INTRINSIC VALUE ASSESSMENT OF

DICK’S SPORTING GOODS INC. (DKS)

APRIL 30, 2018 This article was written with David J. Flood from The Investor’s Podcast

IntroductionDick’sSportingGoodsInc.isanAmericanbasedomnichannelsportsgoodsretailerwhoseoperationsinvolvethesaleofsportsequipment,apparel,footwear,andaccessories.Thefirm’smarketcapcurrentlystandsataround$3.31Billionanditsrevenuesandfreecashflowsforthepreviousfinancialyearwerearound$8.6Billionand$0.27Billionrespectively.Thecompany’scommonstockhasfluctuatedbetweenahighof$52andalowof$24overthepast52weeksandcurrentlystandsataround$34.IsDick’sundervaluedatthecurrentprice?

The Intrinsic Value of Dick’s Sporting Goods, Inc.TodeterminetheintrinsicvalueofDick’s,we’llbeginbylookingatthecompany’shistoryoffreecashflow.Acompany’sfreecashflowisthetrueearningswhichmanagementcaneitherreinvestforgrowthordistributebacktoshareholdersintheformofdividendsandsharebuybacks.BelowisachartofDick’sfreecashflowforthepasttenyears.

Asonecansee,thecompany’sfreecashflowhasbeenlumpyoverthepastdecadewhichisacommonfeatureforcyclicalcompanieswhosebusinessistiedtothefluctuationspresentinthebusinesscycle.TodetermineDick’sintrinsicvalue,anestimatemustbemadeofitspotentialfuturefreecashflows.Tobuildthisestimate,thereisanarrayofpotentialoutcomesforfuturefreecashflowsinthegraphbelow.

INTRINSIC VALUE ASSESSMENT OF

DICK’S SPORTING GOODS INC. (DKS)

Whenexaminingthearrayoflinesmovingintothefuture,eachonerepresentsacertainprobabilityofoccurrence.Theupper-boundlinerepresentsa5%growthratewhichisbasedonthemarket’scurrentexpectationsforthecompanyisthenextfiveyears.Thisgrowthratehasbeenassigneda30%probabilityofoccurrencetoaccountforthethreatofcompetitivepressurefromthefirm’speersandtheincreasinglikelihoodofarecessionaryenvironmentemerginginthenexttenyears.

Themiddlegrowthlinerepresentsa0%growthratewhichisbasedonthefirm’shistoricalfreecashflowgrowthfortheprevioustenyears.GiventhecompetitivepressureDick’sisfacingandsignsofweakeningconsumerdemand,thisscenariobeenassigneda60%probabilityofoccurrence.

Thelowerboundlinerepresentsa-5%rateinfreecashflowgrowthandassumesthatconsumerdemandfurtherweakensandthatcompetitivepressurescontinuetomount.Thisgrowthratehasbeenassigneda10%probabilityofoccurrence.

Assumingthesepotentialoutcomesandcorrespondingcashflowsareaccuratelyrepresented,Dick’smightbepricedclosetoa7%annualreturnifthecompanycanbepurchasedattoday’sprice.We’llnowlookatanothervaluationmetrictoseeifitcorrespondstothisestimate.

BasedonDick’scurrent‘forwardrateofreturn,’ametricwhichusesnormalizedfreecashflowplusrealgrowthandinflation,thecompanyiscurrentlyyielding13.91%.Thisisinlinewiththefirm’s10-yearhistoricalmedianof13.90%,suggestingthatthecompanymaybetradingatafairvaluerelativetoitshistoricalcomparison.Finally,we’lllookatDick’snormalizedfreecashflowyield,ametricwhichassumeszerogrowthandsimplymeasuresthefirm’saveragefreecashflowforthelasttenyearsagainstitscurrentmarketprice.Atthecurrentmarketprice,Dick’shasanormalizedfreecashflowof5.92%.

Takingallthesepointsintoconsideration,itseemsreasonabletoassumethatDick’siscurrentlytradingaroundfairvalue.Furthermore,thecompanymayreturnaround7%atthecurrentpriceiftheestimatedfreecashflowsareachieved.Now,let’sdiscusshowandwhytheseestimatedfreecashflowscouldbeachieved.

