In 1996, the Wall Street Journal wrote its first article on online competition for travel agents. “For more than a year,” the newspaper reported, “airlines have been trying to cut their payments to travel agents, who account for 80% of the bookings for some carriers, and the Internet holds potential for helping trim those costs.” In fact, the Journal felt there was a real risk that independent travel agents could become the “milk men” of the 1990s.
Fast forward twenty years. Online booking is simply superior because of efficiency, price and range of inventory. According to a CNN report from 2013, the number of bricks-and-mortar travel retail locations is 13,000, down from a peak of 34,000 in the mid-1990s. Those who do survive must do so on much lower commissions from airlines than they once earned.
What lessons can we learn from this experience? Is industry structure fate? That is, the travel industry in the 1990s was dominated by a few large suppliers, the airlines. By contrast, the travel agents were heavily fragmented with no single travel agent having significant market share. As a result, the travel agents were powerless to stop the airlines when they began to sell direct to consumers over the internet. Are all fragmented industry participants doomed to suffer the same fate?
This post will focus on the sporting goods industry which faces some of the same issues as the travel industry in the 1990s.
THE SPORTING GOOD INDUSTRY
The sporting goods industry in the US is relatively straightforward. There are three nationwide chains of generalist retailers, Dick’s (DKS, Financial), Big 5 (BGFV, Financial) and Hibbett (HIBB, Financial). The other big companies are either regional or specialists (or, in the case of Sports Authority, in liquidation). But the retail segment is highly fragmented. DKS is the industry leader with an estimated 10% market share. Other than the 11 companies shown below, there is competition from many mom-and-pop shops, big box retailers and Amazon.
Upstream, manufacturers supply everything from golf clubs to basketball shoes to camping stoves. Consumers buy the products via two primary channels, bricks-and-mortar stores and the internet.
As of 2015, sporting goods stores in the US generated $48 billion in sales, according to IBISWorld, up from $39.8 billion in 2012. Sports participation is up, too. According to Euromonitor, participation in high school sports has increased from 25 percent to 35 percent over the last 35 years, with nearly double the number of female students playing sports as compared to the 1980s.
Like the travel business, the sporting goods industry is dominated by a few large suppliers. For one nationwide retailer, Hibbett Sports (HIBB, Financial), just two vendors, Nike and Under Armour, provided over 70% of their inventory in fiscal 2016. The lines are increasing blurred between manufacturers, bricks-and-mortar retailers and internet-only sellers. Manufacturers sell direct-to-consumers (DTC) via the internet and bricks-and-mortar stores. Similarly, the traditional retailers all have web sites.
Traditional retailers have suffered in recent years. In the last year alone, we have seen five major bankruptcies: Sports Authority, City Sports and Vestis Retail Group (owners of the Sports Chalet, Eastern Mountain and Bob’s stores chains). Those who have avoided going bust have seen their market capitalizations slashed. HIIBB, for example, peaked at $67.50 at the beginning of 2014 and is at $35.80 as of the date of this post.
Given the similarities, is it inevitable that sporting goods retailers will suffer the same decline as travel agents?
Or, is there an alternative view here? Is it possible that certain bricks-and-mortar sporting goods retailers could survive and even thrive in the internet era?
HIBBETT SPORTS
We will focus on HIBB because it employs a differentiated business model. This business model greatly increases the probability that it will survive the current industry shake-up and to emerge stronger.
Hibbett is a sporting goods retailer headquartered in Alabama with a heavy store presence in the American Southeast.
Unique Real Estate Strategy
HIBB employs a unique real estate strategy that drives everything else. HIBB currently operates 1,053 small format stores of approximately 5,000 square feet in 33 states (for comparison, Dick’s has 746 stores averaging 50,000 square feet). HIBB targets county populations of 30,000 to 100,000. Approximately 81% of the store base is located in strip centers, which includes free-standing stores, while approximately 19% of the store base is located in enclosed malls.
HIBB tries to locate stores in the center of commerce in these town and cities which more often than not is the local Walmart. HIBB stores are located primarily in strip centers which are frequently influenced by a Walmart store. HIBB has a synergistic relationship with Walmart (more on this below).
Does the strategy work?
By comparing HIBB’s performance to BGFV and DKS, we can see that HIBB is clearly the superior business. Over the past 10 years, its margins have dramatically exceeded those of its larger rivals.
Operating Margin, Hibbett Sports, Dick’s Sporting Goods, & Big 5 Sporting Goods, 2007-2016
Data per company filings via Sentieo.com
The return on invested capital has a similar history.
