This owner operator showed strong growth combined with healthy profitability over the last years. However, last fiscal year’s results and an uncertain outlook put pressure on the company’s market value. Negative media attention was another drag on the stock price. The current market value implies a 50% discount to its peer group. From my perspective, the large discount is irrational given the company’s strong positioning in its market segment and a management team in place that has been successful in allocating capital over decades.
Sports Direct (SD) sells sports and leisure clothes, equipment and footwear in 473 stores in the UK, 260 stores in the EU and over the internet (17% of sales). Sports retailing is the most important segment generating 85% of sales. In addition to that, the company operates premium retail businesses such as Cruise, Flannels and USC (7% of sales). The third segment contains the licensing and wholesale of the company owned brands (8% of sales).
SD is focusing on price led retailing offering best value to customers. The company’s business model is based on selling relatively low margin third party products (i.e. Nike, Adidas and UnderArmour) alongside higher margin proprietary brands (i.e. Dunlop, Slazenger and Lonesdale). Consequently, SD is differentiating the company‘s sports retailing stores from its competitors, both in terms of the range of products on sale and the competitive prices at which they are offered. Combined with a lean supply chain where the company tends to look after most of its logistics itself rather than use external servicers, SD has been very successful over the years as can be seen from the table below:
Since its foundation in 1982, SD has become the leading sports retailer in the UK in terms of revenue and operating profit by offering shoppers cheap deals and wrestling market shares from rivals.
SD not only competes successfully over conventional sales channels but also over the internet. As far as I can see they offer more value to customers than amazon.co.uk does. The following table provides an overview of a small randomly selected basket of products offered at sportsdirect.com (UK) and amazon.co.uk as of July 2016:
Interestingly, amazon.co.uk offers better deals on only 6 out of 15 sample products. Moreover, discounts are generally larger at sportsdirect.com.
Mike Ashley is the founder and controlling shareholder of SD. He and Dan Forsey, CEO, have been part of a small team that has led the company for decades. SD is based in Shirebrook, a small town in the Midlands, where they also operate UK’s second largest logistics center.
Though this business has been a great success, it has not been spared from adversity. Briefly after the IPO in 2007, the relationship between the City and management broke down. The chairman left within three months after the floating and concerns about corporate governance emerged. Ashley called some analysts, investment bankers and shareholders “a bunch of crybabies“ and said that in hindsight he finds going public „very challenging, especially the procedure“.
This together with a deterioration in the economic outlook led the share price fall from 300 pence from the IPO to around 30 pence in 2008. From here, the share price reached an all-time high of more than 900 pence in 2014. During that period, SD had grown revenue by 100% and operating profit by 170%. Operating margins and return on investment showed strong improvement.
The current downturn
Sooner than later adversity has returned. From its all-time high in 2014 the company’s equity value has lost more than 70% and shares are now trading at 260 pence. How has this situation evolved?
(1) European expansion weighs on profits
Over the last twelve months, management announced two profit warnings reducing EBITDA target for the fiscal year (FY) 2016 (ending in April) from GBP 480 m to GBP 380 m. Though this keeps EBITDA flat compared to the year before, the longer term development is still impressive. Over the last years same store sales increased by roughly 7% per annum, but for the first time since the financial crisis were down by 0.8% in FY 2016.
The company is struggling with its expansion into continental Europe. Ashley and Forsey believe SD‘s model of cut-price offers on top brands such as Nike and Adidas, subsidized by high-margin sales of own-brands including Dunlop and Slazenger, can be replicated across Europe. In the UK, SD profited from the demise of JJB and Allsports.
However, SD is now competing against the sport retailing giants Decathlon (EUR 9 bn in sales with 1,056 stores in 29 countries) and Intersport (EUR 11 bn in sales and 5,400 stores in 43 countries). Both have an established presence in continental Europe.
Moreover, it seems that at least Austrian shoppers are not prone to heavy discounting without any services. In 2013, SD bought Austrian sports retailer Eybl. After the acquisition, Austria together with Belgium had become SD’s largest market outside the UK. Since the acquisition the integration of Eybl has been a financial debacle as former customers shunned away from the new store concept and management has not been able to cover the shortfall with new customers. Revenues in Austria fell from EUR 307 m in FY 2013 before the acquisition to EUR 189 m in FY 2015 shortly after the acquisition. Austria contributed losses to the group of EUR 45 m in FY 2015.
