Palm Beach, FL 11/10/11 (StreetBeat) --With Dick's Sporting Goods (NYSE: DKS) still facing what we view as somewhat challenging comparisons, a soft economic backdrop, and unusual late October weather, we anticipate another modest same-store sales increase for FY3Q. We also expect continued strong gross margins and cost controls to lift profit margins and EPS growth. We expect Dick's to also report a further build in cash balances as cash flow exceeds capital spending and working capital needs, even as expansion accelerates. Longer term, we believe the company has opportunities to double its store base and boost operating margins. Accordingly, we maintain our Buy rating and $42 price target.KEY POINTS:
- On Thursday, November 17, Dick's Sporting Goods is scheduled to report its FY3Q (October) financial results and host a conference call at 10:00 am EST. Our EPS estimate is $0.27 versus $0.22 a year ago (up 22.7%), a penny above consensus and management guidance of $0.24 to $0.26 (see Exhibit 2).
- We estimate that same-store sales improved 2.5% in FY3Q, continuing a pattern of modest increases posted during the first half of 2011. Dick's is up against a 5.1% increase in the comparable period a year ago (a combined 7.0% increase over two years). While this is not a substantial hurdle, in our opinion, the continued sluggish economy and harsh late October weather probably restrained any improvement.
- We expect a solid 74 basis point increase in the gross margin to help lift the bottom line. Although this projection is less than the 132bps margin improvement in FY2Q, we note that the company's decision to end its advertising test that shifted sales from outdoor merchandise to higher-margin indoor product categories will likely temper the effects of effective inventory control and expansion of private label products.
- We expect tight control of expenses to enable Dick's to leverage SG&A expenses by 28bps. We believe that the double-digit increases in expenses last year gives the company some flexibility to trim its key expense ratio. Store-level payroll efficiencies and a reduced advertising spend rate should contribute to leverage, we think. Partially offsetting the lower SG&A rate we are forecasting, we estimate that store pre-opening expenses increased from $6.4 million to $8.0 million in FY3Q as it appears the company opened at least 18 stores in the quarter, up from 12 a year ago.
- Our earnings model also incorporates net interest expense of $4.0 million (up from $2.3 million a year ago), a tax rate of 39.4% (versus 34.8%), and a 3.8% increase in the share count to 126.0 million. We project that the company's cash balance will decline from the $626 million on its books at the end of FY2Q, reflecting a normal seasonal inventory buildup, but year-end cash levels should approach $750 mil.
VALUATION:
We base our $42 price target on three methodologies and ascribe a weighting of these inputs based on our view of their relative importance to investors. Below, we describe the three components:
1) Conventional P/E Multiple Analysis--Because most investors of growth companies rely on a P/E evaluation to determine appropriate valuations, we give this method a 50% weighting. Employing this approach and our assumptions that the company has solid long-term growth prospects and will generate substantial free cash flow, we use a P/E of 19 (the middle of its long-term range) times our FY12 EPS estimate. This procedure generates a price target of $43.
2) Discounted Cash Flow Analysis (25% Weighting)--Using a terminal multiple of 22x (equivalent to a EV/EBITDA multiple of 7.9x), our DCF model calculates a per-share stock valuation of $37.
3) Long-Term Growth Driver (25% Weighting)--Under this method, we project Dick's EPS seven years into the future, calculate a projected stock price using a P/E of 18.5x and, using a 14.1% discount rate (equivalent to the company's weighted average cost of capital), generate a $42 present value price target.
RISKS TO PRICE TARGET:
- Consumers have shown a greater willingness to spend in recent months, but the state of the economic recovery is fragile, and sporting goods is a discretionary category, leaving the company's prospects tethered to further economic expansion.
- The overall sporting goods industry has seen its growth moderate in recent years, according to the National Sporting Goods Association, and is likely to continue doing so as the population ages and as consumers spend less time engaging in equipment-intensive activities.
COMPANY DESCRIPTION:
Founded in 1948, Dick's Sporting Goods is one of the largest operators of sporting goods superstores in the retail industry. As of July 30, 2011, the company operated 455 Dick's Sporting Goods Stores in 42 states (with the greatest concentration in the Eastern United States) and 81 Golf Galaxy stores in 30 states, a business the company acquired on February 13, 2007. Dick's had also acquired Chick's Sporting Goods stores, a 15-store chain in southern California, on November 30, 2007 and the Galyan's chain of 48 stores in July 2004 and has grown the company through a combination of acquisitions and organic growth. Management believes it can more than double the size of the company to 900 units by expanding into a national chain and is planning to open 34 Dick's Sporting Goods Stores and at least five Golf Galaxy stores in FY11. A typical Dick's store is 50,000 sq. ft., with about 40,000 in net selling space. The company has indicated that it requires about $2.2 million to open a unit, including a net inventory investment of $1 million; furniture, fixtures, and equipment of $940,000; and about $230,000 in pre-opening expenses and that the stores, on average, generate about $8.3 million in sales in their second year of operation and about a 12% net cash flow margin, translating into a cash-on-cash return of approximately 45%.
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