INTRINSIC VALUE ASSESSMENT OF

DICK’S SPORTING GOODS INC. (DKS)

The Competitive Advantage of Dick’s Sporting Goods, Inc.Dick’sSportingGoodsInc.hasvariouscompetitiveadvantagesoutlinedbelow.

• NicheAttribute.Dick’sdifferentiatesitselffrommanyofitscompetitorsbyoptingtostockhigher-endspecialtyproductsandmerchandisewhichtypicallycarryhighermarginsthanmidandlow-tierproducts.Thisallowsthecompanytooutperformtheindustryonseveralkeymetricsoutlinedinthetablebelow.

• Omni-channelModel.Dick’shasgrowntobecomethelargestomnichannelfull-linesportsretailerintheU.S.Byemployingthismodel,thefirmisbetterequippedtoreachitstargetcustomersandeffectivelymarketitsproducts.Overthepastyear,thefirmhasmoveditse-commercebusinessin-housewithonlinesalesgrowing16%YOYandnowaccountingforover10%ofnetsales.Bycombiningthefirm’sestablishedbricks-and-mortarbusinesswithitse-commerceplatformandintangibleassetssuchasitsdatabase,Dick’spossessesthecompetitiveadvantagesnecessarytogrowitsmarketshare.

Figure1:Source,Dick'sWebsite

• IntangibleAssets.Throughstrategicacquisitions,Dick’shasbuiltupadatabasecontainingdataonthesportsparticipationofseveralmillionindividualsacrosstheyouthdemographic.Theseacquisitionsincludetheregistrationcompany,BlueSombrero,thegoverningbodysupportsystem

INTRINSIC VALUE ASSESSMENT OF

DICK’S SPORTING GOODS INC. (DKS)

Affinity,andGamechanger(aleadingconsumerappwhichlogsscoringandstatistics).Bypartneringwithnumeroussportsgoverningbodies,Dick’scontinuestobuildthisdatabasewhichallowsittotailoritsmarketinginanincreasinglyeffectivemanner.ThisisapowerfulcompetitiveadvantageforDick’sasneitherAmazonnorTargetpossessessucharichdatabaseofinformation.

Dick’s Sporting Goods Inc.’s RisksNowthatDick’scompetitiveadvantageshavebeenconsidered,let’slookatsomeoftheriskfactorsthatcouldimpairmyassumptionsofinvestmentreturn.

• Dick’siscurrentlyfacingincreasingcompetitivepressureascompaniessuchasNike,Adidas,andUnderArmourareoptingtomovetoAmazonortoselltheirproductsdirectlytotheconsumerthroughtheirownstoresandwebsites.Atpresent,Dick’slargesttwovendors,NikeandUnderArmour,accountforabout20%and10%ofmerchandisesalesrespectively.WithNikeandAdidasaimingtoachieve30%and40%respectivelyregardingdirect-to-consumersalesasaproportionofrevenuegrowthby2020,Dick’smayfacetheriskofobsolescenceifitcannotadapttothesechanges.

• AkeydriverforDick’sbusinessisyouthparticipationinsports,butthecurrenttrendsdonotappeartobemovinginthecompany’sfavor.ArecentstudybytheAspenInstituteshowsadeclineinregularparticipationinbothindividualandteamsportsforchildrenbetweentheagesof6and12intheUnitedStates.

Figure2:Source,aspenprojectplay.

• Dick’shasrecentlylaunchedapricematchingprogramwithmanyofitscompetitorsincludingAmazon,Target,FootLocker,andKohl’s.Thecompanyhasstatedthatitwillmatchanyqualifyingretailer’sin-storeoronlinepriceonidenticalitemswithcustomersgiventheoptionofwheretheywanttopricematch,beitonlineorinstore.TheimplementationofpricematchingandtheassociateddiscountingofproductsisariskyapproachforDick’sasitreliesonthecompanybeingabletomakeupforlossesthroughweakermarginsbygainsmadefromincrementalsalesgrowth.Thereisnoguaranteethatthisstrategywillbesuccessful,anditmayimpairperceptionofthefirm’sbrandasaspecialtyretailer.

