Valuation and Opportunity Sizing
I think a long-term investment case in Big Lots is lacking. You may refer to the second series of the paper below to understand why I think that a long-term investment case in Big Lots is lacking. Although there are currently signs that Big Lots is making the right moves that will, at a minimum, help it avoid going concern issues, I still think there is a lack of a long-term structural advantage that will allow Big Lots to compete effectively. This is an investment type that I would consider under my bucket of “Undervalued – General”. In this bucket, it refers to opportunities that arise from overtly negative sentiment on the business resulting in a dislocation between buyers and sellers. This is often due to macro-events or poor performance from the company, usually due to overtly high expectations. You may also classify “cigar butts” under this category, although Big Lots is not exactly a cigar butt.
From this definition of opportunity, I am not really looking at Big Lots as a long-term compounder. Instead, I am looking at a mean-reversion opportunity where earnings begin to normalize, and a re-rating occurs. In these types of opportunities, I fundamentally believe in sizing the downside risk as the exit strategy is often quite simple to determine. For Big Lots, the downside risk is about 40% after marking down the inventory, other assets, and PP&E by a reasonable amount. Could PP&E net actualization value be marked down 40% instead? Yes, it can be. Furthermore, it is also not so simple now to estimate the liquidation value of the business given the complicated regulation and processes which often result in additional unexpected costs. This is why I have spent quite a lot of time trying to understand if there’s a viable business case for the business. Given that there appears to be an actual viable business model for Big Lots, technically, should the share price fall further towards the NAV value, I would suggest taking a more aggressive position given that the margin of safety increases when the share price falls further.
On the flip side, the upside potential for Big Lots is quite substantial. Under normalized earnings of 150 million to 200 million (Over the past 17 years, only 3/17 years achieved lower than 150 million in sales, and only 1 year (FY2022) is negative), and a P/E rating of 3-5x (substantially lower than furniture players and discount stores), this would imply a potential market capitalization of around 450 million to 1 billion, representing close to a 100% - 330% upside from today’s market capitalization of 227 million. Assuming that it takes another 2-3 quarters to clean up its existing inventory (which would help reduce the downside risk of inventory discounting) and implement successful close-outs over the next 3 years, this would imply an IRR of close to 26 %-49% annually.
At such asymmetrical risk-reward, I believe there presents an attractive opportunity. I do admit that it may take a few quarters before we can see the fruits of this shift in business model. Afterall, attractive and major close-outs opportunities cannot be engineered and may require some time. This would, however, be a good test over the next few quarters on Seth Mark’s capabilities to generate opportunities and Kristen’s ability to re-vitalize the stores. I recommend taking a small position on Big Lots despite all the structural challenges and problems faced by Big Lots.
Summary of Series 1
When taking things together, the two key pillars – 1. Returning to a close-out strategy and 2. Re-emphasizing the key value proposition to customers—the case for a turnaround at Big Lots seems to be building. However, it's important to note that historically, the furniture segment makes up 50% of the sales mix. Even if improvements occur in the close-out and peripherals segments, nothing fundamentally changes for Big Lots due to its reliance on the furniture segment. So, the key question is: What impact will successful execution on these two pillars have on the furniture segment? This is where I think it would be useful to introduce a framework to think about how Big Lots can compete.
Series 2- Breaking down the Long Term Investment Case for Big Lots.
The key question that this second series of the paper is to understand whether there is a long-term investment case for Big Lots. As mentioned above, I currently argue for a small position in Big Lots given the asymmetrical risk reward as well as the more-than-likely chances of a successful turnaround case. However, given the fact that 50% of sales are driven by furniture related sales, I believe a long-term investment case hinges on whether Big Lots can execute on its Furniture segment in the long-run.
How To Think About Competition in Grocery Retailing.
In the realm of discount retailing, the most critical moat is the low-cost structure of retailers. This low-cost structure is derived in part from economies of scale but also from the nature of the customer base itself. It's widely acknowledged that the retailing space is challenging. In a Substack article by John Huber on Munger's perspective on retail stocks, he noted that "the chicken-and-egg issue that retailers face is: without a differentiated product, you need to offer the widest selection or the lowest price, and it's hard to do this if you do not have a large scale. But retail businesses lack scale when they start, which makes it hard to offer the most selection or the lowest price." This inherent challenge is what makes the moats in the retail sector so sustainable, enabling companies like Walmart and Costco to withstand new entrants.
This leads me to the discussion on dollar stores. Dollar stores operate on three key pillars. Firstly, convenience plays a pivotal role. These stores are often strategically located much closer to a broader customer base, ensuring a shorter drive and a relatively more straightforward and seamless shopping experience with lower average customer density per store and shorter queues. Take a look at this comparison of store outlets across retailers.