(2) Challenging relationship with key suppliers
There is a risk that key suppliers cut off their ties to SD. The relationship between SD and key suppliers like Adidas and Nike is two dimensional. On the one hand SD has one of the largest product ranges, for instance it holds more than 5,000 product lines from Nike. On the other hand, top brands are raising concerns that their labels are not well presented in Sports Direct store formats. Top brands are crucial for SD to increase traffic in stores and to enhance the status of the proprietary labels.
Consequently, management has decided to go upmarket. A number of Sports Direct stores are being relocated to better locations and management is implementing “shop-in-shop” concepts for brands like Nike and Under Armour. They are also trying to put more weight on their premium brands segment including retail formats like USC and Flannels to reassure suppliers. For instance, in April 2016, the company announced the acquisition of a freehold property at 161-167 Oxford Street in London for GBP 108 m. The property will be converted to a Flannels flagship store. However, the premium brands segment has been unprofitable so far. Still, for SD it might provide scale to diversify offerings by adding better locations and premium brands to their portfolio. The recent attempt to acquire bankrupt BHS also hints to this direction. In addition to that, they are running 9 concessions within Debenhams stores securing a platform to sell top-end products of key brands that are unlikely to be distributed to its own sports retail shops.
Overall, I believe the supplier risk might be overstated as SD provides top brands an opportunity to get rid of excess inventory which might be difficult to sell over other sales channels than discounting.
In addition, I believe that supplier risk is not limited to cut off price models like the one SD uses. For instance, JD Sports (see peer group analysis below for more information), one of SD’s competitors in the UK, focuses on the sports retail premium segment and has been highly successful. However, one could argue whether JD Sports will face more competition from top brands like Nike and Adidas potentially increasing direct selling to the customer in the future. In addition, JD Sports is also following a similar strategy: they are offering high margin private labels in combination with top brands (though at a different price level).
(3) SD targeted by the press and Government officials
Recently, SD attracted a number of negative press headlines. SD like other UK employers has repeatedly been criticized by an extensive use of zero hour contracts with their workforce. Under a zero hour contract employees do not know how many hours they will work each week and have no holiday or sick pay and can be cancelled with a day notice.
Following a public outcry, the company set up a special committee led by Mike Ashley to examine the allegations. Ashley told the media that SD is “in trouble”, a comment which irritated shareholders once again. In June Ashley appeared before a House of Commons Select Committee. For investors the hearing provides some interesting insights in SD and Mike Ashley as a businessman.
Apart from setting up a special committee, the most meaningful reaction by the company was an increase in pay for SD’s directly employed UK employees and directly engaged casual workers from being on the National Minimum Wage to being above the National Minimum Wage from January 2016. Hence, based on my understanding this increase does not include workers who are coming from agencies. Overall, this issue has been a public relations disaster for the company. However, from my perspective I believe that this is a more general problem not only specific to SD which should be dealt with by the legislator and which concerns the industry as a whole .
According to management, the workforce needed at their warehouses increased substantially over the last decade. Reason for that is the rise of the internet. Packaging a large number of different small volume customer orders is much more work intensive than packaging a small number of bulk orders being delivered to stores. Consequently, the availability of zero hour workers came in handy for the company. However, management has been allocating large amounts of capital to enhance logistics and warehousing. So I expect SD’s warehouses to be fully automated soon which simply will make a large part of the existing working force redundant. As a consequence, the discussion will move on to “how to employ the people”.
(4) Questioned corporate governance practices
Corporate governance practices are an ongoing concern with market participants. Mike Ashley is holding 55.1% in SD. Despite being a public company, at least from an operational perspective SD is still owned by Mike Ashley. The interference between being a public company and at the same time no clear distinction between the person Mike Ashley and Sports Direct has been neglected by market participants as long as the numbers were right. Now, with a slowing growth rate concerns about shareholder treatment have returned.