Return on Invested Capital, Hibbett Sports, Dick’s Sporting Goods, & Big 5 Sporting Goods, 2007-2016
Data per company filings via Sentieo.com
BENEFITS OF HIBB’S ISOLATED MARKET FOCUS
We believe that HIBB’s strategy of focusing on isolated, rural markets drives these out-sized returns and creates a moat.
Small-Town Monopolist
The biggest benefit of HIBB’s strategy is that the small rural towns it focuses on can only support one store. As a result, 281 or 27% of its stores have no competitors at all within a 15 minute drive. This strategy is preferred over a model that forces HIBB into larger markets already saturated by competitors.
It is a truism in business that less competition leads to more profits. HIBB is able to charge more than its rivals. The biggest driver in the huge difference between HIBB and Dick’s EBIT margins is gross profit percentage. Over the past 10 years, HIBB gross profit percentage has been about 5 points higher. Dick’s and Big Five are simply caught up in more price competition.
Data per company filings via Sentieo.com
Economies of Scale
Secondarily, HIBB also achieves economies of scale by clustering stores in close to proximity to one another. This store density drives HIBB’s lower sales, general and administrative expense (SG&A) as a percentage of sales. The company observes that higher store density “enables us to achieve significant cost benefits including lower corporate expenses, reduced logistics costs and increased economies of scale from marketing activities.”
Data per company filings via Sentieo.com
Efficient Logistics and Distribution
Over 80% of HIBB’s stores are located in eleven states radiating from its Alabama headquarters. HIBB services them from its single warehouse; few of the stores are more than three hundred miles from the distribution center. It uses its own trucks to pick up much of the merchandise at the distribution center and haul it to the stores. The system is efficient.
HIBB opens new stores are located within 2 hour drive from existing stores
Reduced Advertising Expense
HIBB spends a microscopic percentage of sales on advertising. This is a function of the cheaper advertising markets they focus on as well as store density. The local newspaper doesn’t charge more if HIBB has 5 stores in the relevant market or 1.
Data per company filings via Sentieo.com
Improved Vendor Relationships
Both UA and NKE have trouble reaching HIBB’s target customers via the internet. At the same time, The markets are too small and isolated to make it worthwhile for UA or NKE to build retail locations. As a result, suppliers leverage HIBB’s position in small and mid-size markets. HIBB’s stores are among the primary retail distribution avenues for brand name vendors that seek to penetrate our target markets. In fact, HIBB management disclosed on the Q2 2016 earnings call that Nike had opened a “gigantic office” in Birmingham to tighten the relationship with HIBB.
Accordingly, the suppliers are willing to allocate premium products to HIBB that they do not make available to all retailers. HIBB intentionally stocks up on branded merchandise that isn’t found at either Walmart or any of its competitors in the vicinity. As a result, HIBB feeds off Walmart’s foot traffic, with no worries of cannibalization. This premium product strategy insulates HIBB from painful price competition. “When we have gone to the value play we have actually probably more competition around us than we really want to try to compete against. And we have found a sweet spot in really staying premium in our assortments.”
This focus on premium products goes hand-in-hand with HIBB’s small town focus. As management described it: “We feel like that’s where we can do the best job of bringing that most important premium product into underserved, isolated markets. So we want to ensure that the merchandise strategy aligns with the real estate strategy. That’s where we’re at the most successful.” Further, “(W)e’ve learned that when we go into these small markets, they’re really hungry for premium products that they couldn’t get before. And as we go into these small markets, it makes sense for us to really give them the premium assortments that they’ve lacked in the past.”
Leverage over Landlords
This unique real estate strategy also gives HIBB leverage over landlords. The landlords need HIBB in these small towns to complement the Walmart. This enables HIBB to sign short-term operating leases. If agreed upon sales targets are not hit at the end of the third year and the seventh year, the lease is terminated without any penalty. HIBB also has the ability to exit the lease if the landlord brings in a competitor.
CONSOLIDATION CAN BE AN OPPORTUNITY
The US is the most over-retailed country in the world. As this chart shows, the US has twice the amount of retail space per person of the next closest country.
If all of this capacity was ever needed, it certainly is of little use now that e-commerce is a viable channel. Taking all of this excess capacity out of the market has been and will continue to be a painful experience. More bankruptcies can be expected. Is it inevitable that HIBB will be one of the companies that go bust or at least suffer a long, slow decline?
The risk of a Sports Authority implosion seems very low. We have identified three factors highly correlated with retail chains going bankrupt:
- Too much debt. Growing by means of acquisition saddled these companies with debt. Sports Authority had $1 billion of debt at the time of its bankruptcy. Vestis revealed in its own bankruptcy filing last month that it had as much as $35 million of debt and would be taking $125 million worth of bankruptcy financing from Wells Fargo in order to keep store doors open during the dealings. The interest expense squeezed out other forms of investment. The chains could not update their stores or make other investments because there wasn’t enough money to do what had to be done.” HIBB has no debt.
