Big Lots, big gains?
Business overview
Big Lots is a home discount retailer with over 1400 locations in the United States as well as an e-commerce platform. They sell a broad range of merchandise, with furniture, home décor, food, and consumables being the most prevalent. They purchase inventory from both domestic and international manufacturers and frequently take advantage of various close-out opportunities such as production overruns, liquidations, packaging changes, discontinued products, and so on.
Big Lots' main goal is to provide their customers with huge savings and exceptional value with their never-out products and essentials, as well as to surprise them with unique products (purchased in close-out deals) in the treasure hunt section of the store (similar to Ollie's)
The majority of their inventory is delivered to stores from five regional distribution centers in order to reduce transportation costs and make the entire supply chain more efficient.
In addition to the distribution centers, Big Lots operates two other warehouses within its Ohio distribution center. One warehouse transports fixtures and supplies to their stores, whereas the other warehouse serves as a fulfillment center for the e-commerce business. They also fulfill direct-ship e-commerce orders from 65 store locations
Overall, the business was historically stable, with extremely consistent gross margins in the 39–40% range and generating anywhere from $150 million to $250 million of free cash flow in a typical year.
Operation North Star
In 2018, they appointed a new CEO, and in 2019, he launched Operation North Star, a strategic overhaul focused on unlocking Big Lots' true value.
The plan has three primary goals:
1. Drive profitable growth by
growing sales with a bigger store footprint, closing underperforming stores or upgrading them in the newly formed store intervention program
increasing same-store sales (with various initiatives I will present later) and accelerating e-commerce growth
2. Fund the journey by
increasing gross margins, improving store efficiency, and creating a frugal culture
improving bargaining power with vendors
3. Create shareholder value by
optimizing capital allocation
returning money to shareholders in the form of dividends or buybacks
The three-year execution of Operation North Star was less than promised but decent overall.
Mill Road Capital, a 5% owner of Big Lots, wrote about the strategic execution in the text below. Although they did cherry-pick the information, the progress of the business is summarized pretty well.
(the text below is from March of 2022, and I suggest you read it)
Now, you may be wondering why am I pitching you a "nothing-special" retail business. The answer is that this company, which has been profitable for 31 of the 34 years it has been in operation, is trading at less than 0.1x P/S. This equates to less than 2x normalized FCF, assuming they maintain their historic 4.5% FCF margin.
The only thing you need to make a lot of money in this setup is for Big Lots to stay in business and resume normal activities.
Recent developments
Big Lots, like many other retailers, had an abnormally good year in 2020. Sales, margins, and profitability were all at an all-time high as a result of stimulus checks and people wanting to "upgrade their homes."
Then came '21 and '22, and management made a series of strategic missteps. In late 2021, management acknowledged that they had "left sales on the table" during the previous two holiday seasons and planned to finally meet demand that winter.
As a result, they prepared the company for another record year by stocking more inventory than usual, for which they paid higher-than-usual prices. Inventory prices rose due to supply-chain disruptions and higher freight costs.
We expect her spend to be up from the research we've seen, up 25% in the Holiday season. So, we have done a nice job preparing our stores, getting them in stock – Q3 ’21 earnings call
This line from the earnings call was the root of all their problems. (P.S. If you're wondering who "she" is – it is Big Lots' core customer, and they call her Jennifer)
Furthermore, Big Lots had a fortress balance sheet in '20 and '21, so management decided to buy back 417 million dollars worth of stock at an average price of 54 dollars. For reference, Big Lots' current market capitalization is $460 million.
To say that 2022 did not go as expected would be an understatement.
The gross margin fell from 39.6% in Q2 21 to 32.6% in Q2 22. Rapidly declining gross margins are unacceptable in the retail industry. It usually indicates that the company is facing severe competition and lacks pricing power. And it is for these two reasons that most retailers fail.
Management's reasoning:
The core consumer was harmed by all-time high oil costs and worried about future inflation.
Big Lots also paid peak freight expenses as a result of the agreement they made in the spring.
They did not sell as much inventory as intended and were forced to be more promotional, resulting in lower gross margins.
Big Lots is heavily reliant on selling furniture and home décor items, which are discretionary, high-ticket purchases for the majority of its clientele.
Part of the explanation appears reasonable, while the rest seems to be excuses and softening of the facts. If we compare it to their nearest competitor, Ollie's, we can see the same trend in gross margins. However, when compared to Dollar General, Dollar Tree, or any other discount retailer, the margin reduction is not as severe as is the case with Big Lots.
Of course, there are nuances to each business and the products they import, distribute, and sell, so it is not an apples-to-apples comparison.
The third quarter also had a record negative operating margin of -10% and a drastically deteriorating balance sheet. What was 53 million in cash and only 3.5 million in long-term debt at the end of FY21 is now 62 million in cash and 459 million in long-term debt. Furthermore, they halted their share repurchase program after Q1 22. The stock fell nearly 70% in the meantime, and they are now unable to capitalize on the opportunity. The company is burning through cash.
