Growth Game's Not Over for This Sporting Goods Retailer

 Dick's Sporting Goods (DKS) has slowly but steadily improved operating margins and returns on capital since its initial public offering, and we expect further improvement. In what we consider a fragmented and competitive industry, Dick's has emerged as a best-in-class operator, and one of only two competitors that has U.S. national coverage. We believe its growth and profitability improvement potential have not been exhausted, as there are still markets not fully penetrated, the competition remains fragmented, and operating margins leverage with scale. Yet because of seasonal and cyclical issues in two product categories, Dick's shares trade at a discount to our fair value estimate.

Dick's Sporting Goods has grown from less than 300 stores in 2006 to more than 560 Dick's branded full-line sporting goods stores and 84 Golf Galaxy golf specialty stores today. Its revenue has grown from just over $2.1 billion in 2004 to a projected $6.8 billion in the year ending January 2015, representing a 14.7% compound annual growth rate. Even with this consistent and lengthy growth trajectory, the firm only began penetrating markets west of the Mississippi in 2008, and we believe there is still white space for Dick's to fill in stores, particularly in the Western United States. Despite its growth rate, we calculate that Dick's market share has only approached 11%. Typically, smaller stores and retailers that aren't sporting goods specialists are the share losers when Dick's enters a market. After the financial crisis of 2008-09, obtaining suitable commercial real estate appeared to be an issue, but we believe today the environment has improved enough to make management's 2017 goals of more than 800 Dick's stores and nearly 90 Golf Galaxy stores very achievable.

By locating stores in the underpenetrated retail trading areas of the U.S., Dick's management believes it can open another 300 eponymous stores, of which 200 will be smaller-market layouts. In the specialty golf business, although just a few net store openings are planned under the Golf Galaxy banner, offsetting closures, the firm will selectively expand and/or relocate stores to a new, larger, more interactive store format that has performed well in test markets. We think Dick's will eventually have a significant percentage of its Golf Galaxy store base in the larger golf store format, as it is not real estate constrained and the larger store format further differentiates the concept from smaller pro shops and big-box retailers.

Field & Stream Holds Promise
Dick's has been testing a new outdoor specialty store concept, Field & Stream, and while we are usually cautious about new concepts, we believe the stores have great promise, in part because of our test store visit, but also because we believe a major competitor, Gander Mountain, is vulnerable as its merchandise assortment is inferior, in our opinion. Gander's store locations are also an issue, we believe, due to the firm's strategy of renting low-cost recycled real estate, often in hard-to-access or lower-traffic sites.

Management projects roughly 55 Field & Stream stores by 2017, and we believe the long-run potential is actually higher, given that larger-format competitors such as Bass Pro Shops and Cabela's locate outside traditional retail trading areas but both have store counts greater than 50. At the heart of the Field & Stream store strategy is a smaller, often more suburban-located store that focuses on hunt-camp-fish outdoor categories by carrying the top brands, with only a small portion of the store devoted to the Dick's-controlled private-label brand Field & Stream. While many observers believe the concept is in direct competition with Bass Pro Shops and Cabela's, we believe Field & Stream has some substantial differences and also some advantages.

For one, Field & Stream stores focus on the true outdoor stock-keeping units, carrying roughly 80% of the hunt-camp-fish products that a 200,000-square-foot-plus Cabela's has, while housing those products in roughly one fourth of the retail square footage. Despite carrying the Field & Stream name (Dick's licenses the brand from the magazine of the same name) and despite Dick's significant capabilities in developing private and exclusive brands, the concept will focus less on in-house brands than Cabela's and Bass Pro Shops.

In addition, Field & Stream does not carry the breadth and depth of lifestyle products, from bedding to furniture, food, and home goods, which fill in a good portion of the additional merchandise space at the large-box destination-format competitors. Because the stores are smaller, located closer to population centers, and don't need to attract out-of-town visitors, their valuable retail space is not taken up with destination-creating memorabilia, stuffed trophy animals, large-scale fish tanks, and other amusement attractions. The stores' smaller footprints and closer-to-home locations make them more convenient for consumers, both to visit and to shop. As Dick's continues to grow online, we believe that ship from store or buy online/pickup in store will become more important, particularly in the outdoor market, given the SKU intensity and the greater potential for Field & Stream-size stores to be located near more densely populated retail areas.

Online and Omnichannel Opportunity Is Large and Strategically Attractive
Online growth is another area where we see positive implications for Dick's. The firm targets $1.1 billion in e-commerce sales by 2017, implying a 22% compound annual growth rate from just under $400 million in e-commerce sales during 2013. We view sporting goods as a category that has some natural advantages for an omnichannel retailer compared with an Internet-only or brick-and-mortar-only retailer. Fishing tackle and certain hardgoods categories that are highly researched purchases, with a high numbers of SKUs and high value but small size and low weight, are natural for direct businesses, and we believe these will boost Dick's online growth. We also believe when purchasing private-label products online, consumers are especially sensitive to brand since they cannot touch and feel the product, and Dick's strategy of licensing national brands for exclusive use gives it an advantage.

