Summary
Big Lots is facing economic headwinds in 2023 due to high inflation and interest rates impacting the consumer discretionary sector, specifically due to cautious spending habits and less discretionary.
The company is focusing on expanding its store relevance. Additionally, optimizing its supply chain and driving productivity through cost-saving measures to drive growth and profitability.
Big Lots' Operation North Star strategy aims to improve the customer experience, reduce shipping costs, and drive productivity primarily through reducing expenses and making vital investment decisions.
The liquidation valuation method suggests an estimate of $6.5 per share, but I would be comfortable opening a sizable position in BIG at any level below $5 per share.
Big Lots storefront in Houston, TX.
Investment Thesis
In 2020, Ancora and Macellum, two activist investors, took large holdings in Big Lots, Inc. (NYSE:BIG) to turn it around and maximize value through restructuring. Following the restructuring, the stock gained significant market attention primarily due to its improved fundamentals and later due to the macroeconomic tailwinds.
Today, Big Lots faces economic headwinds in 2023 due to high inflation and interest rates impacting the consumer discretionary sector. In a previous analysis, we explored why BIG was reverting to its mean and did not qualify for a buy rating after reaching unprecedented all-time highs with massive downside risk. Since then, the stock has crashed by nearly 76%, and even though it might be an attractive speculative trade, it does not qualify for a buy rating for the long term.
The company focuses on expanding its store relevance to drive growth and profitability. However, despite these efforts, the company's stock price is on a downward trajectory, plunging lower than its pandemic low in March 2020. Investors can attribute the fall to macroeconomic adversities for Broadline Retail, the impact of the Federal Reserve's quantitative tightening on the consumer discretionary sector, company-specific underperformance, and weak fundamentals.
Nevertheless, I have recently opened a speculative long position in BIG, but the stock does not qualify for a buy rating at current levels, earning the hold rating. Nevertheless, I plan to revisit the thesis once the retail outlook improves or if the stock drops around $5 per share, which I would consider a deep-value opportunity.
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Macroeconomic Conditions & Outlook
The retail industry entered a challenging phase in 2023 as consumer spending slowed, with rising wages and input costs due to the higher interest rates. In addition, the high cost of living squeezes consumers, leading to cautious spending habits and less discretionary spending.
Additionally, March retail sales show an overall decline of 1% compared to February, indicating a slowdown in consumer spending as expected. Specifically, apparel and accessories stores, department stores, furniture and home stores, and home improvement stores have a considerable impact. These are the key offerings of Big Lots.
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Furthermore, YoY retail sales for March reported a 3.1% increase, but fiscal YTD sales were up 4.5% compared to the same period in 2022. However, these figures do not take inflationary prices into account. In addition, with the Federal Reserve increasing its benchmark rate to 4.75–5%, retailers may face difficulty securing future loans, impacting their ability to fund a growing business.
As consumers already pay higher prices for goods, further price increases to offset higher costs may not be feasible. As a result, retailers like Big Lots will have to make tough decisions regarding their expansion plans, operational efficiencies, organizational structures, inventory management, and technology investments to navigate the headwinds they face in 2023.
BIG's Performance Assessment
In 2022, Big Lots faced challenges due to high inflation and a shift away from home-based purchases, resulting in overbought inventory and unprecedented markdowns. In addition, furniture sales were adversely impacted by product shortages from a vendor closure. Nevertheless, despite these challenges, the company improved margins, managed expenses, and rightsized inventories.
Investigating this further reveals that the company's operating cycle faces headwinds with slower inventory turnover performance. This is because the company had proactively grown its inventory in anticipation of the pandemic-related disruptions to the supply chain, leading to excessive inventory levels and, as a result, inevitable markdowns. However, after the inventory peak, the total inventory levels dropped to $1.15 billion, but inventory days are on a rising trajectory, currently standing at 128 days, despite the markdowns.
To that effect, the cash conversion cycle (CCC) increased dramatically, indicating a deteriorating efficiency in the inventory-to-sales pipeline. For the last 12 months, the CCC reached almost 79 days; during the third quarter, has peaked at nearly 93 days. Favorably, there was a slowdown in Q4, with CCC falling to 74 days, which is still above average but the first sign of a minor improvement. However, to regain confidence, we should see at least another quarter of improvement in inventory performance.
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Big Lots expects to fully mitigate the impact of the supply disruption by the first half of 2023. Big Lots' Q4 results were in line with guidance, with Q4 gross margin at 36.3% against the guidance of the mid-30s. Additionally, the company strengthened its balance sheet and liquidity position by selling underperforming store locations. Specifically, Big Lots opened 18 stores but closed 5s, ending Q4 with 1,425 stores.
Additionally, Big Lots reported a decline in the soft furniture home and hard home categories due to consumers delaying or reducing high-ticket purchases. Further, product shortages caused by United Furniture Industries' closure negatively impacted the company's comp sales by about 600 basis points.
Moreover, Big Lots focuses on better adapting to continuously evolving customer needs. The key themes are attaining Core competencies, delivering competitive value, and, ultimately, driving customer growth and loyalty. Notably, Big Lots plans to increase its relevance by opening stores in rural and small-town markets, where it outperforms and has a lower cost structure in these areas.
