This note was originally published March 25, 2013 at 21:44 in Retail
Conclusion: We think the biggest takeaway from the Dick's Sporting Goods (DKS) 10K is the one that noone will talk about. Specifically, the rate at which the company has been de-risking its real estate portfolio has halted in its tracks. We recently turned negative on DKS -- and that was before having this data point. A negative change on the margin in its lease portfolio on top of weak comps, peak margins, and a dramatic increase in capital intensity is a great formula for returns to go negative. DKS remains a value trap. Avoid it.
Here’s Our Logic
One things we focus a lot on is a given company’s ‘Lease Flexibility Ratio’, which is a term we use to measure the weighted average duration of a company’s operating lease portfolio. We calculate this by dividing the total lease obligations by the payments obligated in year one. Simply put, in almost all cases, the shorter the Lease Flexibility Ratio, the more flexible and healthier it is for the company in question. This does not mean that the asset is not secured for a longer time period, but simply that the minimum financial obligation associated with the asset is low.
Why would a company have a high ratio (ie very inflexible)? One of two reasons. 1) Either it has extremely long-dated leases. Target and Whole Foods are both at 20x, while Kohl’s is 26x (JCP is only 11x -- bad for KSS). 2) The other reason would simply be that a given retailer wants to secure real estate that it can’t afford. If such is the case, then one of three things happens.
a) The retailer signs up for a significantly escalating minimum payment each year, or
b) It signs up for a location before competitors, and accepts the obligation well before it sees associated sales, or
c) It removes kick-out clauses or other safety features that would otherwise reduce certain obligations in the out-years of a lease agreement.
We think DKS is a combo of a) and b).
We look at these ratios to compare two things; 1) a given retailer’s lease structure versus competitors, and 2) how a company’s lease portfolio changes on an annual basis versus itself. That’s where Dick’s is interesting.
Historically, DKS has had a Flexibility Ratio that we’d call egregious. 5-years ago, for example, DKS’ average portfolio duration was over 12-years. That’s nearly as high as Costco – which sits at 14x. Costco is a destination if there ever was one in retail. Dick’s may be a nice store, but it’s no Costco.
The good news is that over the past 4-years, DKS’ weighted average duration has come from 12.2 years down to 8.0 years. That’s been very bullish for DKS’ ability to leverage occupancy with a lower comp than the 4-5% it needed back in 2007. We’ve seen that hurdle rate come down closer to 3% over the past few years. Again, good news.
The bad news is that in 2012 it ticked back up again. It only went up by 0.2x, which is hardly enough for us to cry wolf. But make no mistake, the reduction in its lease minimums is one of the factors why we’re been positively predisposed to owning DKS at certain times throughout the past few years.
But today, margins are at peak, comps are trending only in the +1-3% range, and management admitted that it needs catch-up investment to acquire the appropriate omni-channel strategy. As such we’re seeing capex trend up this year by almost a third to $300mm, without an obvious near-term payoff. Maybe we’d be patient for a retailer with above-average defendability in its business model, but unfortunately, we think that over a third of DKS’ business is at very significant risk from web-based competition (not to mention brands’ own direct brands – mind you, Nike is 17% of sales).
Our research call here is clearly negative.