Ollie's Bargain Outlet: Discount Retailer with a Long Runway

In our recent Fall Portfolio Update, we wrote about how focusing on things that don’t change is much easier than trying to predict what will change. Ollie’s Bargain Outlet plays into this idea nicely. The motto at Ollie’s is “buy cheap and sell cheap” which is based on the idea that humans always have and always will enjoy a good bargain.

I wrote about other discount retailers earlier this summer, and I’ll reference parts from the original article given the overlap between Ollie’s and the previously discussed companies. For the full background you can read the post here.

While Ollie’s employs a similar approach to sourcing bargain deals, they offer a much different product portfolio than other discount retailers. Rather than focusing on fashion and clothing, Ollie’s primarily sources household items:

Ollie’s does not sell junk. Like the other discount retailers, they offer deeply discounted higher quality items, hence the slogan “Good Stuff Cheap”. A good example is you might find a lime-green KitchenAid mixer – something that may not sell well at Williams-Sonoma but nonetheless a high-quality item – on the shelf at Ollie’s.

Ollie’s is known for its witty and self-deprecating humor inside its barebones “semi-glamorous” stores along with its engaging advertising campaigns. They aim to make shopping at Ollie’s about more than just finding value, but rather tapping into a shopping experience that human’s love.

Business Model

Procuring a wide assortment of dramatically discounted items is the engine that drives the rest of Ollie’s model. Opportunistically buying cheap and selling cheap enables:

- A treasure hunt experience, and

- Recession resistant earnings with antifragile characteristics

First, a quick overview of the buying process.

Opportunistic Purchasing

The buying process is nearly identical at Ollie’s as Ross/TJ Maxx/Burlington. As I wrote in the previous post:

These retailers obtain merchandise at a significant discount from manufacturers by opportunistically taking advantage of an imbalance in retailers’ demand and manufacturers’ supply. Most of the buys are “close-out” purchases – made late in the buying cycle and when a manufacturer has an overrun or canceled customer order. This creates an excess supply of clothing or other items where the manufacturer simply needs to salvage some of its costs, and they know who to call when this happens.

Ollie’s has a deeply experienced buyer team entrenched with their supply base. They give the buyers extreme autonomy to opportunistically source the best deals for customers. Ollie’s size is also important because manufacturers generally need a buyer who can take a whole order immediately. Given these dynamics, management believes they are the first-call from suppliers whenever a deal arises.

Another benefit for customers is Ollie’s value proposition is strengthening each year. Management explicitly explains that as they open more stores and enter new territories, they command better deals and pass along more savings to their customers (by maintaining their 40% gross margin target despite receiving better deals from their increased buying power). This is an element of “scale economies shared” which has been the engine behind Costco for years (not that I’m comparing Ollie’s to Costco, but it is the same idea). With years of growth ahead of it, Ollie’s should be able to harness this positive feedback loop for some time.

Treasure Hunt Experience

I didn’t fully appreciate the treasure hunt experience dynamic until studying discount retailers and talking to fans of these stores. After the last several months, I’m convinced that this qualitative aspect matters as much as any quantitative measure you can find.

The nature of buying closeout items means that no one knows what type of product is going to be arriving at the stores from week to week. Further, quantities are usually limited and, as Ollie’s in-store signage reminds shoppers, “when it’s gone it’s gone”. The variability and limited quantity of products creates a sense of urgency in shoppers making them more likely to spend money each visit.

Shoppers go to Ollie’s not just to find an item they need, but to hunt for bargains as a form of entertainment. Fans of the store visit to buy something even though they don’t yet know what. It’s almost as if leaving their house is a sunk cost as they intend to come home with a bargain on a quality item and have fun while doing so.

None of this can be quantified but the ramifications are real. Just like the other discount retailers, Ollie’s maintains no online presence, yet flourishes more every year. From what I’ve gathered by talking with fans of closeout retailers, maintaining a constantly changing website of products at each location is not something that the company or its customers are interested in. The main reason customers come to Ollie’s – to treasure hunt – isn’t the same online when users would be clicking through web pages instead of physically looking for bargains. As CEO John Swygert said on a recent investor call:

“We have no interest of being on the Internet. So that's not a strategy that, we believe, meshes with a close-out retailer”.