At the national vendor level, not all brands are willing to sell their goods to an Internet-only retailer. Brands want a certain level of sales, service, and presentation to be offered, and they don't want consumers shopping for the lowest price online and then returning to a brick-and-mortar store expecting service. In product categories with low service needs--books, for example--this is not a problem. In sporting goods however, many products do need high levels of service. A bicycle shop or fishing tackle retailer, for example, often will not service or will charge a higher price to work on certain brands that are sold predominantly on the Internet. This competitive advantage appears to be visible in U.S. Economic Census data that suggest sporting goods retail sales, which exclude general merchandise sellers such as Wal-Mart and Sears as well as Internet sales, are growing faster than the overall category. Given the strength of sporting goods sales growth in online channels such as Amazon, it appears market share losses to the Internet-only channels are coming from general merchandise stores.

Sporting Goods Retail Has Some Defenses Against Internet-Only Sellers
Overall, we believe sporting goods stores have some natural defenses against online retailing. A fair number of sporting goods items are needed immediately, and thus consumers prefer a full-service, deep-product-assortment, full-line store such as Dick's. Also, Dick's has a solid business supplying kids with items needed for team sports from hockey to football and baseball, from cleats to mouthpieces and undergarments. Most products need to be tested and tried on for fit, feel, and performance before purchase, which is particularly important for kids who often have grown a size or more since the prior season. 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.

Some sporting goods items are difficult or prohibitively expensive to ship. Live bait, for example, is difficult and expensive to ship in small quantities to a consumer. Large items such as fitness equipment or small watercraft are expensive and difficult to ship and have relatively low value as a percentage of size and weight. These items are thus most effectively shipped in bulk via truck to a central location, such as a retail store. Smaller stores do not have the footprint to properly represent such items, while direct shippers must add a relatively large additional charge for shipping. This makes these attractive businesses for Dick's as a full-line, omnichannel retailer. Firearms and ammunition have the highest level of shipping difficulty: both face legal prohibitions on shipping and interstate commerce.

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In addition, some sporting goods categories require significant service, which is a natural defense against online sellers with no physical retail presence. Firearms, hunting bows, fishing equipment, golf clubs, and bicycles require service, technical adjustments, and add-on sales with a product compatibility and setup component. Some items require additional individual fitting and a consultation service to decide which product to purchase. While some of these areas will continue to be left to specialty shops, one category where Dick's competes effectively even with pro shops is golf, in part because of its market strength with vendors, which hinged on its Golf Galaxy acquisition. We believe a similar service and location advantage will exist in the outdoor category as Dick's expands its Field & Stream concept.

In sporting goods, premium brands are important to consumers. In addition, the best brands are very 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. Dick's is the only national big-box sporting goods retailer able to offer all the major golf equipment brands.

Investors May Worry About Sport-Specific Growth, but Dick's Has Flexibility
With news in early 2014 of a difficult environment in the golf category and top-line pressures in the firearms and outdoor categories, some investors have become focused on lackluster growth or even declines in sports participation (as shown in the Sports and Fitness Industry Association's annual participation study), extrapolating negative implications for Dick's. According to U.S. Bureau of Census statistics and National Sporting Goods Association estimates, sporting goods has grown at a compound annual rate that is not above GDP expansion rates for all sporting goods sales and modestly better growth in sporting goods retail, albeit with some volatility in individual sports categories and declines in segments such as boating. Other industry-sponsored surveys vary, but most observers agree that spending per participant continues to rise, as overall sports participation is flat to slightly negative, with some variation by sport. During the same time, sporting goods firms have been increasing revenue despite declining participation rates, largely from increased spending per participant. We believe spending per participant has been driven by greater specialization in sports by youth and adults alike and also by product technology improvements introduced by vendors. We see no reason either trend would reverse in the near term.

As a full-line multisport retailer, Dick's has the flexibility to shift floor space to the categories that are selling the best. Even considering the golf specialty channel, where Dick's owns the Golf Galaxy retail brand (golf is about 20% of Dick's annual sales), we believe the firm has great flexibility to manage its merchandise mix, and we do not believe it is overly dependent on any particular category or vendor.

