's superior return on equity (ROE). This important measure of potential shareholder rewards still leads this group, but in fact, at Dick's, it's been declining steadily for several years, from a high of 46% in 2002. For this reason, Dick's stock looks fully, if not richly, valued to me.

Speaking of trends, you many want to take a look over your shoulder at Finish Line. In addition to continuing to improve its margins and increase its rate of sales growth, the firm has made tenfold improvements in ROE and return on assets (ROA) since 2001. Factor in plenty of cash, no debt, and a reasonable-looking valuation, and this sport should make anyone's short list on draft day.

Foot Locker is on a similar trajectory, having doubled ROE and ROA in the past three years. And the familiar shoe-hawker's expanding international presence may offer it growth opportunities that its peers don't have. As a final bonus, the stock pays yields of 1% -- not enough to get it on the radar screen of our dividend-hungry Income Investor -- but better than a baseball to the old noggin.

And finally -- do I need to say it? -- The Sports Authority is simply a wreck. Avoid it at all costs. If the numbers here don't convince you, visit one of its stores and see what you think. I know the last two I encountered bore ample evidence of the operational problems that are exhibited in the financials.

For related Foolishness:

• Can you find hidden gems in the mall?
• Is Nike an undervalued powerhouse?
• Will all those acquisitions crush K2?
• See why this sport comes up short.
• Review the basics: free cash flow, return on equity, and return on assets.

At The Motley Fool, we believe it's more important to teach folks to fish than just hand out the trout. But if you'd like a little something to munch on while you pick up the basics, you'll enjoy the stock picks in our newsletters. A trial is always free.

At the time of publication, Seth Jayson held shares of Reebok and Chico's FAS but had no position in any other firm mentioned. View his stock holdings and Fool profile here. Fool rules are here.