Discount retailers offer a rare defense against the Amazon effect, or at least have thus far.

It’s a unique model and one people continue to buy in to as evidenced by the burgeoning network of loyalty members.

Ollie’s Army

Unlike the other discount retailers, Ollie’s enjoys a large and growing loyalty network which they refer to as “Ollie’s Army”. Members receive special offers, discounts, marketing, and other promotions like “Ollie’s Army Night” for no cost when they sign up to be part of the army. As you can see below, membership is growing rapidly and has compounded at 20% annually since 2013.

Source: Author, company filings (through Q2 2020)

While members don’t pay annual fees, they drive Ollie’s business. Ollie’s Army members spend 40% more than non-members per trip and account for around 70% of sales. According to the company, members are willing to drive more than 25 minutes to visit one of the stores.

Ollie’s Army members enables the company to gather precise data about their consumers allowing for targeted advertising and better insights into who wants what merchandise. Growing this loyal customer base is an important emphasis for the business and provides a stable revenue base.

Strength from Recessions

Ollie’s extreme value model is not only recession-resistant, but the company actually emerges from recessions in a stronger relative position. When the economy contracts, the volume of close-out deals from manufacturers increases. Ollie’s benefits from this by offering the best close-out deals precisely when consumers are trading down to a more value-oriented lifestyle during recessions. The influx of new customers during recessions allows the company to expand Ollie’s Army, which tends to stick post-recession and serves as an accelerant to long-term growth. This was the case in 2008/2009, during the current recession, and should be true during future recessions.

The recent pandemic-induced recession highlights this dynamic well. As Swygert discussed on the August investor call as the company enjoyed record comp-sales growth:

“Ollie's Army was a significant driver of our amazing sales in the quarter with members shopping more often and spending more per visit. We signed up new members and an unprecedented numbers surpassed even the biggest – the busiest of holiday seasons and ended the quarter with 11 million active members, a 13.4% increase over the prior year. Our reach went well beyond Ollie's Army. We believe we have attracted a lot of new customers with our assortment of essential products and great deals.”

The recent recession benefited Ollie’s more than a normal recession because other retailers were closed while Ollie’s was deemed essential and allowed to stay open. The results won’t always be as dramatic as the past six months, but the pattern should nonetheless hold in the future. In this respect, Ollie’s possesses one of the most desirable traits of a business – antifragility to periods of economic hardship.

Fundamentals

Store Economics

When Ollie’s opens a store, they layout around $1M in cash. After 12 months a store generates close to $4M in revenue and 15% EBITDA margins for 50%+ cash on cash returns and a two-year payback. Once a store reaches maturity it will typically grow comparable sales at a low single-digit clip annually, so the real growth driver for the foreseeable future is new store builds.

From 2015 through 2019, the company reinvested roughly 75% of its operating cash flow at ~20% incremental returns (implying 15% compounding of intrinsic value), which is quite attractive and makes sense given the profitable unit economics.

Management and Capital Allocation

Unfortunately, late last year co-founder and CEO Mark Butler unexpectedly passed away from natural causes at the age of 61. Butler owned over 16% of the business, which is now held in a trust, and was an integral part of the company since its founding in the early ‘80s. Ollie’s promoted long-time COO/CFO John Swygert to the CEO position along with elevating other top lieutenants. Luckily, the business is still in good hands as evidenced by significant equity ownership among executives and an unchanged view towards the long-term strategy.

Leadership has been consistent in their approach – prioritizing investing in high return on capital new store builds and continuing to pass along savings to customers. The company has guided that they will increase store count at a mid-teens clip (from a base of 345 last year) with a ceiling of 50-55 new stores per year. The ceiling of 55 stores per year indicates that the company is not emphasizing growth at all costs - a positive that increases the odds of continued success. They’ve picked 55 stores as a ceiling because opening much more than one store per week would risk the quality of hiring, training, and store start-ups.

