Big Lots: Reversion To The Mean Is Still In Progress – Seeking Alpha

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It's been over six months since I last wrote on the Big Lots, Inc. (BIG) stock, which has come down over 46% since my neutral rating. The decline is significantly attributed to its wildly high EPS in the second quarter of 2020, which raised the company's bar through the roof. It seems that the company's EPS is now normalizing, and accordingly, the market will revert to pricing the stock on its pre-Q2 2020 levels. I believe BIG has upside potential in the long run; however, given the volatility, I still hold my neutral rating and avoid the stock for now until it shows the first signs of stability.

BIG has mostly been consistent with its financial performance, but it has recently demonstrated a pattern of QoQ EPS declines from Q1 to Q3 with a sharp ascent in Q4 results. A simple linear forecast using the 10-year trend estimates an EPS of $1.43 for the upcoming earnings release; however, Wall Street has a consensus analyst estimate of $1.91 EPS for the company. Even though consistent, the company's financial performance appears unimpressive at first glance, with 10Y, 5Y, and 3Y median EPS growth of 1.86%, 2.62%, and 0.43% on a TTM basis, respectively.

I've used these numbers with the adjusted EPS of $2.75 for the second quarter of 2020, which reported an unusually high EPS of $11.29 because of the sale and leaseback transactions, distorting all the trendlines spiraling the stock upwards. Adjusting for the irregularities, the current EPS appears to be much in line, following the consistent trendline of the company's performance and growth. BIG has a 3-year diluted EPS CAGR of 20%, in contrast, industry behemoths, Dollar General Corporation (DG), Costco Wholesale Corporation (COST), and Walmart Inc. (WMT) has a 3-year EPS CAGR of 15%, 16%, and 17%, respectively.

Over three years, DG's 76.92%, COST's 161.22%, and WMT's 44.06% have left BIG's 21.79% share price return trailing in the dust. This disconnection between its share price and EPS compared to its competitors reflects the investors' lack of confidence in its future.

3Y Share Price performances Vs. EPS (Author Calculations using numbers from SA)

Undoubtedly, comparing a company with a market cap of a little bit over $1 billion with industry giants isn't identical. Still, it serves to prove that BIG's financial results aren't as meager as they may appear compared to its share price. But, of course, this is also one of the primary reasons the company has far cheaper valuation metrics than its peers.

As previously mentioned, the disconnection between the company's Price and Earnings translates to a cheaper valuation of its stock. BIG's P/E ratio of 6 is significantly lower than DG, COST, and WMT, with P/E ratios of 20, 46, and 48, respectively. Similarly, other price ratios such as Price to Sales and Price to Book also put BIG at a cheaper valuation than its peers.

Even taking the company's valuation to its next nearest peer, its price estimate would turn to $128 by P/E, $122 by P/S, and $160 by P/B. That is a huge difference, more than triple its current valuation. But for the market to price the company with higher price metrics, it needs to show good growth prospects.

Relative Valuation (Author Calculations using numbers from SA)

Additionally, there is still a notable gap in valuations YTD compared with smaller peers. However, Big Lots might be gearing up for growing into more expensive valuation metrics because it is a low market cap company with solid fundamentals and growth-oriented strategic plans in motion. Thus, the declining earnings trend from Q1 to Q3 might act as a catalyst in driving the prices further down through 2022 before any upside can be realized. This makes the stock quite volatile for value & growth investors.

Data by YCharts

Indeed, the restructuring in 2022 with sale and leaseback (NYSE:SLB) transactions unlocked tremendous value for the company. The company wisely followed activist investors' suggestions and redeployed the excess cash generated by the SLB to repay a significant portion of its long-term debt. Almost two years later, the company has eliminated its long-term debt obligations, but its immense total debt to equity ratio remains at 172.85%. This relates to $1.58 billion capital lease obligations due to the SLB.

