Academy Sports And Outdoors- When A Turnaround Business Returns To Growth

Thesis summary

Academy Sports And Outdoors is a specialty retailer focused on sporting and outdoor products, which was turned around by the former CEO Ken Hicks. Their value proposition is to provide a really complete assortment, selling high value private brand at exceptionally low prices and national brand at normal prices. With 277 stores in 18 states, the company is well positioned to grow its store count at a clip of ~10% per annum. The industrial headwinds notwithstanding, the company would benefit from greater private brand penetration and e-commerce presence. They are the best-in-class player in a highly fragmented industry and have the potential to gain significant market share from other players, especially traditional sporting goods stores and mass general retailers.

I assume the company has a normalized net margin of ~6% in 2027, much lower than the current level (over 8%+). If the company successfully executes their expansion plan (120-140 new stores from 2023 to 2027), the annualized return could be 20%+ at a terminal P/E of 10x and dividend yield of 1%. A terminal P/E of 15x in this scenario is not impossible. If the management fails to deliver the plan, and opens, say, 60 stores instead (< 5x FY2023 plan) from 2023 to 2027, we could still have an annualized return in the high teens at a terminal P/E ratio of 10x and dividend yield of 1%. The real downside case is that the new management team fail to focus on operation, brand building and disciplined inventory management. In this case, at least the low valuation multiple of 6.38x forward PE provides us with margin of safety. Due to the management team turnover and industrial headwinds, I am not suggesting you catching the falling knife. But the asymmetric reward to risk deserves your attention.

Price: $45.39
Market Cap: $3.40B
EPS (Forward): $7.16
P/E (Forward): 6.38
P/FCF: 7.35
Dividend Yield: 0.7%
Nov 13, 2023

Introduction

Another retailer. This is true. But I am talking about a best-in-class operator that pays careful attention to provide value product to their customers. I am not saying that it is not a beneficiary of COVID. In fact, the whole sporting and outdoor goods industry benefitted much from the record spending after the outbreak of COVID. But the stock trades at 6.38x forward P/E while its largest competitor Dick’s Sporting Goods, which has twice larger market share than Academy, trades at 9.48x forward P/E. In terms of operation and inventory management, Academy is better than Dick’s Sporting Goods. What’s more, Academy has a much longer growth runway. I can’t think of a solid reason why this is the case. Perhaps this is because Dick’s Sporting Goods is the market leader? Or maybe the investor community holds the opinion that the worst is yet to come for Academy? I can’t come up with a solid reason to justify such a discrepancy.

Background

Company and Business: Academy Sports + Outdoors is $6.4B American retailer of trending outdoor and sport categories, operating 277 big-box stores located in the south and southeast. They strive to provide complete assortments (from balls to bicycles; from baits to outdoor cooking), great value and fun experience to their customers. The total U.S. addressable market is estimated to be $175B+ (half of it is apparel), growing at a CAGR of ~8%. The company currently has ~3.5% market share and its largest competitor Dick’s Sporting Goods has ~7% market share.

Source: Investor Presentation- Sep. 2023

Academy Sports + Outdoors currently operates in only 18 states, with underpenetrated presence in existing markets. They have three distribution centers, each capable of supporting around 120 stores, yet they only have 277 in total at the moment. The capacity utilization of two distribution centers is only ~50%. Therefore, they still have substantial growth opportunities ahead. Furthermore, the company also sees secular tailwinds from population growth. The population growth rate in their core markets is double the national average and is expected to remain strong and sustained for the next few years. With the management estimate of 800+ stores at maturity, I believe that they can at least double the store count from here.

Competition: Academy Sports + Outdoors mainly competes with some other brick-and-mortar stores: mass general merchants (like Walmart), large format sporting goods store (Dick’s Sporting Goods), traditional sporting goods store (stores with much lower square footage like Hibbett Sports), and some other specialty retailers. Their distinct value proposition compared with other retailers is that they aspire to be the one-stop shop that provides value merchandise focused on higher AUR, lower margin goods.

Besides, they also compete with some internet retailers (like Amazon and eBay). In comparison to those brick-and-mortar specialty retailers, the outdoors and sporting goods generally represent a small proportion of merchandise.

A turnaround story: Academy was acquired by KKR through LBO (Leveraged Buyout) in 2011. Just like many other private equity deals, in which the companies took on too much debt and got squeezed of its profit/growth potential, Academy suffered from a consistent drop in unit economics in the years after the deal until 2018. In 2018, Ken Hicks was brought in and took over the CEO to clean up the mess. He introduced shrewd pricing strategy (best price for private brand, and normal price for national brand vs. best price for everything), leaner inventory management and merchandise localization. With massive margin expansion and debt reduction (4.1x net leverage in 2019; 0.25x net leverage in 2022), Academy made much improvement in both financial position and operation. All the mature stores are profitable and have the sector-leading unit economics. A struggling retailer has been turned into a best-in-class operator. For now, Academy is well positioned to return to expand the store counts.

