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Stock Strategist

We See Some Positives for Sporting Goods

Competitors' store closures should help Dick's, which we think is undervalued.

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Despite unseasonably warm weather and a shorter holiday shopping season, we think investors have overreacted to recent retail news, and we believe sporting goods is still one of the healthier consumer categories. Although headwinds exist and there appear to be more discounts and promotions on offer at present, we think sales are picking up in the final weeks of the holiday selling season, and we believe consumer desire for the top brands is still strong.

We believe  Dick's Sporting Goods (DKS) is undervalued. Along with its store opening potential for the next several years, we see the distress of some competitors as a long-term positive. Recent downgrades on Sports Authority's bonds suggest that the formerly equal competitor to Dick's could now shrink. While short-term liquidations can affect local same-store sales, the market exit by a national competitor should see Dick's take share. We also see the potential consolidation of outdoor retailers Cabela's and Bass Pro as a plus for Dick's and note that another outdoor chain, Gander Mountain, has appeared weak for years and could eventually close stores as well. Gander was a public company in the mid-2000s, but like Sports Authority went private before the 2008 recession.

The current valuation of Dick's Sporting Goods suggests that store openings will have to be halted or that margins will decline, or both. There have been some near-term headwinds, especially the weather, but we expect some rebound now that it's colder, with comparisons cycling over the longer term.

Growth Opportunities Ahead
Dick's Sporting Goods is the only full line sporting goods retailer with a national store base and viable e-commerce business. We believe this is the result of a differentiated merchandising strategy that prioritizes performance goods, as well as superior selection and brand presentation. Although the retailer carries products across a wide range of skill levels and price points, the emphasis on higher-performance goods leads to increased profitability and minimizes the product overlap with competitors. Mass merchants and online sellers have limited access to branded high-performance sporting goods because they cannot offer the level of service and presentation that manufacturers require. Through a shop-in-store layout for active apparel, golf, footwear, cycling, outdoor recreation, and team sports categories, Dick's provides access to experienced enthusiasts and value-added repair, maintenance, and fitting services.

Despite growing to over $6.8 billion in revenue in 2014, Dick's will still have only about 10% of the sporting goods market (including bicycle retailers) and has substantial opportunities to grow, in our opinion, through share gains in current markets and by entering new markets.

Management has identified the potential for approximately 1,000 Dick's and Field & Stream stores in the United States before nearing saturation, implying that it can still add more than 35% to its store base. We expect the company to maintain square footage growth in the mid- to high single digits, excluding potential growth from acquisitions.

While some might not view the 2007 acquisition of Golf Galaxy as a complete win, Dick's is now firmly the leader in the golf business. Golf has been cyclically weak in recent years, with declining big-ticket sales and now product technology acceptance issues and weather, but we believe it will eventually turn around, depending on product cycles, weather, and macro trends. Also, had a competitor acquired Golf Galaxy, Dick's would not have the same clout with golf vendors and might be offered lesser products. Dick's record on acquisitions is quite good, and we cannot rule out the possibility of future deals.

Not Enough Competitive Advantage for a Moat
Despite Dick's ability to improve margins and consistently make returns sufficient to pay down debt and expand the store base, we do not think the firm has an economic moat. Although Dick's does have advantages with vendors, landlords, and above-average operating margins, retailers must fight to maintain such advantages, and it is less certain that such advantages will endure over the long run. Competitive advantages in retail are fleeting at best, and supply and inventory pressures can affect margins.

Customers have few switching costs. Services can add a component to the business that can be difficult to replicate, but we doubt that even with its higher-than-average levels of service Dick's could create stickiness with customers that would command enough pricing power that the firm could charge consistently more than the competition. An example in sporting goods would be a hockey shop that is the only one that can sharpen your skates in the manner in which you are accustomed, or a bike shop that can offer advice on training and performance. Dick's outdoor business continues to improve, and while service in firearms and fishing is adequate and stores are often more convenient than outdoor superstores, we don't see the company as having or building a competitive advantage in outdoor beyond its current convenient locations, product and service mix.

Aggressive Growth Can Bring Risk
Like most growth retailers, Dick's faces execution risk with its aggressive store growth strategy. The company faces broad and intense competition from specialty sporting goods retailers and mass merchants, which may make it more difficult to enter new markets. Additionally, periods of economic weakness could pressure sales of higher-margin discretionary items.

Dick's leases all of its stores and may negotiate contingent rent provisions. While the current environment is favorable for renters to negotiate attractive terms, it is not certain that such economics can be had forever.

Over the long run, Dick's faces risk from supplier power, as the vendor side of the sporting goods industry is increasingly consolidating. A few key vendors such as Nike, Under Armour, Adidas, or VF would represent a significant drop in business if any of them were to discontinue selling to Dick's or change the allocation of products the firm receives. All vendors are developing significant online capabilities and many are increasing investments in owned retail.

Also, Dick's employs an extensive private-label program, which continues to grow in parallel with the company's revenue. Historically, private brands have enhanced margins for the company, but Dick's merchants must continue to develop products that are sufficiently on trend and of a quality and performance such the image of its exclusive labels is not diluted in consumers' minds.

Finally, Dick's has growth potential from new store formats and different store footprints and geographies. While growth is exciting for investors, it does not come without risk. What has led Dick's to be successful might not always translate to success in subsequent ventures. In our experience, more than half the new concepts that have been tried by even the most successful retailers do not end up becoming long-term growth drivers. We assign Dick's a high fair value uncertainty rating, given these and other risks.

Paul Swinand does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.