INTRINSIC VALUE ASSESSMENT OF

DICK’S SPORTING GOODS INC. (DKS)

Opportunity CostsWheneveraninvestmentisconsidered,onemustcompareittoanyalternativestoweighuptheopportunitycost.Atpresent,10-yeartreasuriesareyielding2.96%.Ifwetakeinflationintoaccount,therealreturnislikelytobecloserto1%.TheS&P500IndexiscurrentlytradingataShillerP/Eof31.5whichis86.4%higherthanthehistoricalmeanof16.8.Assumingreversiontothemeanoccurs,theimpliedfutureannualreturnislikelytobe-2.5%.Dick’s,therefore,appearstoofferamuchbetterreturnforinvestorsatpresent,butotherindividualstocksmaybefoundwhichofferasimilarreturnrelativetotheriskprofile.

Macro Factors Investorsmustconsidermacroeconomicfactorsthatmayimpacteconomicandmarketperformanceasthiscouldinfluenceinvestmentreturns.

Atpresent,theS&PispricedataShillerP/Eof31.5.Thisis86.4%higherthanthehistoricalaverageof16.8suggestingmarketsareatelevatedlevels.U.S.unemploymentfiguresareata30-yearlowsuggestingthatthecurrentbusinesscycleisnearingitspeak.U.S.privatedebt/GDPcurrentlystandsat199.6%andisatitshighestpointsince2009whenthelastfinancialcrisispromptedprivatesectordeleveraging.

Summary Dick’sSportingGoodsInc.iscurrentlyfacinganumberofchallengeswhichdonotappeartobeabating.ItisfacingcompetitivepressurefromplayerssuchasAmazonandWal-Martwhoselow-costmodelisforcingDick’stodiscountitsproductsinanattempttoretainmarketshare.Despitethefirm’spricematchingprogram,FY2017resultsshowsame-storesalesdecliningbynearly1%.Lookingatthecompany’sperformanceoveralongerperiod,marginshavebeenonadownwardtrendsince2013withagrossmargindeclinefrom31.5%in2013to29%in2018,andanoperatingmargindeclinefrom9%in2013to5.6%in2018.

Thefirmisalsofacingtheproblemofmajorbrandschoosingtoselltheirproductsdirecttoconsumersviatheirownstoresandwebsites.Dick’sisoptingtofocusmoreonitsownprivatelabelbrandsinanattempttooffsetthis,butthereisnoguaranteethatthiswillbeawinningstrategy.

ConsideringhowDick’shasperformedinpreviousrecessionaryenvironments,investorsshouldbeundernoillusionthatthefirmwillnotbeadverselyaffectedshouldaneconomicdownturnmaterialize.Thecompanyis,however,inastrongfinancialpositionwithadebt/equityratioof0.03andanAltmanZ-Scoreof4.22suggestingthatthecompanyishighlyunlikelytobeatriskofbankruptcyinthecomingyears.

INTRINSIC VALUE ASSESSMENT OF

DICK’S SPORTING GOODS INC. (DKS)

Thereare,however,somefactorswhichmayworkinfavorofDick’s.Overthepastfewyears,anumberofthefirm’scompetitorsincludingSportsAuthority,VestisRetailGroup,andSportChalethavegoneoutofbusiness.Notonlyhasthisreducedcompetitionbutithasresultedmorethanclearanceinventoryenteringthemarketwhichhasdrivenupsupply.Assumingdemanddoesnotweaken,oncetheexcesssupplyisworkedthrough,Dick’smayseesalesbegintopickup.Dick’somnichannelstrategyisalsoshowingsomepositivesignsofe-commercepenetrationapproaching20%comparedto6.8%forTargetand1.5%forWal-Mart.

WithregardstoShareholderfriendliness,Dick’shasgrownitsdividendpaymentsonanannualizedbasisby5.26%since2012.Withinthatperiod,thefrimhasalsoimplementedsharebuybackprogramswhichhavereducedthesharecountbyanannualizedrateof2.54%

Insummary,Dick’sSportingGoodsInc.isfacinganumberofheadwindsincludingrisingcompetitivepressure,changingconsumertrends,andtheincreasinglikelihoodofarecessionaryenvironmentemerging.Basedontheconservativeassumptionsusedinthefreecashflowanalysis,Dick’smayreturnaround7%atthecurrentmarketprice,buttheauthoradvisesinvestorstocarefullyconsidertherisksbeforeconsideringaninvestment.

Disclaimer:Theauthordoesnotholdownershipinanyofthecompaniesmentionedatthetimeofwritingthisarticle.

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