During COVID, Academy expanded its e-commerce presence (Academy.com) to ~10% of the total sales. ~75% of the e-commerce sales are fulfilled in stores, driving more traffic to the offline business.

Another COVID beneficiary? : The outdoor and sporting goods industry has seen significant tailwind after the outbreak of COVID. Dick’s Sporting Goods, for example, experienced a gross margin expansion from 28%+ before COVID to 38%+ in 2021. Of course, sporting apparel is one of the strongest spending categories. In 2023, however, many retailers in the industry saw negative comparable sales due to tighter consumer budget, economic pressure, shrinkage, etc. Therefore, the prevailing narrative among investor community is that as the industry normalizes, Academy is going to experience a strong short-term headwind. They believe that in a more promotional environment where the customers are hit hard by the economic pressure, all the players will suffer. It is true that the company already saw decline in sales in all the four categories, and the big-ticket items with long replacement cycle were especially challenged. I can’t predict the trough of the industry, but fortunately, the company didn’t accumulate excessive inventory during the favorable industry conditions. When the industrial headwind blows, many other retailers will scale back their outdoor and sporting goods offerings, presenting a great opportunity for Academy to gain market share. I am not suggesting you catch the falling knife here, but the stock is worth monitoring in the next several years.

Source: Tikr Terminal

Competitive advantage

Selling outdoor and sporting goods is not an easy business. Many traditional sporting goods store chains struggle to remain relevant nowadays. For Academy, the competitive advantage is that they provide the largest assortment among those brick-and-mortar retailers and the guarantee to beat any competitor’s price, online or offline, by 5%. That is the reason why their Net Promotor Score, a customer loyalty and satisfaction measurement, is considerably higher than its largest competitor Dick’s Sporting Goods and is the highest in category.

Source: Sept 2023 Presentation

What’s more, their store locations make them better positioned than their competitors. They typically open stores adjacent to major highways and throughfares, and the stores are generally placed in retail centers close to co-tenants who drive significant traffic with no store tethered to crowded mall space. I think this strategy can attract without inviting too much competition. While many traditional sporting goods retailers are adversely affected by the decline of department stores and shopping malls, Academy is still doing well.

Financials

Debt level: The company paid down the long-term debt to $583M in the past several years due to record level cash flow. The LTM EBIT interest coverage ratio is 15.38x, a very healthy level. The company also has $1.061B of capital leases, since they seek to lease all their stores in long-term contracts. At such a debt level, there is no much concern.

Source: Tikr Terminal

Net margin: In the investor presentation, the management targets a 10% net margin for 2027, seeming to presume that the net margin of 8%-10% in the past two years is sustainable, which may not be the case. On the contrary, the investor community appears to be overly pessimistic about a massive net margin compression alongside lower comparable sales. Otherwise, why assign a depressed forward P/E of 6.38x to the stock? Taking a middle ground, I suggest a 6% normalized net margin, but this is guestimate at best. Over the next few years, the larger proportion of private label products and more pervasive e-commerce presence will be a supportive force for margins compared to the tough time before COVID.

Return ratios: I would like to touch on ROIC here. In 2019 and 2020, the company’s ROIC was ~5%. However, during that period, it was still in the early stages of a turnaround and confronted industrial headwinds, leading to an extra thin net margin. After the outbreak of COVID, financial stimulus in the U.S. prompted increased customer spending on outdoor and sporting goods category. Massive margin expansion propelled the overall ROIC to 20%+. The LTM ROIC remains at 19%+, even though the company has seen industrial headwinds in 2023. I estimate the normalized ROIC to be 15%+ even after taking into moderate margin compression into account.

The management stated that they carried an internal standard of ROIC against “everything they do”. What I especially dislike about the stock is that the management uses EBITDAR (EBITDA + rent) after estimated tax as numerator instead of the expected NOPAT (Net Operating Profit After Tax) in the calculation of ROIC on presentation. This is bizarre. Of course, by using such a trick ROIC appears to be much higher, but what is the meaning of it? (This could be a telltale sign that the management is promotive.) I don’t know. Let’s wait and see.

Inventory: Academy seems to maintain a proper level of inventory. As of the end of Q2 FY2023, the inventory balance was $1.3B, which was flat yoy in terms of dollar value and down 2% yoy in units. On a per-store basis, units declined 5% yoy. The inventory balance is better than its largest competitor Dick’s Sporting Goods and much better than some traditional players, which accumulated excessive inventory when time is good but then had to make promotions latter. The LTM inventory turnover came down from its all-time high in 2022, which is a common in the whole industry. Due to short-term headwinds and consumption cycles, the inventory turnover might be even worse in the next n months.

