Go Big or Small in Sporting Goods?

Steve is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Big is not necessarily better in the sporting goods retail business. Yes, size does bring with it economies of scale whereby the unit cost declines as volume increases and, yes, larger sporting goods retailers do have more power over their suppliers to reduce costs than do smaller retailers. But comparing the operating performance of mid-cap retailers like Dick’s Sporting Goods (NYSE: DKS) and Cabela’s (NYSE: CAB) against small cap companies like Hibbett Sports (NASDAQ: HIBB) and Big 5 Sporting Goods (NASDAQ: BGFV) suggests more factors are at play than just size. These four companies represent around $10 billion, or less than 20% of the mature and highly fragmented $57 billion (domestic sales) sporting goods industry. Although Foot Locker (NYSE: FL) has a greater store base and more revenue than each of these four, it is concentrated in footwear and apparel as opposed to broader sporting goods sales and has significant operations outside the U.S. General merchandisers like Wal-Mart Stores also contribute to the industry’s revenue total but are not “pure play” sports retailers.

Stores Locations
Although Foot Locker has more than 4 times the domestic store count (approx. 2300 vs. 500), Dick’s has much more total square footage (28 million vs. 5.5 million) and a larger market cap ($6.5 billion vs. $5.4 billion) and is the largest of the more pure play companies. Hibbett Sports’ 848 store count is also significantly more than Dick’s, but its total square footage is only about 4.2 million because its average store size is only 5,000 square feet compared to Dick’s 55,000 average. Similarly, Big 5 has only about 100 less stores than Dick’s but its average store size is 11,000 square feet, giving it total square footage of about 4.5 million. Hibbett carries a market cap of just $1.4 billion and trades at 1.8x revenue while Big 5 trades at a market cap of $800 million or 0.3x revenue. Dick’s market cap to revenue multiple is about 1.2x, a fairly sizeable premium to Foot Locker at 0.9x. Cabela’s is unique among this group in that it operates only 40 locations (3 of which are in Canada) and has a reliance on its website, mail order catalogs and independent retailers for its sales. Even so, Cabela’s stores are massive (127,500 square foot average) with its total square footage at about 4.7 million and its $3.3 billion market cap is 1.1x revenue.

Operating Metrics
When it comes to past performance, Hibbett is the clear leader. The company has produced long term average operating margins north of 10% which has helped Hibbett generate outstanding return on invested capital that has averaged about 23% annually. These metrics compare very favorably to Dick’s at 5.5% and about 15%, respectively; Cabela’s at about 6% and 9%, respectively; and Big 5 at 5.6% and about 14%, respectively.

Investors have recognized this outperformance and are willing to pay a premium with a forward price to earnings to growth (PEG) multiple of 1.5x for Hibbett. This PEG multiple is in excess of Dick’s at 1.3x, Cabela’s at 1.1x, and Big 5 at 0.7x even though Hibbett has the slowest estimated EPS growth rate at 11.8% versus 14% for both Dick’s and Cabela’s and 23% for Big 5. In addition to besting its competitors in operating margin and ROIC, Hibbett also leads the pack with a long term average free cash flow to revenue ratio of just under 6% which far surpasses the 2% or less of the other companies.

Strategies & Outlook
This divergence of results between companies in the same business is the consequence of their different strategies. And execution of these strategies will help determine the companies’ success going forward. Dick’s has chosen to operate massive stores in densely populated medium and large sized cities while Big 5 has chosen to operate smaller stores in a mix of small and large cities like Seattle and Omak Washington. Over half of Big 5‘s stores are in California so it has a greater concentration risk than any of the other companies. Hibbett has chosen to avoid direct competition as much as possible and has its locations exclusively in small towns like Delta Colorado, Bucyrus Ohio, and Baxley, Georgia. Logically, the company has very small stores of around 5,000 square feet located in strip malls because the population density does not support bigger sizes.

As the operating metrics suggest, this strategy of avoiding competition, even from the likes of Wal-Mart, which generally does not operate in the same towns as Hibbett, has been a winning one. Like Hibbett, Cabela’s has chosen to avoid retail competition by limiting its store locations and having much larger catalog and website operations as a share of its overall business. Additionally, Cabela’s relies heavily on its private label credit cards with almost 60% of its assets in credit card receivables and about 10% of revenue from financial services.

Even though Hibbett carries the highest PEG of the group, it is at a reasonable level well below my 2.0x limit. I think the company’s strategy of dominating the small town niche confers some competitive advantages that are sustainable while trading off other advantages. The company has some pricing power over its customers who are, to a certain degree, a captive audience due to their location. Also, the sparse populations in these small towns act as a barrier to entry by competitors and protect Hibbett against the threat of substitute products. The internet as a substitute does erode these advantages somewhat but consumers generally still like to touch merchandise before buying. The biggest trade off that Hibbett makes is in its comparatively weak position with its suppliers. The company has the lowest total square footage and thus has limited economy of scale and is in the worst position to bargain for preferential pricing.

Because I believe that Hibbett will be able to continue its winning strategy with minimal chance of disruption from rivals, I like it the best among this group as a long term investment. In the medium term, Big 5 appears to have the best catalysts and at a PEG of just 0.7x, is the cheapest if its estimated EPS growth is realized. These catalysts include a new business-analytics system that should lead to more efficiency in inventory management and a new digital marketing and e-commerce strategy advised by IBM including the launch of a refreshed product-intensive website. My enthusiasm for Dick’s and Cabela’s is less than either Hibbett or Big 5 because I do not foresee any significant catalysts.

In investing, being big isn’t bad but it isn’t the final objective either. Investing is about finding better companies with better management and better strategies. In sporting goods retail, like other industries, size does allow economies of scale but factors other than just size are at play. By devising a niche approach and executing on that strategy, Hibbett has taken a very strong game to the big players and investors could continue to score big with their shares.

56Steve has no positions in the stocks mentioned above. The Motley Fool owns shares of Dick's Sporting Goods. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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