Description
CAB: Short Recommendation
Description
Cabela’s Incorporated operates as a direct marketer and a multi channel retailer of hunting, fishing, camping, and related outdoor merchandise. The company was founded in 1961, went public ($20 per share) in June 2004, and has its principal executive offices in Sidney, Nebraska. The company offers its products through regular and special catalog mailings, the Internet, and retail stores located in Nebraska, Kansas, Minnesota, South Dakota, Michigan, Wisconsin, and Pennsylvania.
Thesis
We are short this company for the following reasons:
1. Rich valuation (27x 2004 EPS, 24x 2005 EPS)
2. Company’s retail format is not generating returns that are as strong as investors are expecting.
3. Competition could hinder the company’s growth expectations.
4. Expiration of a lock-up provision on 56.5M shares on October 22nd
representing 87% of basic shares outstanding.
5. Insiders sold 10.9M shares (or roughly 33% of their holdings) nine months before the IPO at $13.73 per share (or roughly half the current price).
6. Declining SSS and difficult 2H 2004 comparisons at the retail segment.
Segment Information
Cabela’s business model has three segments: direct, retail, and bank.
Direct
The Direct business generates most of its sales from catalog and Internet sales and makes up roughly 62% of CAB revenue and 60% of CAB’s profits. Over the last several years, CAB has grown its Internet business at a 50% rate while the catalog business has been relatively flat. Overall, CAB expects the catalog business to grow at a MSD rate.
Retail
CAB opened its first retail store in 1987, and currently operates 10 retail stores, most of which have been opened in the last 5 years. The company is using IPO proceeds (along with operating cash flow) to open 3 stores per year with the hope of eventually getting to 50 stores. CAB generates roughly 33% of its sales and 29% of its profits from the retail stores. The % of sales from retail is expected to grow as the company is targeting 20-25% annual growth in square footage. The company has historically opened stores with square footage ranging from 35K to 84K square feet, but has recently found that they have increased productivity by opening up a large store format, ranging from 175K-225K square feet. The company has two primary distribution centers, both of which serve retail and direct operations, and a third major facility opened up in July. The company expects to have enough of a distribution network to support retail store growth through 2007.
Bank
Through World’s Foremost Bank (a wholly owned subsidiary), CAB issues the Cabela’s Club Visa Card. At the end of 2003, CAB generated about $700M in managed receivables and expects receivables to grow at roughly 20% per year. Currently, the bank generates roughly 5% of total revenue and 11% of total profits.
Overall
Overall, the company expects to grow revenues and earnings per share at roughly 15% per year.
Why we are short
Premium Valuation
The company is quite expensive with EV/EBIT multiples of 18.7x, 16.5x, and 14.2x and EPS multiples of 26.6x, 24.3x, and 20.5x for 2004, 2005, and 2006.
Price: $25.70
Diluted Shares Outstanding: 66.6
Market Cap: $1,711M
Cash $111
Debt $154M
Enterprise Value $1,754M
(In Millions) 2001A 2002A 2003A 2004E 2005E 2006E
Total Revenue 1,077 1,224 1,392 1,550 1,800 2,100
Operating Income 65.3 76.1 84.8 94.0 106.2 123.8
Net Income 41.8 47.0 51.2 60.5 70.5 83.9
EPS 0.77 0.88 0.93 0.96 1.06 1.26
Operating Cash Flow 69.4 55.7 67.2 100 105 136
FCF (OCF-Cap ex) 22.1 2.3 -5.8 6.5 0.0 -13.9
P/E 33.3x 29.2x 27.8x 26.6x 24.3x 20.5x
EV/EBIT 26.9x 23.0x 20.7x 18.7x 16.5x 14.2x
Additionally, if you consider that roughly 25% of the earnings comes from their credit card business, the direct and retail business are trading at roughly 29x 2005 EPS (compared to 24x earnings for the consolidated company) if you were to assume that the credit card receivables could be sold at a 15% premium.
Poor Return on Capital
If the company could grow earnings at 15% for the next 5-10 years, current valuation might be reasonable. But given our belief that the retail stores are generating poor return on capital, we think that this will be difficult to accomplish.
The company, however, has indicated that the return on capital of a new store is quite strong:
Capital Investment: $60.0M
Inventory Investment: $6.0M (Net of Payables)
Total Investment: $66.0M
Revenue 4 Wall EBITDA Margin ROI
Year 1: $90M $15.8M 17.5% 24%
Year 3: $96M $17.1M 17.8% 26%
Additionally, the company has noted two additional things to consider.
