Since the release of the annual accounts on July 20, 2017, shares of Sports Direct rallied by 40%.
The results were largely as expected with a drop in operating income of 44.1% to GBP 124.8 m (adjusted for the gain on the disposal of the Dunlop brand, realized FX losses and exceptional items). Gross margins came under pressure due to the weakening of GBP against USD. Most of the procurement costs are denominated in USD. Pre-Brexit the company was not hedged against a drop of UK Sterling. Also restructuring expenses for the international business increased operational costs.
Currently, the company has hedges in place at a GBP/USD rate of 1.31 compared with a historical long-term average closer to approx. 1.6. As a consequence, pressure from currency effects might continue for the time being.
On a positive note however, management expects EBITDA to grow between 5% and 15% for fiscal year 2018 ending in April 2018. In addition, the board finally appointed a CFO, filling this key role with a permanent member of staff for the first time since 2013.
Most importantly, however the company is currently in the process of changing its business model.
So far, the company’s business model has been 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, Sports Direct differentiated 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 were offered. Combined with a lean supply chain where the company tends to look after most of its logistics itself rather than use external servicers, the company has been very successful over the years.
As the charismatic owner operator Mike Ashley puts it Sports Direct’s aspiration is now to become the “Selfridges” of sport. This means that the company is elevating their retail proposition shifting the store base from a large number of smaller branches focused on price led retailing offering best value to customers to a smaller number of larger upmarket new generation/flagship style stores that attract less price sensitive customers.
The strategic shift seems to be a reaction to the pressure from third party product companies. Top brands have been raising concerns that their labels are not well presented in Sports Direct store formats. Sports direct is emphasizing in the recent annual report that they want to improve the relationship to third party suppliers. A recent announcement of a collaboration with ASICS hints into this direction.
The elevation and relocation of the store portfolio not only includes new rentals but also the investment in freehold property and even development projects. Management wants to invest a total of up to GBP 1,000 m over 2 to 4 years in company owned properties. Roughly one third of this amount has already been allocated in fiscal year 2017.
To finance these investments, the company is now targeting a net debt to underlying EBITDA ratio of up to 3 times or roughly GBP 800 m based on trailing underlying EBITDA. Net debt to underlying EBITDA is currently 0.6 times.
Apart from that, rental payments increased by 39.5% to GBP 183.3 m (adjusted for sub-lettings) in fiscal year 2017. Current obligations from non-cancellable operating leases stand at GBP 785.9 m.
Consequently, the company is expected to increase financial leverage substantially over the next years. A retailer, that combines a hefty debt burden with a considerable amount of lease obligations is ringing my alarm bells.
I also believe that the entrance in the upscale/premium market will require substantial investment in the existing company owned portfolio of brands to re-position them.
Moreover, Sports Direct used to have little overlap with competing retailers of similar size in the UK. From a pricing perspective, they are very competitive and also in the online space they can easily keep up with Amazon. Now they are focusing on a different market segment for less price sensitive and more fashion orientated customers that has been dominated by the likes of JD Sports. JD Sports is a sports retailer that has been extremely successful over the years and that will not be easily to overcome. Early indications by management suggest that the new store formats are slightly more profitable than the older ones but I am not sure whether this will stay like that.
On a different note, I was missing more substance on the online channel in the annual reporting. I could not find any information on online sales (different from last years) and the strategy going forward. This is frustrating because so far, I have been of the opinion that online sales are progressing very well compared to other brick and mortar retailers.
I highly respect Mike Ashley and his team for their operational performance. In the retail space, you have to adapt quickly to remain relevant. With the strategic shift, they might be doing the right thing for the business, because the current retail proposition might not be viable in the future. My investment thesis however was based on a different business model which used to be more attractive but seems to be not sustainable over the long term.
Fortunately, I now have the opportunity to dispose my shares realizing a healthy return. I assume that I sold my position today at a price of 416 pence per share realizing a total return of 31.7% and an IRR of 27.4% over a 14 month holding period.
I will keep following Sports Direct and might consider an investment at some point in the future again.
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