There's a season for studying new investment ideas, and there's a season for keeping track of the companies you already own. I'm in the latter right now because so many of my companies have recently published their annual reports -- and more importantly, their annual SEC Form 10-K. Ahh, to a nerdy analyst like myself, there's nothing like relaxing with a 10-K and a cup of coffee.
Yes, I'm an unabashed 10-K fan. The fact that these documents run 80-plus pages of colorless text does nothing to dispel my enthusiasm. Besides, you don't have to read all 80 pages to get the substance. I focus on the business description -- typically the first section, labeled "Item 1" -- which offers the most candid, no-spin, in-depth explanation of a company's business you'll find anywhere. I've never read a 10-K without uncovering at least a handful of striking insights.
So, my plan for today, and continuing for the next several Monday columns, is to share some of my findings from various companies' 10-Ks. No, I won't load you down with a full company review -- just some of the high points from my research.
We'll start today with Sportsman's Guide (NASDAQ:SGDE), one of my larger holdings and a company I've written about a number of times. Since first telling you about this niche outdoor gear cataloger in May of last year, the stock is up some 50%. Despite the strong run, however, there's still a lot of value here -- primarily because the stock was so darn cheap to begin with.
At the current price of around $9.05, shares of Sportsman's Guide are valued at 9.7 times free cash flow. Going one step further, when you back out net cash per share of $3.43, the price-to-free cash flow multiple drops to only 6.0. That's a low multiple for any company, but especially for one with such remarkable efficiency.
The big picture of efficiency: ROIC
How efficient is Sportsman's Guide? In 2002, it generated a return on invested capital (ROIC) of 39%. By my estimates using a proprietary database, Sportsman's Guide's ROIC is in the top 3% of all publicly traded companies. Perhaps even more important, its efficiency is on the rise, up from an ROIC of 19% in 2001. In other words, for each dollar invested in the business, Sportsman's Guide earned more than twice the profit in 2002 as it did in 2001.
Still, this is all very high level. What are the underlying causal factors for this boost in ROIC? That's the question I want to answer today. The 10-K provides three key metrics that shed tremendous light on exactly what Sportsman's Guide is doing to optimize its business:
1. Buyer's Club, garnering customer loyalty
Buyer's Club has been the company's most important and successful marketing initiative to date. The club is a fee-based discount buying program, à la Costco (NASDAQ:COST). Begun in late 1999, Buyer's Club now boasts 310,000 members, up 21% over the past year and now accounting for 31.7% of all active customers.
Here's how it works: Club members pay $29.99 per year (or $49.99 for two years) to get 10% off all purchases. In addition, members receive an exclusive monthly catalog, "Buyer's Club Advantage," which offers special deals and limited-availability merchandise. Together, the discount privilege and the extra catalogs help drive purchasing activity among club members that's two to three times greater than that of non-club members.
This increased purchase activity of Buyer's Club members reveals itself in another important metric -- average sales per customer, which reached $185 in 2002, up from $163 in 2001 and $148 in 2000. Those numbers reflect a massive boost in customer loyalty.
2. Maximizing catalog productivity
Another important aspect of Sportsman's Guide's success in recent years has been a concerted effort to maximize catalog productivity. Its strategy here has been to concentrate mailings to only the most profitable customers, such as Buyer's Club members, and dramatically reduce or eliminate mailings to less active customers.
This is a winning strategy straight out of Peter Drucker's managerial school of thought: A business must deliberately choose its customer and play only to the most profitable segment. Of course, if you're being choosy about your customer, you're likely to lose a few customers in the process. Accordingly, Sportsman's Guide has seen a slight reduction in its active customer base (meaning those who have purchased in the past 12 months):
(millions)
1999
2000
2001
2002
Active customers 1.15 1.05 1.04 0.98Catalogs mailed 80.3 62.5 48.0 45.8
Losing customers would ordinarily be a very bad sign, but as you can see in the table above, the loss of customers is minuscule compared to the reduction in catalog circulation. Between 1999 and 2002, Sportsman's Guide was able to cut its circulation by 43%, while losing only 15% of its customers.
These cuts in catalog circulation have allowed Sportsman's Guide to save millions on printing and postage costs. The result in 2002, for the first time ever, was profitability in all four quarters of the year. In past years, under higher catalog circulation, it was profitable only in the fourth quarter, with losses in the other three quarters.
Given that catalog productivity is so important to its business, I track a ratio of my own: catalog sales per catalogs mailed. This ratio answers the question, how much sales are generated by each individual catalog? This ratio has been improving nicely over each of the past three years, demonstrating the company's awesome strides to get the most bang out of each and every catalog:
1999
2000
2001
2002
Sales per catalog $2.16 $2.10 $2.78 $2.79
In sum, Sportsman's Guide has refined its catalog operations to a nearly perfect science.
3. Reaping benefits from the Internet
The Internet was supposed to "change everything" -- and for catalog retailers, it actually did. The Sportsman's Guide website is essentially an electronic version of the catalog, creating a very similar sales experience but without any of the catalog's prohibitive printing and postage costs. In addition, its management estimates that its cost to process an Internet sale is only $0.50, versus $4 to $5 for a telephone-based sale.
With all the economic advantages afforded by the Internet, Sportsman's Guide has been pushing its customers online since 1998. Since then, the company's huge catalog circulation has served as an instrumental marketing tool -- and the company's only marketing tool -- in driving sales to the website. Apparently, it didn't need any help from outside advertising or promotion, because the mix of sales to sportsmansguide.com has grown dramatically each of the past four years:
1999
2000
2001
2002
Internet sales, as % of total sales 7.7% 15.3% 21.3% 29.1%
As sales continue to shift to the Internet, Sportsman's Guide stands to reap increasing efficiencies, especially in the area of marketing. Unlike catalogs, with email, the company can liberally send out promotions at very little incremental expense. Already, it sends out weekly or biweekly email to 879,000 people, who have voluntarily chosen to receive such promotions.
The catalogs will no doubt continue to be the primary sales driver for Sportsman's Guide, but the Internet opens the door to capturing marginal customers that wouldn't be cost-effective via catalog.
Putting it all together
Sportsman's Guide will never be a household name like Amazon (NASDAQ:AMZN), but it runs an operation no less lean and mean. And at an enterprise value-to-free cash flow multiple of 6.0, Sportsman's Guide looks a heckuva lot better as an investment than Amazon at a comparable multiple of 83.
Next week, I'll offer some thoughts about ValueClick's (NASDAQ:VCLK) 10-K and explain why I recently sold the stock.
Matt Richey ([email protected]) is a senior analyst for The Motley Fool. At the time of publication, he held shares of Sportsman's Guide. 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.