First, the company’s capital investment looks high relative to other retailers because the company owns all of its real estate rather than having leases.
Second, and most importantly, the company gets on average 1/3 of its costs reimbursed by the local government for opening up a store in their town. Cabela’s often opens up stores in rural areas that benefit heavily from the additional tax revenue and employment opportunities. This reimbursement takes the form of a bond backed by the tax revenue generated from a store. Assuming a 1/3 reimbursement and a gross capital cost of $60M, CAB would pay out $40M directly to the contractors and $20M to the local municipality. The municipality would in turn pay the contractor the $20M, and then Cabella’s would own a $20M bond to be paid down by the municipality over 20-30 years (the bond only gets repaid if the store generates enough tax revenue). If you figure that the capital investment is $46M rather than $66M, the ROIC jumps from 24% to 34%.
These strong returns are further supported by segment information in the prospectus:
(In Millions) 2001 2002 2003
Retail Revenue $262.3 $305.8 $407.2
Retail Operating Income $41.9 $41.4 $56.2
Retail Margin 16.0% 13.5% 13.8%
So, why how do we come to the conclusion that the stores are a poor return on capital?
First, the company has a large base of unallocated corporate costs. We think these costs should be allocated to the segments and that brings down margins substantially. Although direct and retail segment margins range from 13%-16%, consolidated margins range from 5.8% to 6.2%. Additionally, if you take out the higher margin credit card earnings and associated revenues, then the direct and retail businesses have seen margins decline from 5.9% in 2001 to 4.8% in 2003.
According to the Prospectus, corporate and other expenses consist of unallocated shared-service costs, general and administrative expenses, and various small businesses such as travel and lodging which are not aggregated with the other segments and eliminations. Unallocated shared-service costs include receiving, distribution and storage costs, merchandising and quality assurance costs as well as corporate occupancy costs. General and administrative expenses include costs associated with general corporate management and shared departmental services (e.g., finance, accounting, data processing and human resources).
We are trying to figure out to what extent these costs may be fixed vs. variable, but expenses such as receiving, distribution, storage, merchandising, and human resources seem to me to be somewhat variable and are an inherent part of running a retail operation. This is supported by the 20% increase in unallocated corporate costs from 2001 to 2003 on a 29% sales increase. Additionally, 1H 2004 unallocated corporate costs are up 14% on a 16% increase in sales compared to 1H 2003.
Sales 2001 2002 2003
Direct 787.2 867.8 924.3
Retail 262.3 305.8 407.2
Financial Services 27.3 46.4 58.3
Other Revenue 0.8 4.6 2.6
Total Revenue 1,077.6 1,224.6 1,392.4
Operating Profit 2001 2002 2003
Direct 128.0 134.0 144.0
Retail 42.0 41.3 56.2
Financial Services 3.9 12.9 19.3
Total 173.9 188.2 219.5
Corporate (111.9) (112.4) (134.5)
Total 62.0 75.8 85.0
Operating Margin 2001 2002 2003
Direct 16.3% 15.4% 15.6%
Retail 16.0% 13.5% 13.8%
Financial Services 14.3% 27.8% 33.1%
Total 5.8% 6.2% 6.1%
If you were to assume that each new store generates operating margins of 6%, then pretax return on capital would be closer to 10% assuming no municipal subsidy and 15% assuming that a 33% municipal subsidy could immediately be monetized.
Given that margins excluding credit have declined from 5.9% in 2001 to 4.8% in 2003, 6% operating margins for new stores is not unreasonable, when you factor in additional unallocated corporate costs. Also, it should be noted that stores open up very productively and decline over time, evidenced by the steady decline in SSS over the last five years
+12.9% in 1999
+6.2% in 2000
+3.8% in 2001
+3.7% in 2002
+2.4% in 2003
There is nothing particularly awful about 10% pre-tax ROIC but it certainly does not justify a 24x 2005 EPS multiple.
Furthermore, the company may have to access the capital markets to fund its growth plans. If the company expects to grow the store base by 3 stores per year, that would require $210M of total capital expenditures per year ($60M per store plus $30M of maintenance cap ex.) The company currently only generates $100M-$110M of operating cash flow. Even assuming that operating cash flow grows at 20% per year, the company will use up its cash balance (expected to be at about $200M at December 2004) within 3 years. Granted, the company eventually gets back 1/3 of its capital costs, but that takes years to happen. Accessing the capital markets may slow down earnings growth through higher interest costs or share dilution.
