By Brian Nelson, CFA
The discounted cash flow [DCF] model is a great tool to estimate a company’s fair value. For starters, it cuts through qualitative factors and focuses on the two primary cash-based sources of intrinsic value: net cash on the balance sheet and future expectations of free cash flow. These two components form the cash-based foundation of any company. For example, if a company holds a net cash position, it should be worth more than a company with a net debt position, all else equal. If a company generates robust and consistently strong free cash flow, it should be valued higher than a company that does not.
The DCF model is also unique in that it values precisely the cash-flow dynamics of the entity one is modeling. It does not have the pitfalls of relative valuation techniques, where systematic overvaluation or undervaluation may occur. For example, just because a comparable firm has, let’s say, a 30x forward price-to-earnings [P/E] multiple doesn’t mean that the company one is comparing it against should garner a similar multiple. Varying balance sheets coupled with different earnings growth trajectories almost assure that each company should receive its own firm-specific multiple. That’s where the DCF comes in. It derives the “right” multiple that should be placed on the firm.
Dick’s Sporting Goods (NYSE:DKS) is an interesting candidate because it has a low P/E multiple and is coming out undervalued on a DCF valuation basis, the best of both worlds. We think it is fine to use relative valuation considerations when investing, but only when a DCF model is used alongside it. Finding stocks that are undervalued on both a DCF basis as well as undervalued on a relative valuation multiple basis is like finding the Holy Grail for value-oriented investors. Dick’s Sporting Goods meets such criteria, in our view. In this article, we’d like to update readers on our new fair value estimate from our previous work in August, and address the firm’s latest quarterly results. Let’s dig in.
Latest Earnings Report
Dick’s Sporting Goods reported impressive third-quarter results on November 21 with revenue advancing 2.8% from last year’s quarter as a result of comparable store sales expansion of 1.7% that anniversaried a nice 6.5% improvement in the same period a year ago. The company’s non-GAAP earnings per share was $2.85 in the period, better than the $2.60 in the year-ago quarter. Dick’s Sporting Goods also increased its guidance for 2023 comparable store sales growth to the range of 0.5%-2% from flat to 2% previously. It also upped its 2023 non-GAAP earnings per share target to $12.00-$12.60 from its previous expectations of $11.50-$12.30. We liked the news a lot.
The athlete today has never been better equipped. Youth sports are hardly anything like they were 20-30 years ago when baseball teams used to share a couple old bats and a few hand-me-down helmets that were 5-10 years old. Today, youth baseball players have their own bats, their own helmets, and some even have two bats. This isn’t only 15-18 year-old high school players with such personal equipment, but rather 8-14 year old kids, too. DICK’s Sporting Goods has benefited from trends such as these across all sports, and parents are all-too willing to keep spending on the latest and greatest gear and equipment (and instruction) for their kids. Even as some sports face declining participation rates, those that stay in the sport are spending more and more each and every year, and DICK’s Sporting Goods is meeting their demands.
Across footwear, apparel and hardlines, we’re looking at roughly a $140 billion total addressable market for DICK’s Sporting Goods, and it only has an estimated high-single-digit percentage share at this time. We expect the company to continue to drive share gains, perhaps a percentage point or two every few years or so (with the biggest gains in the ‘outdoor’ category), and by our estimates, we think it could command as much as 15% of this market in the long run. It all comes back to its differentiated product assortment, brand engagement and growth (e.g. Yeti, adidas, Columbia, Nike, Marucci and the like), and how it offers an appealing athletic experience from visual presentation to enhanced service and in-store technology and beyond. For one, those looking to try out a new baseball bat can go into The Cage and take some hacks to find exactly the feel they want for their swing.
The company’s ‘GameChanger’ app continues to put its brand in front of youngsters, too, building brand awareness. We view ‘GameChanger’ as the Brownie camera of our day: “Plant the Brownie acorn and the Kodak oak will grow.” In the coming decades, those kids that were hooked on watching ‘GameChanger’ for updates will have DICK’s Sporting Goods top of mind when looking for some new gear or equipment, and the company is delivering in ways that they want either via in-person at its stores, curbside pick-up, or traditional delivery. The company estimates that omni-channel athletes represented more than 65% of sales and were twice as valuable as single-channel athletes. DICK’s Sporting Goods has found a unique way to connect with today’s athlete, and its economic moat will only grow stronger as today’s younger generation become the adult volunteers of tomorrow’s sporting events.
For the 39 weeks ended October 28, 2023, DICK’s Sporting Goods net cash from operations came in at $764.7 million, up significantly from $35.6 million in the same period a year ago, as the firm benefited greatly from improved inventory management. Capital expenditures came in at $409.5 million over this time period, up from $274.3 million in the year-ago period, and the company has turned the corner nicely with respect to free cash flow, generating a robust $355.2 million so far in its fiscal year. Though DICK’s Sporting Goods has material operating lease liabilities, it is running roughly a net-neutral balance sheet, ending its quarter with $1.4 billion in total cash and $1.48 billion in total debt.
Updated Valuation Statistics
Back in August, we had valued DICK’s Sporting Goods at $160 per share when shares were trading at roughly $115 each. Shares have advanced considerably since then and now are trading at $138 per share, but we think there is more upside to come on the basis of our valuation. Our top-line assumptions haven’t changed much since the prior article, but we are now building in slightly better average operating margin expectations over the next five years (13.9% versus 13.5% previously), which accounts for most of the delta in our fair value estimate revision to $165 per share in this update.
We’re expecting earnings before interest expansion over the next five years of 4.8% as of this writing, compared to 3.8% previously. Pricing strength, better inventory management and improved shrink are the key drivers for the margin revision. At the high end of DICK’s Sporting Goods guidance range, shares are trading at just 11x forward estimated earnings, further supporting the view that shares look cheap. The DCF-derived forward earnings multiple stands at 13x, using the high end of management’s guidance for adjusted earnings per share–and this multiple, itself, could even be considered low, too.
Margin of Safety
The DCF is a powerful tool, but one has to use checks and balances to make sure to avoid the pitfall of precision that comes with any DCF effort. The end result of the DCF is a fair value estimate, but when it comes to valuation, the application of a margin of safety to one’s work just makes a lot of sense. For example, if one uses the DCF and thinks shares of the company are worth $100, it is more appropriate to say that shares of the company are worth somewhere between $80 and $100. Using a margin of safety or a fair value estimate range helps conceptualize upside and downside scenarios, too. For example, it’s likely that DICK’s Sporting Goods’ shares may be worth somewhere close to the high end of the fair value estimate range, up to $206 per share, and this would only imply a 16.3x earnings multiple. Hardly egregiously expensive, in our view.
DICK’s Sporting Goods offers a lot to value-oriented investors. We believe that shares look cheap on both an absolute valuation basis via the DCF and also from relative valuation parameters when compared to where the overall market is trading. The company holds roughly a net neutral balance sheet, meaning that investors shouldn’t necessarily be punitive on shares relative to companies with net debt positions, and we like the company’s future potential as its brand becomes a staple in communities everywhere. Our updated $165 per share fair value estimate seems within reach for the company’s shares these days, and we simply cannot rule out the high end of our fair value estimate range. We like Dick’s Sporting Goods quite a bit.