The Good, the Bad and the Ugly
There are a few ways to make sense of the current situation and it is best if I cover them one by one.
The Good
As I mentioned before, the company has only had three negative operating cash flow years in its history. Additionally, they have a price advantage and have been unaffected by both retail and online competition so far (as demonstrated by the gross margin trend). Unlike traditional retail, which will be killed off by Amazon sooner or later, discounts act as an anti-online solution for customers and are the primary reason people visit stores. To find bargains and the lowest prices possible.
Furthermore, during the financial crisis, they not only remained profitable but even increased operating cash flow. The situation may be different now, but the business model is at least partly recession-proof as customers trade down from more expensive stores to stores like Big Lots. Value never goes out of style, right?
Although management made severe mistakes with inventory buildup in '21, they did strengthen Big Lots' value proposition and seem to be moving in the right direction. As I watched YouTube videos that took me around several of the Big Lots stores, I noticed more positive customer feedback from both the creator and folks in the comments on the videos that had recently been produced as opposed to the older ones. All time high Net Promoter Score of 85 in Q2 '22 confirms this notion.
Believe me now. I'd like to keep ranting about recent positive strategic and operational developments, compare their performance and offerings to competitors, and so on. However, this would merely waste your time and extend the write-up while leaving the thesis unchanged. Again, the business does not have to be exceptional to be a great investment at less than 0.1x P/S, nor does it have to be moving in the right direction. It only needs to survive, make a fraction of what it used to make, and transfer it to your pocket.
Now that I've cleared that up. Back to the Good.
Management is shareholder-friendly. Although they did mess up the timing and sizing of buybacks in FY20 and FY21, weakening the balance sheet as a result. They do have a long history of at least adequate capital allocation. Since 2015, they have been regularly paying a dividend. The dividend yield currently sits at 7% (although I don't mind if the dividend is cut to keep Big Lots in business).
Moreover, Big Lots' share count has fallen from 110 million at the start of 2007 to 29 million now. 8–9% average annual reduction over 15 years. Buybacks are virtually never "Outsiders style opportunistic," as one would hope, but they are, at least, not value destructive because Big Lots nearly always trades at a low multiple. Certainly, I prefer buybacks like this to retail companies investing in unprofitable locations that cannibalize their current business. Moreover, I noticed that Big Lots is one of the few companies that has a Capital Allocation Planning Committee, and the CEOs' and CFOs' comments on the earnings calls as well as their incentives give me confidence that returning excess money to the shareholders will remain an integral component of their strategy.
Another thing that can give investors confidence that lower margins and profitability are only a short-term issue are the following comments from the Q2 ’22 conference call:
As we move into Q4, we expect the cleaner inventory levels improving sales momentum due to our efforts in providing better value to customers and lower freight and non-freight costs will lead to a recovery in Q4 gross margin to be approximately in line with the prior year. While we expect the sales environment to remain uncertain, we see a more normalized fourth quarter gross margin rate for a few reasons: relative to Q3, sales should improve sequentially on a one-year comp basis as our inventories get into a clean position creating open-to-buy opportunities to offer better deals for our customers increased bargains and closeout offerings, unique and exciting treasures and lower opening price points. With improving sales in clean inventories, there is a reduced need for markdowns and promotions which will benefit our gross margin. Second, inbound freight costs are easing. In Q2, higher inbound freight costs, including retention and emerge charges approached 400 basis points of gross margin rate erosion versus 2019. Freight costs have been coming down since the early spring, and we are starting to see this benefit flow through. Third, non-freight costs are also coming down as we're seeing price reductions from our vendors as raw material prices have moderated. Fourth, as Bruce referenced, we have been more targeted and efficient with pricing and promotions. Our ruddy work in food and consumables indicates a $20 million annualized gross margin opportunity that we are already actioning and expect to see benefit from in the second half. Last, we expect to see a shrink benefit in the fourth quarter versus headwind we have faced in the first three quarters.
This remains to be seen, given that their most recent guidance fell short. However, because of their clear reasoning and communication, we should at least give them the benefit of the doubt.
Because the company trades at a P/tangible book value of 0.6, the downside is somewhat limited if not completely protected (depending on the price they would get for their inventory).
However, I doubt that current management will ever want to stop running the business and just liquidate its assets. They have ambitious plans, and I assume they would rather bury the company than shut it down. Nonetheless, creditors seem to think that Big Lots is not in a bankrupt-type situation. On September 21st, Big Lots completed the refinancing and replacement of their existing $600 million senior unsecured credit facility with a new $900 million five-year revolving asset-based loan facility, with an additional uncommitted increase option of up to $300 million. This deal further covers the downside. Moreover, Big Lots owns 25 underperforming stores that management believes can be sold for a significant multiple of the cumulative EBITDA generated.
