Our investment thesis on no-moat Dick's Sporting Goods (DKS) remains intact after its third-quarter update, as the company navigates several merchandise assortment changes and better positions itself for future profitability. As expected, negative comps continued into the quarter (down 3.9% on a comparable calendar basis) and will likely fall close to the same rate in the fourth quarter (based on full-year guidance calling for a 3%-4% decline) as Dick's continues to rationalize its lower-margin hunt/firearm assortment (which declined double-digits and contributed 255 basis points to the comp decline) and adjusts to distribution/merchandising changes at Under Armour. However, like last quarter, we believe these strategies are validated by the 72-basis-point increase in gross margins to 28.2% (led by a 213-basis-point increase in merchandise margins, which more than neutralized occupancy expense deleverage and increased freight/fulfillment costs) as well as SG&A cost containment efforts (SG&A increased 76 basis points as a percentage of sales to 25.2%, which we view as reasonable after factoring in labor/marketing deleverage, strategic investments, and incentive compensation). In total, operating margins increased 28 basis points to 2.85%, and Dick's appears on track to hit our 5% target for 2018.
Barring a near-term recession, we expect comps to accelerate to the low single digits as Dick's replaces its hunt/firearm assortment with outerwear, baseball, and private label products. We also expect online sales (which grew 16% in the quarter) to remain in the low to midteens as Dick's expands 2-day shipping across the country. Our $40 fair value estimate remains unchanged as we remain confident in our outlook calling for average annual sales growth of 2.2% from fiscal 2018 to 2027 and average operating margins of 5.7% over the same period. While we see shares as modestly undervalued, we would not be surprised to see market optimism prop up Dick's stock as comps accelerate.
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R.J. Hottovy, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.