Dick's Remains a Premier Brick-and-Mortar Retailer

Dick's DKS is the largest full-line sporting goods retailer with a national store base and a high-quality, growing e-commerce business. It controls approximately 12% of the sporting goods industry, up approximately 150 basis points over the past few years, aided by the 22 million square feet of storefronts that have closed following competitor bankruptcies (including the 2016 closure of Sports Authority, which previously had around 3% of the market).

We believe Dick's has fared better than rivals thanks to its execution and company-specific initiatives, including a technology platform for youth sports leagues, private brands (10% of sales) including Calia and Reebok, and strong partnerships with vendors, which prefer to work with national retailers like Dick's. Despite these efforts, we believe the company hasn't amassed a sustainable edge and may be plagued by faltering structural dynamics down the road.

Highlighting the intensely competitive landscape, Dick's is slowing its unit growth in an effort to secure better leasing terms over the next two to three years as it suspects competitor closures may create a better supply/demand environment. We view this move as prudent but are cautious that its units may not reaccelerate to historical levels, if at all, given the structural shift (particularly vendor efforts to move more sales direct to consumers at the likes of Nike and Under Armour). We expect Dick's will increase its units at roughly 1%-2% over the next 10 years, down from 7.3% over the previous five years.

To take advantage of growing online penetration, the company completed a proprietary buildout of its own e-commerce platform in January to enable better control over its customer experience and access to more customer data. We view this as a leg up over other smaller peers but don't believe it negates the competitive pressures from vendors going direct to consumers or Amazon AMZN hungering for a larger stake in the category. Because of this, we lack the confidence that Dick's will outearn its cost of capital for at least the next 10 years.

No Competitive Edge Means No Moat
We don't think Dick's has amassed a competitive edge, and as a result, we do not believe the company has an economic moat. Our contention with the company's lagging advantage is structural rather than company specific. Dick's has executed well in areas it can control, evidenced by its ability to stave off competitive closures and capture market share over the previous years (we estimate 100 basis points to around 12.5% of the $70 billion sporting goods market), but despite benefiting from the consolidation of competitors, we don't think this translates to a sustained competitive advantage. While Dick's is the largest sporting goods retailer (with 704 units, about 3 times the size of the next largest player, Academy Sports, at around 230), we don't believe this store base affords the company much negotiating leverage with vendors.

The main issue is the low switching cost consumers face, which may continue to pressure Dick's as its vendors find ways to take their products directly to consumers. We view this headwind as particularly pronounced because Dick's two largest vendors, Nike and Under Armour, account for 20% and 12% of the retailer's sales, respectively, and are both emphasizing their own direct-to-consumer sales, a continued negative for Dick's. Vendors are decreasing their dependence on retailers like Dick's by selling through their own brick-and-mortar store base; Nike operated 362 retail stores at the end of fiscal 2016 while Under Armour maintained 169--not much below Dick's 704 namesake stores. As a result of these efforts, excluding currency impacts, Nike increased DTC sales 25%, accounting for $7.8 billion, while Under Armour increased DTC sales 27% to $1.5 billion in fiscal 2016. This trend incorporates both company-owned e-commerce sites and physical retail stores and should constrain Dick's bargaining and pricing power over time as the company's revenue was a mere $8 billion in fiscal 2016.

Beyond pursuing their own distribution, we also are concerned about vendors selling their products through Amazon's online platform. This should continue to fuel e-commerce and DTC trends across the industry, which we believe may dent profitability (more rational pricing as it provides an increasingly transparent channel) and reduces dependence on its physical stores, deleveraging the fixed cost of each brick-and-mortar location. We think customers won't find a material difference ordering sporting gear from Dick's or its vendors directly, given the ease of online ordering, blurring lines, and ultimately stripping away the company's ability to protect profitability, supporting our stance that the company has failed to amass a brand-driven moat source.

Even in the face of an intensely competitive landscape, we believe the company is partially insulated from DTC and e-commerce trends in some of the categories in which it plays, but not enough to instill confidence that it can outearn its cost of capital over the next 10 years. For one, we think “physical touching” needs, combined with legal constraints surround firearms and ammunition (the Gun Control Act of 1968 strictly regulates direct mail of virtually all firearms), make it less likely this business will migrate materially on line. Dick's Team Sports HQ, a platform that provides youth sports a digital ecosystem, is differentiated and conducive to building loyalty, but we don't view this as significant enough to warrant a moat. The company offers exclusive and private brands expected to reach $1 billion in 2017, or around 12% of sales, while contributing 600-800 basis points higher gross margin. However, we think further growth in this offering (a 6% compound annual growth rate through 2026 to a midteens percentage of sales or more than $1.6 billion annually) could ultimately impair Dick's relationships with larger branded vendors, which could opt to stock their wares in other channels.

Supplier Power Is Biggest Risk
Nike and Under Armour account for roughly one third of Dick's sales, a challenge that is more pronounced because these vendors are increasingly opting to go direct to consumers through their own-e-commerce platforms and company-owned physical stores. Nike and Under Armour increased their collective DTC sales more than 20% in fiscal 2016, and we don't anticipate either will back down from this pursuit. We also think Dick's significant exposure to these vendors subjects it to the success each realizes in terms of innovation, which could constrain the company's ability to drive traffic to its stores.

The company sells general merchandise, which is predominantly discretionary and is closely correlated with the health of the consumer. If the economy falls into a recession or sees a period where consumer confidence falls or unemployment rises, we believe Dick's would be challenged to realize profitable comparable-store sales growth. Additionally, outsize exposure to faltering categories may weigh on sales. Golf (which we estimate accounts for nearly one fifth of Dick's sales) has been plagued by declining annual rounds played the past five years (down around 7%), and we don't anticipate this to materially rebound.

The fourth quarter accounts for roughly one third of sales, so seasonality and weather may also hurt Dick's more than other retailers. If it fails to predict consumer preferences and supply outpaces demand, Dick's could be forced to more aggressively promote its seasonal merchandise to clear excess inventory, which could erode its already thin mid-single-digit operating margins.

Efforts to increase private-label penetration (10% of sales in fiscal 2016) expose Dick's to erratic changes in input costs and may increase the complexity of manufacturing versus strictly selling nationally branded items.

We think Dick's priorities for cash include investing in the store base and bolstering shareholder returns through its dividend, followed by share repurchases. The company paid a dividend each of the past six years, with an average payout ratio around 20%, excluding a $2 per share special dividend in 2012. We expect the company will maintain a similar payout level, implying dividend growth around 10% a year over our 10-year explicit forecast. We forecast excess cash will be used to retire around 4%-5% of shares outstanding a year.