Cabelas: Little Room For Error – Diamond Hill Capital Management via Diamond Hill Capital Management

“CAB has set the bar high in terms of long-term earnings growth targets, giving the company little room for error.”

Through our research process, we attempt to identify actionable investment ideas, but we often conclude that a company does not present an immediate long or short investment opportunity. A decision not to invest in a company is valued just as much as a decision to invest in one, but we are always expected to stay current on our area of coverage in case conditions change. Our desired outcome from consistent, long-term coverage is an enhanced ability to discern those instances when there is a meaningful divergence between a company’s stock price and our estimate of intrinsic value. One such example is Cabelas , a company we followed at length before first initiating a short position in 2014. We covered our position when the price reached our estimate of intrinsic value in a short period of time. When CAB issued its latest earnings report, there were a number of indications that our initial assumptions were too generous. We thus incorporated the incremental information into our cash flow forecast, and with CAB trading at a significant premium to our revised estimate of intrinsic value, we re-initiated our short position. Below, we outline the key points of our thesis and the additional information we considered in our analysis.

Cabelas sells hunting, fishing, and outdoor gear in the U.S. and Canada through its direct-to-consumer and retail channels. The company estimates that the size of this market is roughly $60 billion, with Wal-Mart commanding the largest share at around 15%, CAB the second largest share at around 4%, and Bass Pro-Shops with about 3% share of the market. CAB is a strong brand that for many years had the advantage of being one of just a few aggregators of a highly fragmented vendor network. It also pursued a conservative strategy of grounding its catalog business in a small base of destination stores, designed to showcase its products and reflect the lifestyle of its customers. Thus, for many years, CAB operated in what seemed to be a benign competitive environment, pursuing a balanced approach to growing its direct-to-consumer and retail businesses. But like so many good brands (Starbucks, Gap, and Coach to name a few), we believe CAB’s aggressive retail growth strategy puts it at risk of oversaturating its target market. Compounding this issue is a changing competitive environment and a period of historically high profit contributions from CAB’s Finance segment.

Saturation of Retail Store Base

In 2013, CAB announced plans to reaccelerate unit growth to levels last seen in 2007, citing a long-term target of around 225 units – over three times the size of its current store base. Key to CAB’s unit growth plan was the introduction of two new store formats – the New Generation and Outpost stores – that are 50%-75% smaller than CAB’s Legacy stores. When it first provided higher unit-growth targets, CAB management expected minimal cannibalization of the Legacy stores and its Direct (catalogue and e-commerce) segment. However, over the last two quarters, there were signs that the degree of cannibalization is exceeding CAB’s initial expectations. On CAB’s fourth quarter 2014 earnings call, management cited four (out of an annual target of 12-14 new store openings) examples of new stores that were cannibalizing existing stores, the combination of which reportedly hurt same store sales by 150-200 basis points. In addition, sales in the Direct segment continue to decline at a rate that suggests CAB’s initial estimate of $2 million-$3 million of Direct segment cannibalization for each new retail store opened is too low. Management also announced that performance metrics for Outpost stores (40,000 square feet) were not meeting expectations and that they were suspending plans to open Outpost stores. This is troublesome since smaller formats were noted as a key driver of CAB’s future unit growth targets.1

Nonetheless, CAB still plans to open roughly the same number of new units in 2015, noting that it was focused on developing an optimal small store size and was still very pleased with the performance of the New Generation stores, which are closer to 80,000 square feet. Sales at these stores are said to average around $450 per square foot – lower than the initial target of $500 in sales per square foot targeted in late 2013 – and are reportedly much more profitable than the Legacy stores.1 At the same time that CAB management is accelerating unit growth through new store formats, key competitors such as Bass Pro Shops and Field and Stream also have aggressive expansion goals, with many new stores planned for locations that overlap with CAB’s stores. There are other companies, such as Gander Mountain, that also continue to grow retail units and have been in the market with a small store format for years.2

Changing Competitive Landscape

Cabelas  is also facing more competition from other on-line brand aggregators such as Amazon, as well as from the brands that Cabelas sells in its stores. In contrast to past practices of selling primarily through larger retailers, almost all the third-party brands (which represent around 70% of Cabelas’ merchandise) sold through CAB are now also sold on Amazon, as well as through their own web sites. For example, a search for Yeti coolers on Amazon yields 12 pages of product; a search for Browning product – more of a mid-market brand – yields 200 pages of product. Both brands also have their own websites and in-house shipping capabilities (Yeti is even offering free shipping for its coolers). In addition, more points of exchange leads to enhanced price transparency and pressure to match competitive promotions. These factors have and likely will continue to weigh on CAB’s merchandise margins. On its most recent earnings call, when addressing a question on the decline in merchandise margins, CAB management noted the intensity of promotional activity, citing a “fiercely competitive environment” and heightened coupon redemption activity as well as a need to “get smarter” about how they promote.1

The surge in gun and ammunition sales that drove most of Cabelas’ same store sales growth in 2012 and 2013 invited new competition to the market, potentially eroding CAB’s market share in these product categories. This is important, because we estimate that the guns and ammunition category grew to 20%-25% of Cabelas’ total sales in 2012 and 2013, almost twice the average number of sales represented by these categories before the surge. There are more alternatives for purchasing these products, such as Midway USA, a company that now offers a broad assortment of ammunition and gun accessories and provides same day shipping for most products, and Gunbroker.com, the largest hunting and sporting shooting auction site that has over 3 million registered users and averages more than 800,000 auction listings for firearms and accessories. So even though demand for guns and ammunition could be approaching trough levels, we doubt Cabelas will ever be able to restore sales to peak ranges. Thus, CAB will be more reliant on new categories and/or expanded share of other product lines to drive future same store sales growth. Yet in the fourth quarter of 2014,

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