Dividend: The dividend yield is 0.7%, with a payout ratio of 4.7%.

Management

The former CEO: Under the tenure of the former CEO Ken Hicks, the company was turned from a declining business to a best-in-class player. He is a low-key figure. He made the inventory leaner, made the business more efficient and set a shrewd pricing strategy that improves the margin without turning away customers. Prior to his stint at Academy, he also turned around the American sportswear and footwear retailer Foot Locker from 2009 to 2014. Sales rose 35% and we saw a dramatic margin expansion. The situation at Academy is quite similar to that, even after taking the COVID anomaly into consideration.

“I tell people all the time that I don’t actually do anything. My job is to make sure we have the right people, with good direction, plans and resources, but it’s the people who do it. They’re the ones who drive our business. If I don’t show up for a day, the company will still move along fine. Leaders need to understand that the people are the ones that really make things happen.”

Ken Hicks’ public remarks about people and leadership.

The new management team: The previous CMO Steven Lawrence took over CEO as a planned successor in June after the retirement of Ken Hicks. Ken Hicks became the executive chairman. The previous CFO Michael Mullican became president and departed later this year. Under the supervision of Ken Hicks, hopefully the corporate culture and the disciplined inventory management will be maintained. It is worth monitoring the inventory, store expansion plan and customer satisfaction to appraise of the operation under the new CEO.

About his plan to open 120-140 stores (more than a half is adjacent to the current footprint) in the five-year period by 2027, I don’t think it is a stretch. This is not a retailer that takes on too much debt to expand 30%+ per annum. Such a growth planning gives the management more time to find the suitable real estate and maintain operating quality. Besides, it is highly likely that the growth expenditure will be fully covered by the operating cash flow. A little bit of unit economics here. It takes $5-6M capital to open a new store, which has a general year 1 sales target of $18M. The store attains maturity at year 4/5. If he indeed expands ~10% of the store count annually, chances are high that the margin will be pressured for the next few years. As a result, I think their 2027 net income margin of 10%+ can hardly be achieved. (It might be another telltale sign of overpromise here)

Capital allocation

Since Academy was bought out by KKR in 2011, the company didn’t make any acquisition. I don’t think they will make any acquisition any time soon. The management reduced the share count by almost 19% in the past 2 years. The capital allocation priority is 1) self-fund growth and strategic opportunities 2) return capital to stakeholders through dividend growth, opportunistic share repurchases, and debt paydown.

Amateur’s edge (opt.)

Valuation

First assume that the management successfully executes on its expansion plans and achieves a store count of ~400 by 2027/2028. Take the unit economics of new store into account, I estimate the total sales of the company to be ~$9.1B, instead of the 2027 management goal of $10B net sales. I assign a 6% terminal margin to the business, which is conservative after factoring in the COVID overearning and new store opening, because of the increasing trend in private brand penetration and e-commerce presence. What about the share buybacks and dividend in the next few years? This depends on how much free cash flow is left after all kinds of growth and maintenance capex. The management estimated capital expenditure plus working capital and adjustments to be ~$2.0B-$2.5B from 2023 to 2027. I keep this figure. I assume that the company produces $1.0-$1.5B free cash flow for the next 4 years (significantly lower than the management target). Compared with the market cap of $3.4B, this is a massive amount. For convenience’s sake, imagine that the company buys back 5% of share outstanding and has a dividend yield of 1%. All those assumptions bring us to a terminal EPS of ~$9 (the consensus for FY2024 is already $7.91) in 2027. Assign a conservative 10x P/E ratio, the stock price will double from the current price. Together with the dividend, this presents us with an annualized return of 20%+. In this scenario, I don’t think a 15x P/E ratio is unreasonable.

What if the company doesn’t expand at that clip? What if the company only increases the store count at 4%-5% CAGR like the planning for FY2023? If this is the case, the sales estimate for 2027 will be $7.5B. The company could have $1.5-$1.8B estimated free cash flow for the next 4 years. Imagine that the company buys back 6% of the share outstanding and has a dividend yield of 1%. I have my terminal EPS “guestimate” of ~$8.0 at a net margin of 6%. A 10x terminal P/E will bring us with an annualized return in the high teens.

Why this opportunity exists

• An exceptionally low consumer confidence in the U.S.
• Worries about the brick-and-mortar retailers in general
• The negative comparable sales in 2023 (don’t forget the crazy increase in 2021 & 2022!)

Risks

• The change in management: the new CEO hasn’t proven himself in this position
• The inverting trajectory of consumption
• An excessively promotional environment
• The management doesn’t focus on operation, brand building and disciplined inventory management anymore

Catalysts (opt.)

• Increasing the store count as planned