- Too much competition. Retailers have no switching costs. Popular inventory can easily be carried by all competitors. This problem is only exacerbated when competing stores sit in close proximity to one another. Considering the plethora of industry peers consumers could choose from, having relatively commoditized, un-differentiated items did not bode well for the chain. In the case of Sports Authority, there is a case of competitors encroaching upon one another — Dick’s Sporting Goods, for example, having many stores located near Sport’s Authority locations. Geographic positioning often offers consumers that much more of an ability to quickly switch stores and purchase elsewhere, all the while fueling a need to differentiate on more than price.
- DTC competition from the UA and NKE. As Greg Thomsen, the managing director of Adidas’s outdoor division, puts it, “It’s hard for sporting goods stores when their number one brand also becomes their number one competitor.” “The lines between wholesale and retail faded from black and white to gray to nonexistent,” Greg Baldwin, vice president of merchandising at sporting goods chain Schuylkill Valley Sports, told thePhiladelphia Inquirer. “I now compete with 90 percent of my suppliers via e-commerce, physical stores, or a combination of the two. The importance of the retailer as a pipeline to the consumer has been greatly diminished.”
HIBB has limited or no exposure to the first two factors. Further, we actually see consolidation as creating an opportunity for HIBB to reduce DTC competition. Winners will certainly emerge from this consolidation – as painful as it is. By reducing supply from the market, the survivors should benefit from reduced competition. “There is lot of activity in the sporting goods landscape right now. The long-awaited consolidation is taking place. Over the past several months, City Sports in Boston is liquidated, Sport Chalet has announced the closing of all of their stores, the Sports Authority is in the midst of liquidating and closing their 400 plus stores and others are evaluating strategic alternatives. Although it’s a mess, it’s a great opportunity for DICK’s Sporting Goods.”
Unlike Dick’s thought, HIBB seems unlikely to benefit directly from these closures. As described above, HIBB has little overlap with Sports Authority or other competitors. What then is the opportunity for HIBB?
We see high likelihood that HIBB will benefit from consolidation as fragmentation is reduced and the survivors will have greater scale to bargain with the manufacturers. In other words, it by consolidating demand, the balance of power will shift from the suppliers to the retailers. As the retailers gain scale, they will face the suppliers on more equal footing. Thus situated, the retailers should be able to get them to curtail their DTC efforts. In this way, the sporting goods retailers can avoid the fate of the travel agents.
The CEO of DKS recently commented on the benefits of scale when bargaining with suppliers: “If we were a smaller retailer, a smaller regional retailer, I think you’d have the right to be very concerned about what’s going on. But the size of the player that we are here in the United States and what these brands mean to us and then what we also mean to those brands, there’s a great relationship that we know that we need each other and we’re working very, very well together.”
We have already seen examples of DKS, the largest retailer, retaliating against the DTC efforts of UA and NKE. As the manufacturers forward integrate, DKS reverse integrates. DKS introduced its own private label products that compete with UA and NKE. On the Q1 2016 earnings call, the company stated that they expect the private label business to generate $1-billion of revenue over the next few years, with margin rates of 600 to 800 basis points higher than the brands they replace. Also, they expect their private label brand of women’s apparel, CALIA, to be the number three women’s brand in their stores by the end of 2016. Obviously, if DKS or the other retailers are able to get traction with their own in-house brands, this would give them leverage with other suppliers.
DEFENSES AGAINST ONLINE COMPETITION
Beyond increased scale, HIBB and other sporting goods retailers have additional defenses against online competition.
- Limited Online Distribution – In sporting goods, as discussed above, premium brands are important to consumers. The very best brands are sensitive to discounting, presentation of the product as fit for the prestige of the brand, and service levels needed before and after the sale. As such, not all products are offered by vendors to all retailers. Many brands are unwilling to sell their goods to an Internet-only retailer. They do not want their brand tarnished.
- Fit, Feel and Performance – Most sporting goods need to be tested and tried on for fit, feel, and performance before purchase. Fishing, cycling, hunting arms, golf clubs, baseball mitts, and hockey sticks are all examples of items that consumers prefer to test for performance before purchase
- Service – In sporting goods, many products need high levels of service. Bicycles and fishing equipment are but two examples. In product categories with low service needs–books, for example–this is not a problem and can be sold without the need for a physical retail presence. Sporting goods, however, often require a convenient local store to fill service needs.
