Big Problems for Big Lots

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

Shares of Big Lots (NYSE: BIG) have been under pressure following the company's lackluster earnings announcement on May 30. The company reported earnings of $0.36 per share, missing analyst estimates by $0.05. More importantly, management offered a disappointing outlook for the rest of the year.
 
Considering the negative guidance and the increasing uncertainty for this company, investors should sell their shares of Big Lots and look for better opportunities in the retail arena.
 
Big Lots operates in a fiercely competitive niche. The latest quarterly report indicates that the company is falling behind the competition, which is bad news for shareholders. Conservative investors should liquidate their positions, and more aggressive investors should consider buying puts on this troubled stock.
 
A tepid forward outlook
 
As part of the Q1 earnings press release, Big Lots issued forward guidance for the second quarter, in addition to an updated outlook for 2013.
 
The most important statistic that caught investors off-guard was the same-store sales figure. For the second quarter, Big Lots expects same-store sales to decline between 2% and 4%. And for the full year, management expects same-store sales to be flat to down 1%.
 
A decline in same-store sales indicates that the company is losing market share to other discount retailers. This is particularly troubling, given the number of potential competitors who are scaling their product offering and pricing to better compete with discount retailers like Big Lots.
 
Deep-discount retailers, such as Big Lots, typically operate with very thin profit margins. Therefore, a continued decline in revenue could dramatically affect long-term profitability, as the company will likely have to drop prices or increase its marketing budget to hold on to its current market share.
 
Analysts have been quick to adjust their models to the new information. The average estimate is now for earnings of $2.97 per share this year - which is actually $0.02 lower than last year's earnings. In 2014, expectations are for 10% earnings growth, but there is a tremendous amount of uncertainty surrounding this figure.
 
 
Competition increasing 
 
Not only does Big Lots have to compete against other deep-discount retailers, but a number of big-box retailers are also adjusting prices to compete directly for the dollars of budget-conscious shoppers.
 
Last week, Dollar General (NYSE: DG) lowered guidance for 2013 as sales growth and profit margins came under pressure. The company focuses on low-priced consumable household products and strives to offer them at the lowest possible price. 
 
Analysts have also lowered estimates for Dollar General. The stock is currently trading at a premium valuation of 16 times expected earnings this year. If the company is not able to sustain profit growth, that multiple will surely contract.
 
But with large retailers like Wal-Mart matching any advertised price, many marketing initiatives paid for by Dollar General or Big Lots just wind up as fodder for customers who take the circulars to Wal-Mart for the price match.
 
Target also has a price-matching guarantee. The company has already invested significant capital to improve the quality of their stores. The more pleasant shopping experience has led to increased loyalty from the company's customers.
 
Target and Wal-Mart also have an advantage over deep-discount retailers in that they can match prices of advertised items and then make up the difference through higher-margin products. Companies like Big Lots and Dollar General typically do not have a wide assortment of high-margin products to help boost profits.
 
In today's retail market, it is very hard to compete simply on price. But it is also costly to employ and train staff to be able to compete through superior customer service. And spending capital to renovate stores can also be a waste of money if there is not a reasonable expectation for increased profits from each renovated location.
 
Long-term price erosion

For Big Lots, analysts are expecting earnings to be flat this year and to potentially grow 10% in 2014. Unfortunately, investors aren't likely to place much faith in the 2014 estimates until they can see real evidence of increased profits.
 
Shares of Big Lots are currently priced at about 10 times 2014 estimates. This would be a reasonable price if the company exhibited stable growth. But with so much uncertainty for this company specifically, as well as in the discount retail industry, investors will likely discount any growth expectations.
 
Over the next 12 months, I would expect Big Lots to trade much lower. The stock could easily trade into the low $20's which would represent seven to eight times current earnings. 
 
If you own shares in this troubled retailer, it's time to throw in the towel. There are plenty of other healthy growth stock opportunities, and it doesn't pay to tie up capital in a company that is struggling just to tread water in an ultra-competitive market.
 

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Zachary Scheidt has no position in any stocks mentioned. The Motley Fool owns shares of Big Lots. 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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