Golf Still a Category Where Dick's Has Advantages
Dick's is the only national big-box sporting goods retailer to offer virtually all the major national golf brands, thanks to its vendor leverage obtained through the acquisition of Golf Galaxy. In addition, Dick's has acquired a number of nationally recognized golf brands for its own exclusive development, such as Top Flite. As a total category, golf is the fourth-largest equipment sales category (based on U.S. Economic Census figures). This is larger than camping or fishing and ranks only behind exercise equipment, bicycles and related products, and hunting and firearms. We believe golf also maintains some attractive attributes relative to some other sports categories, with high spending per participant and positive customer demographics such as high levels of education and high income (more than two thirds of players have college degrees and income averages over $95,000 per household, according to the National Golf Foundation). Golf is thought to have declined from nearly 30 million participants in 2000 to just over 25 million participants today. Yet that means golf still has a number of participants that is more than 4 times that of baseball, more than 8 times that of American football, and 6 times that of youth soccer.

The best brands of golf equipment are also almost exclusively sold in sporting goods stores and specialty shops, and rarely in general merchandise channels. Online, brands such as Top Flite, Ping, Callaway, and TaylorMade only sell accessories or older models and don't compete online with lower prices. New clubs often require fitting and testing and are expensive to ship, lowering the value proposition of online retail. Golf equipment also requires service levels to fit, feel, test, and try before purchase; again, we believe this gives an advantage to an omnichannel retailer such as Dick's over online-only alternatives.

Some of Golf's Weakness Is Cyclical
Golf equipment sales growth is correlated to innovation cycles, and the drop in sales experienced in 2014 corresponds to a low point in the equipment innovation cycle coupled with poor spring weather trends in many of the most populous areas of the U.S. Golf equipment sales also are sensitive to economics. TaylorMade (a division of adidas) is considered the market leader and is estimated to have captured roughly half of the market in drivers, fairway woods, and hybrids as of last year, up from only 11% a decade ago, according to Golf Datatech. It also holds around a 25% market share in irons. TaylorMade showed strong sales increases in 2011 (up 16%) and 2012 (up 20%) largely as a result of new technology innovations such as variable weight-adjusting drivers, which represented a major product introduction. Nike Golf recorded growth rates of negative 2% and positive 9% in fiscal 2011 and fiscal 2012 (ended May), respectively, citing innovations in its product line in its May 2012 annual report. The timing of product introductions probably corresponded with some pent-up demand post-recession, in our view, and positive spring weather conditions in 2012 in the U.S.

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In 2013, TaylorMade showed a sales increase of only 3%. Sales trends at Dick's were weaker following the strong activity of prior years, corresponding to a 15% decline in rounds played through April 2013 (according to Golf 20/20), which is the key selling season. During its first-quarter conference call in spring 2014, adidas reported that TaylorMade golf sales were down 34%; with the market leader seeing revenue drop so substantially, it is not surprising there is an oversupply of inventory now in the market. Compounding the high inventory and uninspiring products from the market leader, rounds played through April 2014 also fell 3%, despite easy comparisons with a wet 2013. In addition to wet and cold weather in much of the country this spring, a significant number of courses were unable to open because of damage from the exceptionally cold and icy winter; this was offset only partially by positive trends in rounds played in the West and South in states with unusually warm and dry conditions, which saw an early start to their golf seasons.

Despite Competitive Threats, We See Dick's as Long-Term Winner
Retail is a competitive industry, and apart from a few branded specialty retailers, many retail segments such as department stores exhibit mediocre returns on capital at best, as consumers have few switching costs and store buildout investments and real estate expansion phases tend to be costly and cyclical. In addition, many retailers today have experienced business model disruptions from issues such as online competition, new concepts expanding store counts, or other difficulties hampering expansion, such as availability and pricing in the commercial real estate markets. Yet Dick's has steadily nudged its returns on capital higher while significantly increasing its top line and has competed effectively over the years despite numerous competitive threats.

Also, the sporting goods market has historically been highly fragmented and dominated by regional competitors. Originally a regional operator itself, Dick's has emerged as the best-in-class operator and one of the few chains to offer vendors truly national coverage. The largest competitor in the category and the only chain to approach Dick's scale and national coverage, Sports Authority, was formed through the merger of a number of regional sporting goods retail chains and was taken private by retail-experience-heavy private equity firm Leonard Green in 2006. We no longer have profitability figures for Sports Authority, but given that the chain has stuck with a store count of roughly 450 since it went private, its strategy appears to focus on maximizing near-term cash flow, and we doubt returns are high enough to support store growth investments. Our research suggests that the firm occupies a significant number of older real estate locations; we believe this will continue to put it at a disadvantage to Dick's, which has used its high returns on capital and store growth to continue investing in new stores in the most desirable retail locations.