Additional Concerns
We have some additional concerns which may affect profitability going forward.
First, the company has indicated that the opening of a new store cannibalizes the catalog business. When a store opens, direct sales typically decline approximately 10% in that state and it takes roughly 12-18 months for sales to recover. As CAB increases store openings, there is some risk that catalog sales will be impacted more than expected.
Second, the company is competing with other retailers to open up stores. Although this is a highly fragmented business (with the top 10 retailers only making up a 20% share), Bass Pro, a competitor with roughly $1B of sales, had 21 stores at the end of 2003, and is planning on opening up 5 stores in 2004 and 10 stores in 2005 and beyond (averaging 140K sq ft). Currently, the closest distance between the two chains is roughly 50 miles, but given that the Cabela customer will drive 100 miles to go to the store, there is increasing competitive overlap between the two chains. Additionally, the two chains not only compete for customers, they also compete for municipal subsidies. Increased competition could drive down the potential subsidies that a town is willing to provide.
Third, comp store sales comparisons get tougher over the next few quarters. Retail comps over the last six quarters were as follows:
1Q 2003: -6.6%
2Q 2003 -4.5%
3Q 2003 +4.2%
4Q 2003 +10.5%
1Q 2004: +6.7%
2Q 2004: +2.5%
3Q 2004: ??
4Q 2004: ??
Additionally, the company is facing very difficult sales comparisons in 4Q 2004 from a very strong opening of its Hamburg, PA store in August 2003 (Hamburg will not be included in the comp base until January 2005). Stores tend to start out very strong at their opening and then revert to a lower sales base.
Fourth, as customers will often drive 50-100 miles to visit a store, higher gas prices could have an adverse effect on business. The company has indicated that this effect on revenues is small, but they do see some increased shipping costs.
Immediate Catalyst: Expiration of lock-up provision
JP Morgan, Richard Cabela (Chairman), James Cabela (CEO), and the McCarthy Group own 19%, 18%, 18%, and 15% of the company respectively, and have lock-up provisions that expire on October 22nd. On this date, 56.5M shares out of a total of 64.8M basic shares will be eligible for sale in the public market. Given that Richard and James Cabela (Chairman and CEO) sold a total of 10.9M shares back to the company at $13.73 on September 23rd, 2003 (before the company was public). I would think that they would find the price of $25.69 to be quite attractive today. The 10.9M share sale reduced their total holdings at the time by over 30%.
Risks
1.Customers love this company. The catalog business is world class. The stores are very popular with customers. This company will certainly continue to grow. The question in our minds is what rate can they grow given current ROIC.
2.Unallocated corporate costs level out and incremental returns from opening additional stores turn out to be quite strong.
3.Some analysts have indicated that their earnings numbers are conservative by $0.10 to $0.20 per year. If the company beats near term estimates, the stock could increase.
4.The company may provide optimistic guidance in the 3rd quarter earnings call (scheduled for October 28th) so that they will have strong market to monetize some of their holdings.
5.If the company can monetize the bonds they receive from municipalities into cash, they immediately lower capital costs.
6.Subsidies from municipalities increase from 33%.
If ROIC is in fact as strong as the company is indicating and the company can fund their strong retail growth, then the premium valuation is justified. If unallocated corporate costs continue to be variable, comps trends continue to decline, competition hurts business or adversely impacts subsidies, higher energy prices slow down sales, or cannibalization of the catalog business is greater than expected, growth would slow and this stock would certainly be worth less than a mid to high 20’s EPS multiple.
Catalysts:
1. Expiration of lock-up provision on October 22nd leads to heavy insider selling.
2. No improvement in retail margins and poor cash flow growth.
3. Difficult 4Q comparisons as the company had an very strong opening of its Hamburg, PA store in August 2003.
4. Any hiccup in the credit card business (higher losses cause securitization write-downs).
Catalyst
1. Expiration of lock-up provision on October 22nd leads to heavy insider selling.
2. No improvement in retail margins and poor cash flow growth.
3. Difficult 4Q comparisons as the company had an very strong opening of its Hamburg, PA store in August 2003.
4. Any hiccup in the credit card business (higher losses cause securitization write-downs).