Dollar Tree and Dollar General stores out numbers Walmart stores (4,622 in USA), and Target (2,000 stores) by 4x and 5x respectively.
Similarly, if you compare the store sizes, an average customer will need to walk around the average 100,000 – 120,000 sqft of store size vs Dollar Tree and Dollar General’s 7,000 -8,000 sqft to get daily necessities.
The second pillar is the premise of the “treasure-hunt” experience. This treasure-hunt experience is similar to what Big Lots was famous for with its close-outs, but except its in a much more engineered fashion. According to an article written by Value Punks on Dollar General, both Dollar Tree and Dollar General excels in brining across this “treasure hunt” experience, with “>1mn posts with the hashtag #dollartreefinds” with more than 2.4billion views on Instagram. These are signals that the value proposition of this treasure hunt experience is still very much alive and appreciated by consumers.
The last premise centers on the idea of Price/Value. Dollar stores are known for maximizing the value of each dollar to fulfill an entire shopping list. However, this often means that on a per-unit basis, dollar store prices are higher than those of big-box retailers like Walmart. For certain consumers with tight budgets, the small pack sizes are the only viable option to complete their shopping list. Nevertheless, when compared to direct competitors such as convenience stores, pharmacies, and mom-and-pop stores, dollar store prices are still 20-40% cheaper. This explains why dollar stores have witnessed robust growth in store count over the past decade, to the detriment of convenience stores, pharmacies, and independent retailers.
What is the problem that Dollar Stores are facing?
In essence, the value proposition of dollar stores is weakening. Their customer demographics are increasingly leaning towards lower-income customers with limited purchasing power. Larger retailers like Walmart and other big-box stores are now providing better value and a more diverse product mix, capturing a substantial share of grocery spending. As mentioned earlier, while economies of scale play a role, customer quality is equally vital for maintaining the lowest cost structure. Examining store metrics, it becomes evident that the lowest cost structure is not held by dollar stores but by major players like Walmart, and Costco too.
On a sales per square foot basis, Walmart dominates, boasting around twice the figure of Dollar Tree and Dollar General. Its customer acquisition costs (CAC) per square foot are approximately 1-2% lower than their counterparts. Although Dollar General and Dollar Tree have higher gross margins, often driven by higher average selling prices (ASPs) on a per-unit basis, these have come under pressure in recent years. Dollar Tree's gross margin declined from 40% in the 2010s to 30% in 2018/2019 onwards. It’s important to note that the higher gross margin does not indicate pricing power. This is because on a fundamental level, the real, actual, consumer surplus is not found by shopping at dollar stores, but at big box retailers like Walmart and Costco. Walmart’s margins are not dependent on raising prices, but rather on its scale economies. This is why I argue that the economies of scale and lowest cost structure moats are not held by dollar stores (despite their higher margins), but rather held by players like Walmart and Costco.
I'm not suggesting that Dollar stores lack a value proposition - lower income customers just sometimes do not have enough income to spend on specific categories that a cheaper on a volume basis. What I'm simply proposing is that when assessing consumer preferences, individuals are more inclined to allocate incremental income gains to retailers like Costco/Walmart rather than increasing their spending within Dollar stores. Therefore, there is this upward movement of clientele group into Walmart and Costco signifies a much more sustainable trend and moat. This implies that the real value proposition of dollar stores and the gap they address is primarily within the lower-income groups. I believe there's a limit to how much the Price/Value gap on a per-unit basis can be increased due to the constraints imposed by this weaker customer group.
How does this relate to Big Lots?
It tells us about the strategic direction that Big Lots can take. If Big Lots continue to try and achieve economies of scale so as to compete more in the food and consumable space, what will inevitably happen is that they face the same structural challenges that Discount Stores currently face. Similarly, if Big Lots tries and returns back to a diversified close-out player, then it has no advantages in many segments like decor, apparel, shoes and other discretionary items where players such as Ollies and TJ Maxx have structural advantages in. The only plausible or potential pivot for Big Lots is to double down on furniture (which management is doing with the new Big Lots Home format), and use close-out as a means to draw in customers. After reading an expert's view on Big Lots future, I do agree with the expert's assessment that this is the best path forward, as trying to compete in the competitive diversified retailer segment is likely to be a futile effort.
Key Framework - How can Big Lots Compete?
As furniture accounts for more than 50% of Big Lots, a good strategy would be to look at a successful business model that can be applied in this low frequency business and relate tangents to this business model. For this, I argue that Restoration Hardware provides quite a good playbook.
