We actually think that DKS has decent business momentum due to the category it is in, which is something not many retailers can say these days. But the reality is that our 6% comp expectation is 1% above the Street, and we’re both coming in $0.02 ahead of the high end of guidance.
Over the past two years, the company has come in above initial guidance – which it raised in this the quarter that it’s about to report. But we think that this year will be different. We don’t think we’ll see guidance go higher due to margin pressures and the overall uncertainty associated with the Macro climate. But also remember that one of its largest vendors (Acuschnet: Titleist/Foot Joy) is being spun off of its parent. That’s not bad. In fact it might be good. But it’s simply different. Foot Locker is comping positive for the first time in a very long time – and therefore traffic is shifting, on the margin, to the mall. It might only be slight, but it matters.
Keep in mind that this is not a good business. Yes, Dick’s is ‘best in class,’ we COMPLETELY get that. Yeah, manage it about as good as it gets in this business. But that does not make it a good business. Margins are at peak today at 9%, though they’ve averaged closer to 4% over the past 10 years. At the same time, return on assets is perennially hugging the 7% mark and working capital turns of 2x. That gives us a sub-10% RNOA how we do the math, and that’s BEFORE actually charging the company for the leases. Imagine that? Actually baking property costs into the model? That reminds me of a presentation I saw in the tech bubble when an analyst was talking about a term called ‘profit before costs.’ I call that revenue.
Where we could be wrong on the quarter, however, is in those very occupancy costs. While Hibbett and Foot Locker can leverage occupancy costs on a flat comp, DKS needs about 4%. We’re talking 5-6% comps here. So the flow-through on (an unsustainable) 7% would be material. But with the stock trading at 24x earnings, and just over 10x EBITDA, we think that near term expectations are way too high for a poor quality business.
Here’s a look at some of the key modeling considerations for the quarter:
Sales: +8.4% on a +6% comp - This represents a 2-year deceleration of nearly 350bps. A few factors to bear in mind…
a) Given the company’s mix consisting of primarily hardlines (54%) with the balance apparel (28%) and footwear (18%), we have good visibility into sales performance for half the business through our industry sports data. In the case of DKS, greater exposure to apparel is favorable with the category up +9% while footwear increased nearly 4% during the quarter. Our proprietary blended mix, which as been within a +/- 200bps margin in seven of the last eight quarters suggests a positive comp of +7.3% in the 1Q. However, with golf facing its toughest compare of the year (+12.4%) aided by continued double-digit growth in e-commerce, we anticipate a LSD comp in hardlines and the total aggregate comp to be slightly lower at +6% for the quarter.
b) Within footwear, two the company’s leading footwear categories have improved considerably versus last year with running up +21% compared to +12% last year and basketball up +3% vs. -3% alleviating a drag from the prior year. Similar to Foot Locker, while toning is a concern, we see favorable growth in running, basketball, and cross trainers driving higher sales and ASPs.
c) One of the realities to consider during the quarter is that we had the wettest April in 20-years. This impacts the company’s Team sports sales and there were few if any retailers that didn’t highlight the Northeast and Northern Midwest as the weakest performing regions in April last week. Just how much weather may have impacted sales is tough to quantify, but it clearly dampens potential upside to sales.
d) Unlike most other retailers that are benefiting from the weaker USD, DKS does not have a FX tailwind to help boost the top-line.
e) Over the last two-years, management at Dicks has had a history of sandbagging comp expectations. Take a look at the chart below. The company has exceeded the midpoint of same store sales guidance by an average of +470bps over the last eight quarters coming in less than 200bps better only once in Q2 F09 when shares responded with a ~10% correction. Our +6% comp estimate implies only 150bps above guidance and is slightly higher than the Street’s expectation for +5% (+50bps). I liken this ~200bps ‘buffer’ similar to the markets margin of beat expectation when Ralph Lauren reports each quarter – there’s an expectation, that if met is not received favorably. While the Street sits at +5%, we think the market expects significantly higher.
a) Merchandise margins accounted for 140bps of gross margin expansion in 2010 with occupancy leverage accounting for another ~60-80bps. While management expects little to no occupancy leverage in 2011, the company is increasingly reliant on continued improvement in merchandise margins driven primarily by more favorable mix, inventory management, an regionalization efforts, which better tailors product to specific geographies. The fact that the later was not already in place for a best-in-class industry retailer is surprising if not downright scary, but certainly presents opportunity for further improvement.
b) With an average lease duration of approximately 10-years, the company only turns 10% of its portfolio each year compared to most retailers that have an average duration closer to 5-years limiting the magnitude of occupancy leverage relative to peers. Coupled with tougher compares when occupancy leverage added 60bps to the Q1 last year, we expect little by way of contribution in the 1Q and the year for that matter.
c) Inventories are in good shape heading into the quarter. With an increase in private label sales now representing over 15% of total sales we expect more favorable product mix to account for the 50bps expansion in the quarter muted by the 200bps expansion realized in Q1 last year.
d) What’s good for the top-line weighs on margins. With apparel accounting for ~28% of sales compared to Foot Locker at around 10% - higher costs are starting to be felt throughout the supply chain and DKS is no different. Management’s comments over the last two quarters concerns me here:
- First, in Q3 management commented that it was buying for Q3 and Q4 of 2011 and not seeing “any pressure that makes us uncomfortable.”
- Then, on the Q4 call Ed Stack (CEO) highlighted that he, “do(es) see some of that pricing increase affecting some of our private-brand products, some of our vendors. But there's a number of our important vendors that have had very little increases in price in the back half of 2011. But I get a little bit concerned that we're going to see that hit us in 2012.” Sounds like management was just starting to face reality by the end of 2010. If tone is any indication of how they’re managing higher costs, our sense is that management is not adequately planning for the pending margin hit.
SG&A +7% (-30bps)
a) Two key factors to consider in Q1 is that the company anniversaries nearly $8mm in one-time technology related investments in the company’s new headquarters, DC, and online efforts in addition to various marketing initiatives.
b) The company also front-loaded marketing spend in the 4Q to drive Q1 sales. We suspect the company realized a favorable shift in spend in Q1 as a result.