Value Investors Club / BIG LOTS INC (BIG)

Description

Big Lots looks like a textbook public LBO. Management recently rejected a private equity buy-out offer for being too low and countered with a massive buyback authorization of their own which is equal to 18% of shares outstanding. The current management team has already bought back 45% of shares outstanding since they joined Big Lots in 2005.

Big Lots is debt free, trades at 9.1x free cash flow and 10.9x P/E. Earlier this year it was a hot stock and rumored to be a buyout candidate. A few months, a rejected deal, and one bad quarter later, it seems to be forgotten.

Big Lots is the largest close-out retailer in US. It was founded in 1967 and has 1,405 stores. If you have never been to a store - think Kmart type layout with lower prices and cleaner and more appealing stores. About half of Big Lot's merchandise is purchased from other vendors during liquidations, packaging over-runs, and discontinued product events. The other half is procured the "traditional way" - by ordering in advance from vendors in China. This is a similar business to the "dollar store" model except Big Lots has much larger stores (30k sq feet usually) and sells larger items like furniture in addition to the standard fare.

What I really like about the business is Big Lots appears to be one of the rare businesses that perform better during recessionary periods. There are two main reasons for this which you can probably guess: first, as a heavy discounter, it benefits from consumers trading down and looking for more value. Second, it is one of the vultures of the retail world - taking advantage of the stumbles of its retailing peers. The harder the retailing environment, the more stumbles and the more discounted merchandise Big Lots gets to sell. Big Lots' performance during 2008 and 2009 is a case study in this. Operating profit grew almost 8% in 2008 and 27% in 2009. In margin terms, operating profit was above 5% in each year. Sales were basically flat from 2007 to 2008 (down 0.2% despite closing 14 stores) and grew 1.8% from 2008 to 2009. Return on equity was solid both years at 17.1% and 21.9%, in 2008 and 2009 respectively.

This is a quality management team. When rents were rising, they closed stores and resisted the urge to grow, but when other retailers were closing stores and rents we falling, they began to expand the store base. Since 2005, when the current CEO joined, they have bought back 45% of the company at an average price of $24 ($1.2bln). Operating margins were 1.7% in 2005 and today are 7.2% which is attributable to fixing up the stores, cutting costs, and focusing more on branded products. Not surprisingly, Wall Street doesn't "get" them, but card carrying contrarians/value investors should. Here is an example from the 2008 Letter to Shareholders that I think says a lot about the management team:

Perhaps the best way to describe our real estate strategy is that we have moved counter to the market and most of retail. During the latter part of 2005 and early 2006, we closed a number of underperforming locations. We told our shareholders and the investment community that we would be slowing new store growth significantly. We source our real estate like we source our merchandise - always looking for great value - and at the time, real estate was not a value. Instead, we focused on improving our internal productivity and operations to more efficiently manage our existing stores.

Shortly after we made the decision to slow new store growth, a Wall Street analyst told me, "If you are waiting for real estate prices or rents to go down, you could be waiting for an awfully long time, or you may NEVER be a store growth story again." Despite his point of view, I was not about to use our shareholders' cash to chase overpriced real estate just to be a store growth story for the sake of the market. Instead, we focused on becoming a more productive and efficient operation, knowing that the real estate market would eventually come back. We understand what works for our strategy, and we understand the value of cash and how to put it to good use.

At the end of May 2011, Big Lots announced another large share buyback of $400mm. They have the cash, cash flow and credit line to fulfill it. If they do the full program, it would be equivalent to 18% of shares outstanding (including $57mm stub from previous authorization). Their other buyback programs have been completed so it is reasonable to think they will eventually complete this one as well.
At 10.9x earnings and 9.1x free cash flow, Big Lots seems unreasonably cheap given its quality balance sheet, management, growth opportunities and most importantly its reverse cyclical nature. You can own a company that will benefit from a double dip recession for under 10x free cash flow and is buying back stock at a rapid clip. Given the free cash flow into buybacks strategy, it is interesting to note that Eddie Lampert's ESL took a position in Big Lots in the first quarter.

Note: I am calculating P/E by subtracting cash from the market cap since they are likely to use it to buyback shares. I used the low end of their updated guidance of $2.75 per share as the denominator. The high end of the guidance was $2.90 and LTM EPS was $2.88.

Free cash flow is calculated by taking reduced guidance of $185mm "cash flow" for 2011. This number which was provided by management includes growth capex as well as maintenance capex so I added back full year management guidance capex of $125mm and then backed out share based compensation of $23.7mm (2010 level), and $40mm maintenance capex (from management). This totals $246.3mm 2011 free cash flow. This compares to LTM free cash flow of $269.3mm [Operating cash flow of $333mm and subtracting maintenance capex ($40mm) and share based compensation of $23.7mm.]

Big Lots looks cheap on an absolute basis. In addition, there seems to be a disconnect between the valuation of the "dollar stores" and Big Lots. The "dollar stores" which include Dollar Tree, 99 Cents Only, Dollar General and Family Dollar trade at an average LTM trailing P/E of 19 times. The "dollar stores" are growing faster and have higher margins, but the discount seems overdone. Big Lots is actually quite similar to Wal-Mart on valuation, margins, and ROE so fans of Wal-Mart may be interested in Big Lots as well. I think Big Lots may have more to offer as a stock though because of the larger buyback (18% for Big Lots vs 8% for Wal-Mart), hostile acquisition possibility, and arguably higher growth capacity.

Since the new CEO took over in 2005, revenue has grown by 19% total (not annualized). From 2005 to 2009 they were closing stores. However as commercial rents have fallen, they have been opening new stores at around a 3% growth clip. Several news articles have stated they are the number one new leasee of space (in terms of square footage) in the US. 3% growth isn't nothing, but its certainly nowhere close to what the "dollar stores" are doing. However, they just made an acquisition of the 91 store Liquidation World chain in Canada. Those stores are losing money on an EBITDA basis and Big Lots acquired it for basically just the assumption of its debt. Big Lots management stated that most people are underestimating the value this new acquisition could provide. It is hard to make any estimate, but what is clear is that Big Lots will be growing at a faster clip than they did prior to 2008 and may even surprise to the upside because of store growth and the Liquidation World acquisition. The good news is you aren't paying for any growth.

So why is Big Lots cheap? In the middle of May they announced earnings which surprised on the downside and lowered guidance for the rest of the year. This was followed by an announcement that they would not sell themselves after receiving bids from several private equity firms. News of a potential buyout had leaked in February and there was a lot of hot money in the stock that left when they announced there would be no deal in conjunction with the poor earnings. The reason there was no deal: Big Lots management thought the private equity bids were too low.

So add it all up and you have a business in and of itself has a margin of safety because it is counter cyclical, is trading at a cheap valuation, a quality management team that understands capital allocation and is plowing free cash into buybacks, and you might even get some unexpected growth. If the economy keeps improving, Big Lots should benefit from increased discretionary income, lowered unemployment and may even see its multiple rise. If we double dip, its cash flow should be protected because of the nature of the business and management looks set to continue to buy back huge amounts of stock.

Catalyst

Continued buybacks, potentially another buyout offer

show sort by

			2011	2012
Price:	33.79	EPS	$2.75	$0.00
Shares Out. (in M):	75	P/E	10.9x	0.0x
Market Cap (in $M):	2,540	P/FCF	9.1x	0.0x
Net Debt (in $M):	-283	EBIT	353	0
TEV (in $M):	2,256	TEV/EBIT	6.3x	0.0x