Much of RH’s success is built on this idea where we combine a high-frequency, low-margin business with an opposite low-frequency, high-margin business.In Restoration Hardware, this takes the form of a restaurant business (High frequency – Low Margin) situated within its expansive furniture showrooms, serving as a showcase for furniture purchases (Low frequency – High Margin).
The idea is to consider these high-frequency, low-margin businesses as customer acquisition costs for its high-margin, low-frequency business. Another example of applying this framework can be seen through the lens of Meituan, which recognized that its food deliveries, at best, offer low margins and decided to view them as a cost expense for acquiring customers. This strategic shift later evolved into an advertising business for hotels, characterized by higher margins but lower frequency.
So how do we think about Big Lots? Firstly, we should not think of it as a diversified retailer but as a "furniture+" retailer. Then, using the framework, the low-margin business should be the other segments of the offerings (food and consumables, electronics, and seasonal items). What will draw in the high frequency are these close-outs that Big Lots will be heavily pursuing, which, in combination, creates this unique blend of specific to only Big Lots in the furniture retailing space. I believe that this part of the concept is pretty intuitive and appears to be a viable business model. However, the key difference between Big Lots and Restoration Hardware is that the positions are flipped. Restoration Hardware has a very strong brand and quality in its high-margin, low-frequency business. Its showrooms are extremely beautiful, and furniture is displayed in such a thoughtful manner that puts even the most luxurious of homes to shame.
San Francisco Gallery, Source: Restoration Hardware Website
RH’s challenge was to generate higher customer traffic so that customers would be more likely to purchase their furniture as they wait for their turn at the restaurant. This position is flipped with Big Lots. Big Lots does not have a very strong and high-quality furniture segment.
Source: Mary Meisenzahl/ Insider
Its stores lack beauty, and the furniture isn't organized in thoughtful manners that attract customers to visit. It's a tough sell for someone to look at Big Lots and think of them as a pure-play furniture retailer. The furniture segment appears almost like an afterthought, relegated to the status of an impulse purchase category. Customers seem to stumble upon a nice couch or table as they casually navigate the store, rather than being enticed deliberately to explore the furniture offerings. And also, who really goes into a furniture store with the intention of purchasing groceries on the way out? This value proposition seems lacking.
Of course, one may argue that its recent success with its private label, the Broyhill collection, is an indication that perhaps there might be some real underlying reasons that have helped it resonate with its customers. To me, I think that it is difficult to judge whether this specific brand has resonated with their customers, given the fact that their success was largely during the COVID-19 pandemic when we saw elevated spending on goods nationwide. Even if the Broyhill collection really did resonate with customers and built some loyalty and interest, this is an added bonus, but I wouldn’t bet on it.
How likely can Big Lots Execute on its Furniture Segment?
Over the past few pages, we have discussed the specific problems that Big Lots faced, the structural issues that discount retailers have, as well as how these problems relate to Big Lots. We then later established a framework to help us think about whether there is a viable business model for Big Lots to implement given its commitment to the furniture segment. To that end, we have arrived at the conclusion that the shift back into close-outs and the recent focus on store improvements are helpful and will help support Big Lots in the short term, but the overall strategy is still quite lacking to argue for a long-term investment opportunity.
To add on my reasoning for why a long-term investment opportunity is lacking, these are the 2 concepts that I use to consider whether a furniture retailer holds any competitive advantages.
Branding Positioning.
An interesting thing about the furniture industry is that, outside of a few exceptions, brands are meaningless. The branding and positioning of a furniture company are not based on the type of furniture, the material of the furniture, or the collection of the furniture. Rather, it is derived entirely from the parent/retailing brand of where the furniture is sold. If you think about it, when you enter a furniture store, brands are rarely displayed. Instead, we care more about where we will be shopping for our furniture and then derive the value that we associate with the furniture.
This quote from a furniture blog tells us exactly how we should think about branding in the furniture space.
“Store names have become the de facto brands of the furniture business. Ask a consumer what furniture brands she’s heard of and she’ll likely answer Rooms To Go or Ashley. (The latter is also a supplier brand, but it has only come to the attention of customers because of its burgeoning retail chain.) That’s also why the so-called “lifestyle” stores like Pottery Barn, West Elm and Crate & Barrel—not to mention IKEA and RH at either ends of the pricing spectrum—have been able to establish footholds in the furniture business using their own store brands. So as good as the brands that Authentic bought are in the context of the furniture business, they will have their hands full getting their money’s worth on their purchase.” – Warren Shoulberg
So how does this affect Big Lots?