Undoubtedly, the company still goes through an experimental phase, where BIG relocates, opens, and closes down stores. These obligations relate to its physical stores, which are expected to expand by 50 in 2022 and more than 80 per year starting next year. Therefore, the liability will likely increase further in the following years. However, adjusting for this liability, the company is essentially debt-free and boasts great credit facilities to facilitate its growth and expansion, as stipulated in its financial reports.

The company boasts a better current ratio than either of the three previously mentioned competitors in terms of liquidity. However, a major chunk of that is attributable to its inventory, and accounting for it brings its quick ratio to the bottom.

A closer look into this reveals a weakness in the company's operating cycle with higher-than-average inventory turnover days. The company had proactively increased inventory in response to supply chain disruptions in the wake of the pandemic. Still, the current circumstances expose the company's inventory mismanagement, with the overall levels reaching almost $1.3 billion. The inventory days have worsened to 124 days, outpacing pre-pandemic levels of roughly 100 days on average. This is worse than DG's 82, WMT's 46, and COST's impressive 32 inventory days. Consequently, the cash conversion cycle has also deteriorated, reaching 68 days in the last quarter, a bad performance since 2008.

Liquidity Ratios (Author Calculations using numbers from SA)

In the latest earnings call, the CFO explained the inventory jump:

The increase versus prior years was a purposeful heavy up of inventory to support holiday to right set furniture depth and support incremental inventory for the Lot and apparel. The increase versus guidance reflects our successful efforts to get more inventory receipts into the supply chain ahead of holiday, as well as increased unit costs due to inbound freight.

Despite the distortion of inventory performance in the short term, considering the supply chain disruption, the management's prudent decision to stock up will protect sales from delays and prolonged issues of suppliers. Moreover, if the company could improve its inventory cycle, the operating cash flow would get even better to fund the expansion plans that the company has bet on since the introduction of "Operation North Star," which has yet to materialize.

Product Categories - Investor Presentation Jan 2022 (Biglots.com)

The Gross Margin has slid down to under 40%, hovering around its 5-year average. In addition, the company's digitization and features being paraded under the banner of Operation North Star seem to have no measurable positive effects on its financial performance. Last but not least, the supply chain disruptions increased freight and labor costs will also support the declining trend in the following quarter.

Data by YCharts

In Q2 2021, Big Lots invested in a temporary distribution center 'bypass network' to deal with the supply chain disruptions caused by the pandemic. According to the CEO, lead times lasted from four to eight weeks. The company expected the investments to pay off in 2022, and we still have the whole year to look forward to. However, the current numbers don't reflect any operational efficiencies achieved through these investments. At the same time, its competitors dealt with these issues through different approaches such as increasing their supply orders, adding distribution centers, and chartering their ships.

The pandemic was well on its way to a fast turnaround when the announcement was made, but since the aggressive spread of delta and now omicron variant, the global supply chain and the labor market suffer from a stunted recovery. This has led to a volatile supply chain environment, and depending on the results obtained by Big Lots from its initiatives, it is likely to make further adjustments to accommodate the unfolding events. These uncertainties bolster my neutral prognosis on the stock, as any trading decisions will also be subject to the volatility of these circumstances.

BIG's excessive earnings in 2020 seemed to have resulted from the company's improvement initiatives, elevated demand due to the pandemic, activist investors' involvement, and the SLB transaction, skyrocketing the stock to new heights. However, the fiscal period turned out to be an outlier that fizzled the share price down, adding volatility which can still be seen in its charts. After a steep decline in price, the price valuation metrics of the company sharply fell, making the stock look appealing.

Given the company's high beta and volatility, plus a trend of declining earnings through Q1 to Q3, attractive valuations might not be able to justify a buy rating right now. However, a good buy rating isn't just about an optimistic future but also about timing your trade. Therefore, I am neutral on the stock until it reaches a more stable point later this year.

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Big Lots: Reversion To The Mean Is Still In Progress - Seeking Alpha