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The Science of Hitting
The Science of Hitting
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Some Thoughts on Big Lots

A look at the retailer's current prospects

January 07, 2020 | About:

Big Lots (BIG) is a retailer with roughly 1,400 stores throughout the United States targeting mass market, value focused customers (they previously had 80 stores in Canada, but they were all closed in 2014). The store count has been essentially unchanged over the past decade. The merchandise mix is an assortment of big-ticket items (notably furniture), seasonal offerings and closeout merchandise. As shown below, the company has struggled to grow in recent years.

The result of lackluster unit growth and comparable store sales growth has been unchanged annual reveues (at ~$5.2 billion a year). This has led to an uninspiring performance for the stock: at $28 per share, BIG is at a level that’s comparable to where it traded before the financial crisis.

While net income has been roughly flat over this period, diluted earnings per share (EPS) has more than doubled as a result of a roughly 60% cumulative decline in the share count (from 103 million average shares outstanding at year end 2007 to 41 million shares at year end 2018). As that math suggests, the price-to-earnings (P/E) ratio has contracted significantly over the past ten years.

Management’s attempts to address the issues facing the business are best captured by a new format known as “Store of the Future.” Basically, these remodeled stores have been designed to focus on Big Lot’s strongest categories – home goods, furniture and seasonal. This is a noteworthy moment for the company; as management noted on a recent call, “we have embarked upon a significant capital improvement project to renovate a significant portion of our stores”. By my math, they will spend about half a billion dollars on “Store of the Future” remodels.

To date, management has consistently stated that the remodeled stores, which cover one-third of the footprint, have delivered high single digit sales lifts (they have plans to covert roughly 90% of the footprint by the end of 2021). As noted on a recent conference call, “almost all of the lift… is coming from furniture, soft home and seasonal.” Taking a closer look at the numbers provides some interesting insights. In 2018, Big Lots generated $5.2 billion in sales and $220 million in operating income, which works out to $3.7 million in sales and $160,000 in income per box.

Assuming an 8% sales lift from “Store of the Future” (in-line with “high-single digits”), that suggests the average store will see $300,000 in incremental sales following a renovation. If we assume that these sales come with 20-25% incremental operating margins, which sounds reasonable for a business with 40% gross margins, that would result in an average remodel leading to $60,000 in incremental operating profits per box – a nearly 40% increase in per store profitability. Compared to an investment per remodel of $400,000 to $500,000 (per management comments at a September 2019 investor conference), that’s a decent return on invested capital.

Assuming 90% of the footprint eventually gets there (and that the other 10% of the store count is ultimately closed as lease terms end), that would leave Big Lots will roughly 1,300 stores that are generating, on average, around $215,000 in operating income. Across the entire business, that works out to $280 million a year in pre-tax income. Compared to today’s market cap of roughly $1.1 billion, the stock potentially trades at roughly four times “normalized” pre-tax earnings.

Recent guidance suggests that my numbers are directionally correct: “Return to operating income and earnings per share (EPS) growth will be a key step on our journey, and we expect the rate of progress to accelerate in 2021 and 2022.”

Now, with all of that said, I’m generally skeptical of retail turnarounds (mostly because I've lost money trying to invest in them). Once you lose customers in retail, it can be difficult to win them back and keep them, even if you have clean stores and offer compelling values. In addition, it seems unlikely to me that investments in “Store of the Future” are discretionary or one-time. Instead, this is more the normal course of action in a competitive business like retail.

Warren Buffett (Trades, Portfolio) addressed this in his 1995 shareholder letter:

“Retailing is a tough business. During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy. This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses. In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail.”

That's a long way of saying that I don’t think this is a very good business. Big Lots has a number of strong competitors, and will continue to face a headwind from industry mix shift towards e-commerce. Sales growth has been hard to come by for the past ten years, and I don’t think that will meaningfully change in the coming decade. I cannot confidently state that this business is likely to have materially improved per share earnings in five to ten years. That’s my first filter, and I don't think Big Lots passes the test. For that reason, it doesn’t matter how cheap the stock appears. My process dictates that this I stay away until I can honestly tell myself that the business clears this first hurdle. That said, it seems to me that under the right circumstances, BIG may be a compelling bet with an attractive risk / reward proposition for certain types of investors.

Disclosure: None

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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