Some of the concerns are related to the company’s investments. The company is regularly investing in other retailers. Most of the time it is difficult to say whether for strategic or financial reasons. However, it is noteworthy that accumulated net cash proceeds from investments from FY 2007 to FY 2016 were GBP 95 m. The current 30% stake in catalogue retailer Findel and an option to acquire a 10.5% stake in retailer Debenhams seem to be more of strategic importance to management. Both companies might provide SD with diversification of sales channels and product range combined with an increase in scale.
In one of the few interviews Dave Forsey gave to the public, he claims that management is very focused on the business development side with a mid to long term view. He admits that they could have done better with regards to public relations in the past, but that the focus on the important aspects of the business is part of the operational success. In addition, watching Mike Ashley’s hearing in front of the committee (an invitation that Mike Ashley first rejected but then attended) strengthens my view of a prudent, experienced and hands-on management team.
On June 23rd, 2016 UK voters decided to leave the European Union. A looming recession in SD’s most important market and the likely negative impact of a weak British pound on procurement prices have led SD’s share price fall by one third since the referendum. In terms of currency hedging, management announced that they have not hedged the USD for FY 2017 in which most of the goods bought are denominated. However, they are to a large extent still hedged against the EUR which is obviously unfortunate.
Overall, a negative impact from the outcome of the referendum on SD’s business can be expected. Nevertheless, SD is offering goods that are essential to customers and which are offered at the lowest possible price. At least in theory, SD’s business model should be relatively resilient during an economic downturn.
(6) Index exclusion weighing on stock price
In March 2016, SD shares dropped out of the FTSE 100 and in June SD shares fell out of the STOXX 600 index.
Economics and valuation
(1) Return on investment
The following table provides an overview of the return on investment, SD generated since the IPO:
1) EBITDAR is defined as earnings before investment income, interest, taxes, depreciation & amortization and rental payments. Average invested capital is the average of beginning and ending total assets, accumulated depreciation & amortization less investment properties and accounts payable, plus an estimation of operating lease liabilities equal to the rent for the fiscal year times a factor of eight (but not less than the PV estimate of future operating lease payments).
For fiscal year 2016, I had to make estimations with regard to rental payments and accumulated D&A, numbers that will be disclosed with the release of the annual report. Average return on investment was 16.0% over the last nine years. Last year’s ROI decline is related to a large increase in invested capital due to additions to working capital and property, plant and equipment.
(2) Peer group analysis
The following table provides a peer group analysis based on last fiscal year numbers:
1) Adjusted for bank assets
JD Sports is a UK sports retailer which in contrast to SD is not focused on the cut off price segment, but on the premium segment. JD Sports has developed very close ties to key suppliers. As a consequence, JD Sports is supplied with products on an exclusive basis which can be sold at a premium to customers. Capital returns and margins have been enhanced significantly over the last years. Market participants honored the improvements with the share price increasing by roughly 500% over the last years.
Interestingly, SD used to own an 11.9% stake in JD Sports. In fiscal year 2016, they reduced their position to 5.4%. The disposition of 11.6 m shares in JD Sports contributed strongly to SD’s income from investments of GBP 148 m in FY 2016 (not included in operating profit). After fiscal year end, SD has further reduced their stake to 3.9% as of today.
Next is somehow the benchmark in the industry and is also highly respected by Mike Ashley and Dave Forsey. The retailer sells clothes, accessories and home products across stores, catalogues and the internet. Half of sales stem from brick and mortar stores. Management reports in a very transparent way to the public and is following shareholder interests.
From the table above, SD is trading at a large discount to the peer group despite generating similar margins and returns. Hence, SD’s current market valuation implies a significantly worse operating performance in the future than that of comparable listed companies.
(3) Performance indicators
The table below shows a number of performance indicators. In line with the company’s reporting the indicators relate to the company’s most important segment sports retail (85% of revenue) excluding wholesale, licensing and premium retailing:
There are three indicators showing a deterioration in operations.
First, cash conversion cycle is slowing down. The number for FY 2016 is an estimate. The increase in days of cash conversion is mostly due to rising inventory levels. Management states that they have invested in inventory to further grow the business. This development is worrying as cash conversion is one of the key metrics for a retailer. However, we can see a similar development in the industry. Cash conversion cycle for Next plc increased from 89 days to 103 days and even JD Sports witnessed an increase from 32 days to 40 days in FY 2016.
