Plenty of market watchers are worried that this market is getting overheated. Across the board, valuations are at or near all-time highs. The market is making new all-time highs seemingly every day. The volatility index is hovering at record lows. It’s been forever since we’ve seen the last 5% pullback in equities.
Most signs will lead risk-adverse investors to the exits, and while a stock market crash may be imminent, most smart investors are looking for places to park their money where they still get a good yield.
The first place those investors should look is Dicks Sporting Goods Inc (NYSE:DKS). The sports retailer has been hammered recently, and with good reason. Brick-and-mortar athletic retail is becoming an increasingly difficult landscape to navigate. Between athletic brands like Nike Inc (NYSE:NKE) and Skechers USA Inc (NYSE:SKX) emphasizing direct over wholesale and non-store retailers like Amazon.com, Inc. (NASDAQ:AMZN) starting to eat market share, DKS has mightily struggled to woo investors.
So far in 2017, DKS stock is down about 50%.
But this athletic retail powerhouse now has a trailing earnings yield of over 10% versus a 10-year Treasury Yield hovering around 2.4%.
That is just too cheap to ignore.
Sentiment on Dicks Sporting Goods Is Dour
There are several problems with DKS stock.
Firstly, all the market share gains DKS reported last year are now being wiped out thanks to Amazon and Nike. Last year, Dicks Sporting Goods reported a 3.5% gain in same-store sales thanks to a whole bunch of sports retailer bankruptcies. As smaller players in the athletic retail space were phased out, the industry consolidated, and bigger players like DKS gained market share.
This year, though, the trend is shifting. Brands like Nike and Skechers are starting to ship less product to wholesale partners like Dicks Sporting Goods and are instead investing heavily in their own branded stores. Plus, Amazon is aggressively expanding its presence in athletic retail, including potentially launching its own athletic apparel line soon. Consequently, 3.5% same-store sale growth last year is turning into negative comps this year.
Secondly, all the competitive pressures are destroying margins. Gross margins have been in free fall this year and aren’t showing any signs of reversing anytime soon. In fact, DKS intends to be more promotional in the near future to retain market share. Consequently, gross margin degradation is a trend that is here to stay.
Thirdly, stocks tend to fall when comparable sales growth goes from positive to negative and when earnings projections go from big growth to slight declines. That is exactly where DKS is today. It’s in transition mode, and the transition is particularly painful to shareholders. Stocks tend not to rise during painful transitions.
Valuation on DKS Stock Is Compelling
But there also one big reason to love DKS stock here.
It’s way, way, way undervalued.
Earnings are supposed to come in around $2.90 per share this year. That means DKS stock is trading around nine times fiscal 2017 earnings estimates versus a five-year average price-to-earnings multiple of 18. That means the current valuation is essentially 50% lower than the trailing five-year valuation.
That only makes sense if the lowly $2.90 figure isn’t a bottom for earnings.
But why wouldn’t it be? Look at a long-term chart for DKS operating and gross profit margins. They are cyclical. Big troughs (2005 and 2009) are followed by big peaks (2008, 2013). We are currently in a profit margin trough. All signs point to a similar rebound occurring soon.
Sales growth is positive. Comps are coming down, but the unit growth narrative remains on track. Gross margins are falling, but this year should bear the worst of that degradation considering DKS is being intentionally promotional to retain market share. Operating expenses were actually levered in the first half of 2017, and this trend should continue alongside positive revenue growth. The company is repurchasing shares.
All in all, earnings shouldn’t fall much more beyond this year’s guided $2.90 level. More realistically, earnings per share continue to hover around the $3 level for 1-2 years before growing slightly from that base.
Bottom Line on DKS Stock
DKS stock offers deep value here. Investor sentiment is dour due to concerns over an athletic retail apocalypse, but that just isn’t happening (see SKX stock).
Once the athletic retail apocalypse fear dissipates, DKS sentiment will normalize. That implies the valuation could run back to its five-year average. A return to a five-year average price-to-earnings multiple by next year implies a one-year price target of $52.
That is essentially 100% upside from current levels. And I don’t think that bull scenario is all that unrealistic.
As of this writing, Luke Lango was long DKS.