The thing we need to be aware of for Big Lots is that they engage in a lot of discounting. It is very common to have discounts of 15 – 20% on their furniture, and in the retail space, discounting is the worst thing you can do to a brand as it erodes its brand quality and reduces the retailer's ability to price its furniture collection. Therefore, if we were to plot out the degree of harm done to furniture retailers across the space, this is how it will look.
So, if we were to accept discounting as the natural mode of operation, then perhaps we should not be putting too much weight on Big Lots being able to build their own brand, as well as their ability to build out their private label brands.
Even when we take into consideration Big Lot’s Broyhill collection, its prices are still significantly lower than competitors, and the way it is being marketed online shows that Big Lots is not trying to create any pricing power on their brands, but just a low-cost alternative to other designer labels. The problem comes, however, when players such as Williams-Sonoma start to do discounting on their off-trend products. This squeezes the value/price gap between premium players and basic players, which, in turn, moves consumer spending towards such premium players. I have no idea what Big Lots can do then to defend against such a move. The most likely path Big Lots will take is to further provide discounts, which, in turn, squeezes the profit margins of its supposedly high-margin segment, which reiterates my argument for why a long-term investment case is lacking.
A player that is rather insulated from this trend of discounting is interestingly, IKEA. The crux of their strategy is to not rely on such one-time off discounts and translate the initial savings directly into their pricing. Honestly, I believe that this is the right sales strategy which Big Lots should seek to move towards. The problem with discounting is not just weakening the brand image but conditioning the customer to wait for a sales period. This by-effect is a much detrimental impact in the long-run, regardless of brand positioning. As I think it is unlikely for Big Lots to execute such a different strategy for the foreseeable future, I just do not think they are able to compete effectively against other players. I will be cautious to have any major assumptions on advantages being built on brand recognition.
Reverse Logistics System.
An additional consideration and by-product of heavy discounting is the spillover effects on the company’s logistics and delivery system. Discounting, by nature, creates a tendency for an impulse buy. However, when consumers make purchases based on impulse, this creates a higher tendency for returns and refunds, which stresses the company’s reverse logistics. More often than not, the returned product is not sent directly back to the store but to a distribution channel where it will be seated and waiting to be re-sorted. During the process of re-distribution, there are touch-up costs, ad-hoc repair costs, and additional labor costs that will be required to reprocess this product. This process is further lengthened during periods of peak returns, which usually coincide with periods of heavy discounting.
Although it appears that Big Lots charges a 20% processing fee to the customer on the purchase price, the key problem is not so much whether the 20% processing fee covers the additional costs, but the duration it takes from the returned product to be ready for sale again. This inevitably lengthens the turnover days, reducing the cash-generating capabilities of the company. From my understanding, this solution is not as simple as introducing more distribution channels or “nodes” in the company’s logistic system. More nodes do not necessarily mean more efficiency and might actually create more bottlenecks. There is currently not much information on how Big Lots intends to deal with logistics, and I doubt this is a key concern for them now. Nonetheless, how one can factor this in is to reduce the overall furniture gross margins of 40% to a much lower steady-state gross margin to take into consideration these challenges that have yet to arise.
Conclusion (Update - 13th Feb 2024)
This company is not typically the type of company that I look for when I invest in my own portfolio. It is also not the same style that I typically utilize. However, it does look interesting from a valuation point of view, as well as from a catalyst heavy micro-cap company with multiple catalysts over the next 1 year timeline. I would use each earnings quarter to monitor the progression of its close-out strategy . In my opinion, a re-rating would occur when earnings and SSSG starts to rebound (Close outs being the key driver). The stock name has quite a limited downside to current prices (~150Mil Market Cap) and I recommend a trade on the name.
Disclaimer - This is not financial advice. Please do your own due diligence.
P.S I did not include any financial forecasting segment on how the Sales/Margins/EPS would grow over the next few years because the theoretical results would be quite misleading given the uncertainty and volatility of outcomes. The main idea of this investment case is to avoid a going-concern situation and a normalization of earnings, which by itself would justify a re-rating. This is addressed by analyzing whether there is a valid business model for Big Lots to execute upon.
Only when a clearer development in the business situation, more specifically, an indication on 1. Whether if close-out model contributes material traction, 2. Economics of close-out activities, 3. Spillover on Furniture, could we then have a meaningful forecast on the future. We could theoretically assume or use a few off-price retailers as a guiding post, but I think the efficient (though arguably lazier) method is just to wait and see.
Thank you for reading!
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Credits to Mary Meisenzah
*Do note that all of this is for information only and should not be taken as investment advice. If you should choose to invest in any of the stocks, you do so at your own risk.
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