Second, sales per square foot are going down. I assume this being mostly due to the European expansion strategy. Management stopped to report regional sales numbers after FY 2013. At that time, sales per square feet in Europe were roughly half of that in the UK. Hence, with a growing proportion of ex-UK sales this indicator is declining. For comparison, sales per square foot for Next were GBP 312 and GBP 534 for JD Sports in FY 2016. JD Sports has smaller shops than Sports Direct with roughly 3,900 square feet on average and pays higher rents.
Third, same store sales growth was -0.8% in FY 2016 marking the first decline since FY 2009. In contrast, JD sports grew more than 10% on a like for like basis in FY 2016. Next’s existing stores produced slightly less sales than the year before.
On a positive note, SD generates strong gross margins and average weighted lease maturity for the UK was down to 4.6 years at the end of FY 2015. This is one of the lowest levels in the industry and provides for ample flexibility for management to react to the changing retail environment. In comparison to that, Next has an average weighted lease term of 7.4 years.
Mike Ashley does not receive a salary. Dave Forsey receives a base salary of GBP 150,000 a year which has remained unchanged since 2002. Not only he, but another 3,000 employees receive a relatively small base salary, but have the prospect of receiving a large bonus.
From the FY 2015 annual report:
“Under the 2015 Share Scheme all employees (including Executive Directors) who are determined by the Board as eligible who meet the qualifying conditions and performance criteria as determined and agreed by the Remuneration Committee and the Board will be able to participate. The terms of the 2015 Share Scheme provide for the grant of nil-cost options over up to 25m ordinary shares in the Company (amounting to approximately 4.2% of the issued share capital of the Company). Senior Executive grants are limited to a maximum of one million shares each. The vesting of any options would be conditional upon the achievement by the Company of four Adjusted Underlying EBITDA targets (before scheme costs) set by the Committee. If these performance targets are all met, 25% of any award would vest following the announcement of the Company’s audited results for FY19 in July 2019 and 75% of the award would vest following the announcement of the of the Company’s audited results for FY21 in July 2021.”
Hence, the scheme is based on the achievement of four consecutive full year EBITDA targets. The following graph provides an overview of the current scheme and former scheme targets:
Although “underlying adjusted EBITDA” provides for some management discretion, the targets itself seem to be quite ambitious. For the first time, the company did not meet the target in FY 2016, although it was revised down to GBP 420 m at the last annual meeting (FY 2016 actual: GBP 381 m). Management recently announced that they are working on a new incentive scheme. However, for many employees this is a significant part of their remuneration and it will be interesting to watch how management reacts to keep talent. From a shareholder perspective, targets related to return on capital are generally better than based on EBITDA. Still, I believe that the remuneration policy in place with a focus on mid to long term achievements aligns interests to a much larger extent than it is the case with most other companies’ remuneration policies.
Concerns about the company’s core values are weighing on the stock price. There seems to be no doubt that staff has been treated unfairly. However, it is highly likely that this malpractice is unfortunately concerning the industry as a whole. Moreover, ongoing automatization might lead to less employment at the warehouses in the future.
There is a number of corporate governance issues like Mike Ashley’s daughter’s boyfriend leading the company’s real estate M&A department or Mike Ashley’s brother heading the IT department. It seems to be part of the company’s culture to have a small circle of managers who are close to each other. In addition, sometimes there seems to be no clear distinction whether Mike Ashley is doing business on behalf of the company or on his own. However, so far I have not identified any misbehavior against minority shareholders. To the contrary, the management structure and the business model have created substantial value for shareholders.
From an operating perspective, uncertainty with regard to profitability in Europe and the negative economic outlook in the UK weigh on the stock price. I expect the company to be able to deal with both issues. Like in the past management will be proactive in shutting down unprofitable stores and in acquiring favorable leases. Supplier relationships should improve with the company diversifying its product range. The company offers best value to customers over several sales channels. Returns on investment are in the mid to upper end of its peer group. Still, the company is trading at half the peer group’s valuation.
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