A significant number of strong regional specialty retailers compete with Dick's Sporting Goods. Yet we see Dick's growth and the store growth stagnation of many regional chains as proof of a trend toward further consolidation. Most high-profile competitors either have strategic disadvantages or don't compete directly with Dick's. Hibbett Sports, for example, only operates in small towns and is predominantly in the South, and its 5,000-square-foot format allows a very narrow assortment of products. Although Hibbett is an excellent operator with strong financial returns, we believe its store location and store size strategies prevent it from being a direct competitor to Dick's. In the Western U.S., California-based regional competitor Sport Chalet employs many strategies that are similar to Dick's: store sizes, merchandise assortment, a focus on brands, and specialty services. But Sport Chalet does not carry firearms and does carry skiing-related merchandise. Sport Chalet was started in the 1950s and operates just over 50 stores, yet has struggled with profitability and has net closed stores since the 2008-09 recession. (It announced June 30 that it would be purchased by a Philadelphia-based private equity firm.) Midwest operator MC Sports is based in Michigan and has approximately 70 stores, although it has not expanded the store base significantly since Dick's acquired Midwest-based Galyan's in 2004. Modell's has been successful in the Northeast with more than 150 stores, despite Dick's long history of expansion in that region.

Texas-based Academy Sports is owned by private equity and operates approximately 170 stores, and it is one of the few regional competitors that is expanding its door count. Although newer stores hold promise and the economies of the Gulf states are probably a tailwind, our view is that Academy lacks scale and national coverage and has a number of older stores that need to be refurbished or even relocated. Despite the presence of large-format competitors Bass Pro Shops and Cabela's, the outdoor market is still very fragmented, and we believe the weakness of major competitor Gander Mountain increases the segment's attractiveness. It is our view that a poor real estate strategy and poor operating results will continue to hamper Gander Mountain and its markets might be ripe for entry with Dick's Field & Stream concept.

We believe many of the regional competitors will be increasingly at a disadvantage to national retailers in online marketing and selling, despite having a history of serving local customer bases and despite our view that sporting goods often has local or regional differences in merchandise and services. As a national retailer, Dick's can spread back-office infrastructure, advertising, and distribution fixed costs over a larger base.

In addition, Dick's can stock a greater depth and variety of merchandise and demand special product makes from vendors. Dick's exclusive-label products should also be more competitive and are often internally developed and sourced. For example, a significant portion (more than 80%) of what Dick's offers under the Reebok label in athletic apparel is actually developed and sourced directly by Dick's merchants. It would be hard for a regional competitor to develop and market a product line such as this at the same level of profitability as Dick's, and additionally a vendor such as adidas might not be willing to let a smaller firm have such a significant license. Vendor growth in direct sales--for example from Nike and Under Armour--appears to be more concerning to regional competitors, as we believe Dick's will continue to get allocations of the best products or, in some cases, product designs or colors that are not available at other retailers.

Short-Term Headwinds Weigh on the Stock, but Valuation Is Compelling
Despite producing modestly positive same-store sales in the April quarter, which was characterized by poor weather and weak consumer spending on the macroeconomic level, management highlighted sales shortfalls in golf and outdoor, with an ongoing product oversupply situation in golf and a tough year-over-year comparisons in firearms being sources of difficulties. Because of management's view that product-specific inventory would take at least through the fall season to work through, investors have assumed Dick's stock should be avoided until the situation has turned around. Yet as investors suddenly were publicly questioning whether Dick's should exit some of these challenged categories, our analysis suggests these segments will remain an important part of the sporting goods market.

Dick's goals of reaching a 10.5% operating margin and increasing the top line to $10 billion by 2017 appear achievable to us, although we've conservatively modeled that the firm reaches its targets in 2018 and ends our 10-year forecast with operating margins right at 10%. This compares with operating margins of 9.0% in 2012 and 8.6% in 2013. The firm has significantly increased operating margins over the past several years, leveraging fixed costs as it has increased scale.

Rent expense as a percentage of revenue has declined more than 100 basis points since 2008. We believe downward pressure on commercial real estate pricing since the 2008 recession and growth in same-store sales has allowed Dick's to leverage occupancy cost, and we project that as leases signed during the mid-2000s real estate boom roll off, the positive trend on occupancy should continue. Other positive gross margin trends, such as the increase in penetration of women's apparel and the ongoing growth in higher-price and higher-margin technical apparel from vendors such as Under Armour and Nike, also suggest Dick's should easily achieve its gross margin increase targets.

Current Price Is Significant Discount to Our Fair Value Estimate
Currently, Dick's stock trades at nearly a 30% discount to our $61 fair value estimate. We believe that because the short-term sales headwinds appear to be quite certain to take several quarters to clear, the market will wait for proof that earnings growth can resume before the stock comes back in favor. Worries about being late in the store growth cycle and the exposure to golf and consumer discretionary activities in general no doubt are also contributing to fears. We believe the shares now trade at a sufficient discount such that superior returns will justify the wait, and concerns about growth are unfounded.