Bargain Bin or Dumpster Fire?

Ollie’s Bargain Outlet Holdings is setting up to be an interesting situation. The company buys “end of run” goods and sells them at deeply discounted prices. Grant’s Interest Rate Observer described Ollie’s business as follows:

“The closeout business is off-price retailing without the frills. Like the cigar-butt investor, the closeout merchant finds stock where it’s cheapest: in discontinued merchandise, canceled orders, modified orders, liquidations. He buys low, sells a little higher.”

Interestingly, Ollie’s has no online presence. Despite that, or perhaps partly because of that, the company has been thriving. https://www.forbes.com/sites/abrambrown/2019/04/01/the-outlandish-story-of-ollies-a-5-billion-retail-empire-that-sells-nothing-online-but-is-beating-amazon/#71c235e850d5 . The question before investors is whether Ollie’s future looks like its past. If so, Ollie’s equity appears reasonably priced.

The average Ollie’s store produces roughly $475k of unlevered earnings. Those stores grow earnings at roughly 2% per year IF you look at 2 year comps. Given where assets trade, it’s not unreasonable to assume a required return of 8% for owning the unlevered equity of the stabilized store base. Therefore, each existing store could be worth ~$8.1mm.

Today, there are 332 existing stores. Thus, the value of the equity of the business as it exists today could be ~$2.7Bn IF the assumptions above are valid. The current offered price of Ollie’s equity is $3.5Bn. Why might that be a reasonable price to pay?

Ollie’s believes they can grow the store count to 950 stores. Their strategy involves entering adjacent markets. They are expanding West as they started on the East Coast. The current store footprint appears to be as far West as Indiana down to just West of Jackson, Mississippi. Importantly, the company has a history of successful store openings.

Each store costs approximately $1.0mm to open. Assuming the $8.1mm value cited above is correct, each store opening creates ~$7.1mm of value. They believe they can open 45-50 stores per year. Therefore, the present value of the growth could be anywhere up to $2.0Bn (assuming a 12% discount rate).

Accordingly, the offered price of the Ollie’s equity is ~75% of the present value of the equity. Not a screaming bargain, but also reasonably cheap given the environment today. Why? First, Ollie’s had a bad quarter. Second, key man risk materialized.

Missed Execution

Note: Technical analysis isn’t part of this discussion but that is a scary chart.

Missed earnings (and a demanding valuation) caused the sell off during the week of August 26, 2019. As the company tells it, accelerating store openings and odd box sizes caused some disruption to the company’s growth formula.

Source: Mark Butler’s opening remarks on the 2q20 earnings call.
Source: Q&A portion of 2q20 earnings call.

The pace of store openings allegedly stressed the entire system and resulted in SG&A deleveraging (meaning SG&A as a percentage of sales increased). This is a plausible explanation because Ollie’s took advantage of the Toys ‘R Us (“TRU”) bankruptcy and acquired some good real estate. On one hand this was an opportunistic way to open stores in good locations. On the other, the store acquisitions complicated Ollie’s growth formula.

First, Ollie’s accelerated its store opening cadence because they wanted to get the TRU stores open. Second, the TRU real estate introduced a different store footprint/layout. Mr. Butler attributed some of the operating hiccups to those factors. Mr. Butler’s track record warrants some deference. Therefore, this appears to be one of those situations where the reality of operating a growth company comes in direct conflict with Wall Street’s Excel models.

Further hurting Ollie’s quarterly results was Ollie’s inventory consisted of lower margin products. This is meaningless to a long term investor. What matters, long term, is whether Ollie’s is satisfying its customers. A skeptic would argue Ollie’s margins came down due to inventory quality. Again, Mark Butler’s record warrants deference.

The Potential Opportunity

To summarize, Ollie’s had a pretty poor quarter and the stock was priced for perfection; not a good combination. Below is a screenshot illustrating Ollie’s multiple compression as market participants realize (a) growth isn’t painless and (b) margins occasionally compress.

At the time Mark Butler tried to settle investors by saying:

Thinking long term, the case for buying Ollie’s shares rests on the power of the business model, increased scale resulting in more inbound calls from companies looking to liquidate end of run goods (and excess inventory), and store openings driving efficiencies through the business (by absorbing the recent distribution center costs, for instance). Scale resulting in better buying opportunities is a particularly compelling thesis. As the barriers to new product discovery continue to erode CPG companies, set up for longer production runs and pushing demand, may have more frequent forecasting misses. Accordingly they could need to sell through a channel that is (a) discrete and (b) can actually move the excess product quickly. Ollie’s appears to have a high probability of solving that need.

The Short Story

In March of 2019 Grant’s Interest Rate Observer wrote negatively of Ollie’s shares. A prescient call, Grant’s rested some of it’s thesis on valuation. But, valuation wasn’t all:

“As no proper bear case rests on valuation alone, our bill of particulars goes well beyond that FAANG-like multiple. Among its highlights: rising competition, operational shortcomings, low inventory turnover, high exposure to financially vulnerable consumers and accounting problems.”