WHAT ABOUT AMAZON?
The elephant in the room during any discussion of the retail industry is, of course, Amazon. It seems inevitable that Amazon will one day dominate the entire retail sector.
Yet, the sporting goods industry has done a surprisingly good job of not playing Amazon’s game. The sporting goods market is very driven by brand names. UA, NKE and Adidas make up 70% of HIBB’s sales. UA and NKE refuse to sell products to Amazon.
A 2013 Deutsche Bank study comparing Dick’s inventory with Amazon’s found that:
- Of Dick’s 190 best-selling products, only 12 were sold and shipped by Amazon itself
- 55 of the 190 didn’t appear on Amazon.com at all, even for sale by outside vendors.
Similarly, a 2016 Credit Suisse/Bloomberg report showed that only 17% of the 3,000 SKUs tracked in the study were sold and fulfilled by Amazon.
CAPITAL ALLOCATION
In a move we appreciate, management has clearly laid out their capital allocation priorities: “First and foremost the priorities for the cash will be to build new stores and remodel existing stores, invest in our major initiatives including the omni-channel initiative and then after that free cash flow will be targeted towards stock buybacks.”
The clearest path to growth for HIBB is to open new stores. Management believes it can grow from 1,053 stores to 1,500 in its current states plus additional growth in states it currently not in. As can be seen below, HIBB as excellent ROIC on its new store investments:
The other growth opportunity is HIBB’s omni-channel initiative. HIBB is rolling this out in 4 phases:
- Phase I – New point of sale (POS) system to be implemented in Q3 2017. , we expect to roll out our new POS system, which will enable Phase 1 of our omni-channel initiative. This phase will provide inventory visibility across the chain, and will facilitate store-to-store transfers to complete a customer sale. This phase will also include a new CRM capability, which will allow HIBB to more effectively communicate and market to our database of over 5 million loyalty members.
- Phase 2 – Store-to-home capability, and is expected to be in pilot by the end of FY17. This phase will allow HIBB to use its chain-wide inventory to satisfy a customer sale by shipping directly to the customer’s home.
- Phase 3 – Digital commerce. It is expected to launch in the back half of FY18. Once implemented, digital will be fully integrated with the brick-and-mortar stores, and will provide a seamless omni-channel experience for customers.
HIBB expects to spend $16-18 million on this initiative in FY17. This spending comes on top of a period of heightened capex. In the prior 4 years, capex is running well ahead of depreciation – reversing a 4 year stretch where it ran well below depreciation. The risk here is that the enormous amount of capital expenditures are simply table stakes for retailers in 2016. The investment will not result in additional profits but merely help them to maintain their current level of profitability. That is, the omni-channel initiative will leave HIBB running to stand still.
With the remaining cash, HIBB has been aggressively buying back shares. The float has been reduced by 25% over the past 10 years. Management expects to reduce the float further in FY17: “Last year we finished the year at about $32 million in cash. We should be at or slightly above that number for this year. So, we still have quite a bit of availability under our authorization and our cash flow to execute a significant buyback for the year.”
Data per company filings via Sentieo.com
VALUATION – IS IT TIME TO BARGAIN HUNT IN RETAIL?
Share price data as of 8/11/16.
Valuations in the retail industry are characterized by high volatility. This volatility is largely driven by the industry practice of reporting same store sales numbers for a year-over-year period on a monthly basis. In most industries the custom is to provide quarterly numbers. The more information you have, the more people try to trade on the information before, after and during. As you can see from the stock chart above, HIBB’s stock price lives and dies with the same store sales performance.
Inevitably these companies are going to miss because of their fault or no fault of their own due to the macro environment. There will be a missed number and the market tends to have no mercy. So the market kills these stocks. I don’t know how to pick the next trend. I really don’t know fashion. I say this: nobody can predict fashion. It is really is not about hitting the next trend on a continuous basis. Are these companies running a good business over the long-term? Are they running a business that can weather the ups and downs?
For us, HIBB is a company that will be around. They have a healthy balance sheet. Yes, they have merchandise misses; yes their same stores sales are down. But they are making changes to their management team and they are investing in E-commerce.
Obviously, the rise of e-commerce and the consolidation in the industry had another level of complexity. The market is even less forgiving now because of the “death of retail stores” thesis and the steady drumbeat of bad headlines. Is it inevitable that HIBB will suffer the same fate as the travel agents before them? We believe it is not.
At 7X EBIT and a trailing P/E of 12, the valuation is reasonable but not great. Assuming that same store sales are flat, the company is able to open 500 stores over the next 10 years and no multiple increase, we assume a 2026 share price of $54.22, a 55% increase over today.