The company also aims to win with omnichannel by improving the customer experience and reducing shipping costs. Big Lots' fifth essential action is to drive productivity by reducing expenses and making vital investment decisions. Finally, the company aims to grow its margins by increasing inventory productivity, optimizing its margin profile, and improving its competitive position through regional pricing models.
Furthermore, Big Lots reported Q4 net sales of $1.54 billion, a decrease of 10.9% compared to the previous year, driven by a comparable sales decrease of 13%. As a result, the company lost $8.1 million compared to a net profit of $53.6 million in Q4 of 2021. However, BIG expects improved gross margins in 2023, driven by lower import freight rates and cost-saving measures, including more efficient pricing and promotions and structural cost savings across store operations, the supply chain, and corporate headquarters.
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Nevertheless, due to the challenging market environment, the company expects Q1 comps to be similar to Q4 and experience a decline in the low-to-mid teens range. In addition, it anticipates a slight increase in SG&A expenses due to general inflation and additional costs in advertising, healthcare, and workers' compensation. Finally, the retailer expects to spend approximately $100 million on CapEx for the year and plans to exceed that with about 18 store openings and closures. The company remains focused on driving improved productivity and efficiency across its operations to return to growth and profitability.
Operation North Star Assessment
Big Lots' progress in Operation North Star in 2022 combines optimistic and cautious moves. Implementing the "Lots under $5" presentation initiative in most stores could attract more customers, thereby increasing revenue. In addition, enhancing shrink mitigation programs and structural savings through cost-saving initiatives could improve the company's profitability.
However, the multi-year project to overhaul their order management system may require significant investment. It could cause disruptions to the company's operations. The execution of Project Refresh remodels in 150 additional stores, and the opening 56 new stores could benefit the company's growth. However, investors would need to monitor the performance of these stores closely.
Notably, Big Lots' next steps for 2023 focus on building its brand identity and increasing customer satisfaction. It could lead to higher revenue and profitability. The plan to own "Bargains and Treasures" through increasing bargain penetration and unique products could attract more customers looking for great deals. Also, the focus on communicating clear, comparable pricing could improve customer trust and loyalty. The plan is to develop a compelling reason to shop across all stores and deliver a simple and pleasant shopping experience. It could also improve customer satisfaction and retention.
Performance Is Nowhere Near Its Competition
BIG still has a sizable retail space, indicating it has room to grow and expand its operation. For example, comparing BIG to the leading rivals, we can see that it has fewer locations than some of the largest players in the sector, such as Walmart, Inc. (WMT) and The Home Depot, Inc. (HD). Even though BIG still has a sizable number of stores, which can aid in reaching a broader customer base, its sales per store stand at $3.72 million, nowhere near the larger players.
BIG opened 24 stores and closed 40, resulting in a net decrease of 16 stores, while WMT did not open or close any stores during the period, HD opened six stores and did not close any, and COST opened 26 stores and closed 3. Thus, it appears that BIG had the largest net decrease in stores during the period among its competitors, highlighting the retailer's challenges and management's efforts to turn the company around.
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Liquidation Valuation Method
The liquidation value (LV) method provides value for shareholders if the company is not a "going concern". I like using this method to estimate the worst-case scenario and get a rough estimate of the rock-bottom margin of safety. While I don't expect Big Lots to go out of business any time soon, the cloudy history of retailers, with the rising inflation and a potential recession, supports my preference for the LV method, in this case, to justify a buy rating with BIG.
Under the LV, all liabilities, including debts and other financial obligations, are subtracted from the assets' net value to determine the company's liquidation value. This approach is typically used in situations where the company is in financial distress or is being sold as part of a bankruptcy proceeding. However, it is important to note that this method does not consider the potential value of ongoing operations or future growth.
Thus, for simplicity, I have reduced the value of the net property, plant, and equipment by 15% and inventory levels by 20% while keeping 100% of all liabilities, leading to an LV of $6.5 per share. However, considering the limitation of this method to a real bankruptcy scenario and liquidation process, the LV can deviate significantly from any estimate. Thus, I would be comfortable opening a sizable BIG position at around $5 per share.
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There Is Still Additional Downside Risk
Big Lots face the possibility of amplified macroeconomic adversities based on the Federal Reserve's ongoing quantitative tightening, which may trigger a recession in 2023. Such a scenario could severely affect the company's financial performance. Finally, Big Lots' operating cash flow remains in a free fall, and while the company depletes its cash reserves, it will seek additional financing by taking more debt, cutting the dividends, and issuing shares, to be able to serve its debt and other obligations on time and stay afloat.
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Conclusion
In conclusion, Big Lots faced challenges in 2022 due to high inflation and shifts in consumer behavior away from home-based purchases, resulting in overbought inventory and markdowns. However, the company took steps to improve margins, manage expenses, and rightsize inventories. In addition, its omnichannel initiatives, cost-control efforts, and transformation initiatives have been successful.
Operation North Star, encompassing driving top-line growth, cost reduction, and infrastructure enhancement, appears encouraging, but there are no signs of meaningful improvement. Although challenges remain, including the ongoing impact of supply chain disruptions, the company remains focused on driving improved productivity and efficiency across its operations to return to growth and profitability.
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