In today’s economy, there is a lot of competition in the physical discount retail industry. Big players like Walmart (WMT), Costco (COST) and Target (TGT) dominate the space. Dollar stores like Dollar General (DG) also serve their niche well. And, with countless indicators pointing to a coming recession, many of these discount retail stores will be supported by price-conscious consumers to weather the tough times.
One of these companies begins to establish itself as a real diamond in the rough, or a cigar butt as the legendary investor Ben Graham would say. This company is a discount home retailer, Big Lots, Inc. (NYSE: BIG). Below I will explain all the reasons why Big Lots is such an attractive investment right now.
A real cigar butt
Ben Graham and Warren Buffett perfected the value investing strategy in the 1930s and 1950s, buying very cheap stocks and bringing them down to normal valuations.
“A cigar butt found on the street that has only one puff left may not offer much smoke, but ‘buying cheap’ will make that puff quite profitable.” -Warren Buffett
Two important valuation metrics they often looked for were companies with a price-to-book (P/B) ratio below 1 and a price-to-earnings (P/E) ratio below 10. They found that companies with these characteristics tend to outperform the market. Over the past few years, sky-high valuations seemed to rid the market of many opportunities like this, but Big Lots is flying under the radar, ticking both boxes with a P/B of 0.61 and a P/E of 9, 08. For comparison, take a look at where some of their big competitors rank here.
As you can see, Big Lots outshines the peers in terms of relative valuation, trades for the cheapest earnings and nearly half the value of their assets. It’s a real cigar butt.
Huge tailwinds ahead
The U.S. consumer price index (CPI) rose 9.1% over the past twelve months, trailing record inflation spurred by pandemic stimulus, supply chain woes and geopolitical unrest. Along with that, CNBC reported this week that US household debt topped $16 billion for the first time ever. And to top it all off, Reuters reported this week that U.S. job openings fell to their lowest level in nine months, signaling a tightening labor market. These are not good trends. And although consumers have largely avoided feeling the effects so far, many experts believe a recession is imminent. And where do consumers buy when times are tough? Discount retail stores like Big Lots.
Like everyone else, Big Lots will surely feel the pressure of rising interest rates and other effects of the economic downturn. But as store traffic and sales continue to rise as wallets tighten, that should outweigh the effects. Using excellent foresight, they have also significantly increased their inventory over the past year, in anticipation of supply chain disruptions and rising shipping costs. Inventory is up 42% since January last year, which they have prudently funded largely through capital-efficient sale-leasebacks at four of their distribution centers. Thanks to loading for expected demand ahead, as well as smart marketing campaigns like their recent back-to-school campus life sale, it looks like Big Lots is poised to capitalize on the times ahead.
Supreme Dividend Yield
Not only does Big Lots offer positive free cash flow at a ridiculously low price, they also pay shareholders outrageous dividends for holding their stock. Big Lots’ annual yield of 5.73% far outperforms the competition. Take a look at the comparables below.
For context, the S&P 500 index dividend yield was 1.69% in the second quarter of 2022 and has hovered around that level for years. Big Lots’ market-beating dividends make these cheap stocks even more attractive to hold for the long term, something many company insiders are doing in the form of equity grants.
Big Lots management has been stocking up on action recently. Over the past six months, 465,446 restricted shares have been granted to insiders, worth approximately $16 million. Conversely, only 178,498 were sold. Granted, these newly awarded shares have a vesting period, incentivizing insider ownership. And while the vast majority of shares in Big Lots are held by institutions, the stock has a large float at 26.69 million shares, or 92% of shares outstanding.
Short Compression Potential
With the right catalyst and publicity, Big Lots could present an attractive short-term opportunity. Typically, some indicators that a business may possibly experience a short squeeze in the near future are:
- High short volume (>5x average daily volume)
- High number of short shares as a percentage of float (>10% of float)
- Increase in short stocks
Big Lots short volume was 9.9 million shares as of 7/15. This is 7.45x the average daily trading volume of 1.3 million shares. Check.
Short Big Lots shares as a percentage of free float were 37.4%, signaling that a significant portion of tradable shares are short. Check.
And with 7.45 days to cover (or short interest ratio), it would take more than a week for short sellers to cover their positions given a significant rise in the stock price. However, it is interesting to note that the volume has tended to decline in recent months. Last month saw a reduction to around 975,000 average daily volumes, which extends the days to cover to 10.15 days; over two full weeks of trading. This long period of time could prove to be an expensive liquidation risk for short sellers, forcing them to close out their positions, in turn driving up the price of Big Lots.
The only part of this three-pronged approach that Big Lots might miss is the growing number of short stocks. Since the end of April, short interest has increased at an average rate of 8.2% every two weeks, which is a good sign. However, as the stock price fell sharply, short interest also fell, falling 5.9% from 6/30. This is not a good sign for the short squeeze opportunity, as it means short sellers are getting out of their positions in the green and relieving the security’s selling pressure. However, stock prices have risen over the past week faster than short selling, which is a good sign for this strategy. A big catalyst, like the Q2 earnings outperformance (which should be a few weeks away), might be enough to tip the scales and trigger a short squeeze.
With conservative assumptions in a basic dividend discount model, Big Lots looks undervalued. See my DDM valuation assumptions below:
To arrive at a conservative cost of equity, I used the capital pricing model, where the risk-free rate equals the current 10-year Treasury rate, the beta is a composite average of five separate sources, and the rate market return is equal to the 30-year inflation-adjusted market return. This amounts to a CAPM Cost of Equity of 10.7%. Big Lots is expected to pay another annual dividend of $1.20 per share next year and has had an impressive five-year dividend growth rate of 6.9%. The combination of these numbers results in a target stock price of $31.59, a 53% premium to the closing price on 8/4/22. This does not include the effects of any short compression.
In my opinion, it is not entirely useful to use a discounted cash flow (“DCF”) model for jackpots because there are so many factors that could impact future cash flows , and cost of capital assumptions change rapidly due to macro trends. I also think comparable performance will be a key part of Big Lots value creation in the short term, and the DCF model does not take this into account.
I’m not going to ignore the many risks associated with Big Lots’ less than desirable finances, questionable growth prospects, and recent shortfalls. And I would normally caution against a relatively small retail chain coming up against giants in times of economic strife. But in my opinion, the pros outweigh the cons. Jackpot trades extremely cheap, they’re free cash flow positive, they’re paying an incredible dividend yield, they’ve got some serious macroeconomic tailwinds looming, and they’re one headline away from a huge short squeeze. Solid fundamentals with huge option. What’s not to like?