The first accounting claim Grant’s alleges is Ollie’s free cash flow and net income diverge substantially. While this is true, it’s also somewhat explainable by store growth. Ollie’s inventory is growing at ~14-16% per year, which is in line with store count growth. Comparing Ollie’s to another high growth retailer, Five Below, its unclear the free cash flow conversion is a concern.

The second, and more compelling, accounting claim Grant’s discusses relates to Ollie’s irregularities pertaining to inventory and pre-opening expenses (oddly these include store closure costs). Grant’s discussion is concerning given the outdated inventory systems Ollie’s allegedly uses. To summarize the concern, if it is true that Ollies has terrible inventory systems, its possible that reported gross margin overstates actual gross margins. That said, it’s tough to overstate cash generation. And Ollie’s generates cash. Enough cash to retire $200mm+ of borrowings since 1/30/16 while investing in growth.

Grant’s concludes by mentioning the internet may increase competition for closeout sellers. While that may be true, Mark Butler contended that Ollie’s offers a preferred liquidation channel because there are no prices found on the internet. Therefore, a company like P&G can sell Tide through Ollie’s without upsetting the brand’s image in most consumer’s minds. Both thesis have merit but again, Mark Butler’s argument seems more likely.

More Fodder For Short Sellers

On December 1, 2019, Mark Butler, Ollie’s CEO and founder, died. Turn on an earnings call and listen to his enthusiasm. The man is irreplaceable.

One example of Mr. Butler’s genius was buying wedding dresses on closeout. No one sells wedding dresses at a closeout store. Consequently, Ollie’s got a fair amount of publicity from selling deeply discounted dresses. It’s unclear whether the remaining buying (and management) team will be willing to take those types of risks.

Mr. Butler’s replacement, John Swygert, has been with Ollie’s for a long time but is untested as a CEO. So, this would be an opportune time for a short seller to test him and/or shareholders. It appears as though that is going on as the side by side shown below is making the rounds.

The implication of that side by side seems to be that Mark Butler talked about toy sales when they were good and John Swygert is not talking about toy sales when they are bad. That conclusion appears tenuous given Swygert’s comments that “we are pleased with what we’re seeing right now.” Further, Mr. Butler and Mr. Swygert have different styles. Some of the language change may be attributable to who delivers the message. Long term investors should be way more concerned with the accuracy of these statements:

The Shorts May Have a Real Argument

Mark Butler’s death is a potentially derailing event. He had a reputation as an extremely sharp buyer and a one-of-a-kind charisma. It’s quite plausible that Ollie’s dependent on one man; that story isn’t uncommon in retail. That said, Ollie’s team has been there for a while. They’ve thought about succession planning as evidenced by elevating John Swygert’s position in the company a few years ago.

Importantly, based on a conversation with a very trusted source, we find it likely that there is institutional knowledge within these types of organizations. Coordinating purchases, store openings, inventory management, and logistics is probably more than one man can handle. JP Morgan has this to say about Ollie’s bench strength:

Source: JP Morgan Ollie’s note released 02 December 2019

Going forward, it’s almost inhuman to expect Ollie’s to hit their short term plan. Those people lost a leader. But, if the team can focus on execution, maintain buying relationships, and continue to open stores then Ollie’s should have a very good future. Parsing short term issues from fundamental long term business erosion probably won’t be easy.

The Balance Sheet: A Potential Asset

Ollie’s doesn’t own its real estate. Therefore, the business doesn’t need to carry the leverage it would need to if it owned it’s real estate. Instead, they have ~330mm of lease assets on the balance sheet. Accordingly, Ollie’s cost of real estate flows through the income statement (and operating cash flows) as rent rather than through interest expense, changes in PP&E, and net financing cash flows. The average lease term is 7.2 years so there could be some liability if certain store results erode quickly.

Other than leases, there is no debt at the company. Many retailers would fund at least a part of their inventory carrying costs with a revolving credit line. While Ollie’s has a $100.0mm revolving credit line, that line is undrawn. If the share price sells off too much, Ollie’s could use it’s $10.1mm of cash and some of its credit line to retire shares. They opportunistically bought in shares at ~$58.02/sh last quarter. We expect some more repurchases in the upcoming quarter considering they should be generating seasonal cash and the shares are currently trading at $53.34/sh.

Conclusion

Today’s investor gets paid for taking execution risk and betting on the business model. Whether the odds offered are enticing enough is another matter. There’s currently uncertainty around whether the new team can execute the growth plan.

An under discussed risk is how the new CEO interacts with the Board. Will he be able to take over after a charismatic founder passed away? Will he feel comfortable implementing “risky” and/or unconventional (like the wedding dress sale) promotions/actions? Mark Butler’s shoes are not easy to fill…

This is one to watch. Assuming the discussion above is accurate, the upside offered in the stock is probably not much more than 40% (assuming no share repurchases). The downside could easily be ~30%. Accordingly, an investor needs to be ~43% or more certain that a Mark Butler-less team is up to the task. Therefore, this may be one to watch from the sidelines.

PS. What will Chuck Akre’s firm do? Is Mark Butler’s death sufficient reason to sell or did they bet on the business and team? That will be interesting to see given The Art of (Not) Selling.