The Bad
Competition in the retail industry is always present, and if you ask me, I couldn’t tell you how durable Big Lots’ business is. They are still trying to figure out their niche and a clear value proposition. A decade ago, they held a dominant position in close-outs, which they have since, surprisingly, abandoned. Now, once again, their goal is to lean into bargains in a bigger way, but the question is whether they will succeed. Meanwhile, their nearest competitor, Ollie's, has made significant progress and is presently the first on the phone for most vendors.
Second, there is a good chance that the gross margin will never return to 40%. While reading Big Lots' and its competitors' 10-K notes, I found that Big Lots uses aggressive accounting for its gross profits. They include distribution and outbound transportation in SG&A rather than COGS, which artificially increases their gross margin. Additionally, leases for distribution centers, which Ollie's accounts for in COGS, are accounted for in SG&A by Big Lots. As a result, if you compare Big Lots to its peers, its realistic gross margin is probably closer to the 36-37% area. And now, if the ‘22 gross margin impact proves not to be temporary but rather structural, the situation for their operating profits could turn ugly real quick.
Furthermore, the "trade war" with China is still ongoing. Big Lots imports 15% of its products straight from China, and they believe that the vast majority of merchandise purchased in the United States is also manufactured in China. If something happens that prevents American companies from importing from China, the increased costs for the merchandise would force them to hike prices and destroy their value proposition.
Despite being a discount business, Big Lots' product mix is largely discretionary. Furniture and other home categories account for around half of their annual sales and are especially vulnerable to challenging economic conditions and demand pressures.
Evidently, both recession and inflation have a significant negative influence on the business; therefore, the question is what would happen if the company, which already has a weak balance sheet, was exposed to a longer-than-expected period of negative macroeconomic conditions, or even worse, stagflation. At this point, I believe a recession is a likely scenario.
All of the Bad can be summed up in two words: competition and a recession. One is always present, and the other is likely to happen.
The Ugly
The ugly starts with this quote from Warren Buffett. “The first rule of an investment is don’t lose money. And the second rule of an investment is don’t forget the first rule. And that’s all the rules there are.”
I did say that the downside is limited by its book, but I didn't show what would happen if they couldn't sell the inventory at anticipated pricing and had to mark it down as they did in FY22. The current inventory value is $1,345 million. The current tangible book value is $463 million. As Ben Graham suggests, assume that the inventory can be sold for only half the price. The book value of the company would turn negative, leaving your downside unprotected now.
Another problematic aspect is that they are now bleeding cash while leasing nearly all of their locations. The question is, how will they be able to continue paying ~300 million a year in lease liabilities if the business does not return to normal? If you don’t want to stop the business operations permanently, leases act as fixed payments that cannot be avoided, hence just as there is operating leverage in good times, there is also deleveraging on the P&L in bad ones.
Why does the opportunity exist?
Apart from the obvious reason that no one wants to own a retailer in a downturn, Big Lots has long been despised by analysts and hedge fund managers. Current short interest is higher than 25%. Moreover, even though they paid a dividend and repurchased shares, the stock is extremely volatile and has remained at the same price since the 1990s.
According to quickfs.net data, Big Lots has a massive share turnover of 993%. This means that the shares change hands ten times per year. I typically avoid these types of companies since it makes them more efficiently priced, but in this situation, I believe the traders are the ones dictating the price. As a result, in good times when the stock is appreciating, traders will push it to absurd highs, and in bad times, such as this one, they will sell it to unreasonable lows, ignoring the fundamentals. Just have a peek at the stock chart to see what I mean.
Additionally, with a market cap of $450 million and low insider ownership, the company is far from illiquid. However, based on the most recent 10-K, there are only about 800 shareholders of their common stock, which gives me some confidence that it is currently underfollowed and left for good.
Conclusion:
Big Lots is not for everyone. This is not the type of no-risk, high-reward opportunity that I would typically look for in the market. This is a unique investment that I believe has value only for a specific kind of investor.
The profile of an investor who is either well-diversified so that this is only one of many bets with favorable odds or a young investor who can still earn a majority of his portfolio in a given year so that the permanent loss does not bother him.
I think one could even play this with long-term call options. That undoubtedly increases the risk, but based on the information I showed you, I am confident that this stock will either crash to zero or be a 5–10 bagger in a few years. There is no in-between. So, by buying long-term calls, you can limit your exposure and downside with a smaller allocation while still benefiting from the upside.
High risk, higher returns, my friends. You will either be left holding the bag, or it will prove out that the business is at least as stable as it has historically been, and you will make a killing from the revaluation.
And if one trusts what the management is confidently forecasting a few years down the road. With sales of 8–10 billion and an operating margin of 6–8%, you're paying anywhere from 0.6–1x future EBIT at the current price. I haven't seen that kind of valuation in a long time.
Disc: long
Very small bet, I'll decide whether to cut it or double down after Q4 results.
This is not investment advice. Do your due diligence.