Also, the company has shown flashes of “Outsider” capital allocation decisions. For example, last year the company spent $40M to retire shares at an average price of $58 – which is a steal as you’ll see later. Leadership characterized the move as opportunistic meaning they are thinking of repurchases as an investment, rather than a way to juice earnings. Also, like most businesses, Ollie’s has held more capital than typical during the pandemic due to the initial uncertainty. When asked what the plan was with the excess $300M in cash the company is carrying CFO Jay Stasz said that in the coming months:

“when the time is right, obviously, we will talk to the board and we will work together to return that cash to the shareholder in the best way possible.”

The teams’ collective actions all point to an ownership mentality and prudent capital allocation.

Balance Sheet

Ollie’s maintains a pristine balance sheet with almost no debt and significant liquidity. I have no concerns about the company over-extending itself as it continues to grow.

Growth Plan

Ollie’s revenue growth is a function of building new stores and generating comparable-store sales growth. New stores are by far the largest driver. Fortunately, it looks like the company has a big whitespace here. The company had 345 stores in the following locations at the end of 2019:

Leadership released a market study last year indicating they believe they can support at least 1,050 stores in the U.S., or more than triple the current number. As mentioned, the team will open at most 50-55 stores per year. This indicates something like 15 years of robust growth. Once a store matures, comps should grow 1-2% annually, which may prove conservative after looking at previous years comps which have typically averaged around 3%. Also, it’s likely the 1,050 store target will prove conservative, as has been the case with estimates from other retailers over the years like Ross, Costco, and others.

Turning to cost, the company maintains a 40% gross margin target, and any direct cost leverage from scale advantages is passed through to customers. SG&A is currently at 25% of revenue but increasing sales should drive this closer to 20% over time. The last quarter showed the potential as demand exploded and SG&A came in at 20% of sales. Management has stated that comp sales growth over 1% - 1.5% creates operating leverage, so the company should achieve a few percentage points of leverage over the next five years at which point SG&A would be somewhere around 22% of sales.

Valuation and Returns

Unsurprisingly, Ollie’s currently commands a premium valuation compared to the general market. At around $90/share, the company is priced around ~30x my estimate of 2020 earnings. This valuation is not out of line given the growth prospects, but certainly not what I would be willing to pay given the lack of a margin of safety.

To get an idea of what the company might be worth in five years, I’ll look at what earnings power should be at the end of year five, along with accumulated cash over that period. If the company opens 45-50 stores annually from now until 2025 (consistent with projections) they’ll have ~635 stores by the end of 2025. At roughly $500K in free cash flow per store and with modest operating leverage (with SG&A reaching 22.5% of sales) here is what I can envision:

Actual store count may vary slightly, but this seems like a pretty down the middle scenario, in which case what I’ll refer to as “distributable earnings” would grow at a high-teens clip annually.

What about valuation?

By 2025 the company should still be growing sales at 10%+ annually given they’ll only have built just over half of their potential stores. Using a 10% discount rate a 20x valuation implies roughly 5% perpetual growth, which seems like a reasonable bar for Ollie’s to clear (if not in perpetuity at least for 5-10 years). In reality, growth should be much better and the market may assign a higher multiple in five years, but we have a moral aversion to assuming an above-market multiple in the future. The current ValueLine market median earnings multiple is about 20x. Earnings will have a long runway to outpace the market average, so a valuation of 20x earnings would not be aggressive and represent significant multiple contraction from today.

Adding up cash build between now and 2025 and assigning a 20x multiple to earnings, I think somewhere around $125 per share of total value seems rational.

Assuming the above $126 value per share by 2025, here are annual returns from different purchase multiples:

Returns appear unexciting from today’s prices, which isn’t shocking given the run-up in the stock recently. If you think a 20x multiple five years out is too conservative given the growth, returns could be quite a bit higher. Either way, I’ll still be watching the business closely.

While it may seem unrealistic given what the stock and broader market have done recently, patient investors may get a shot to purchase Ollie’s at a reasonable valuation in the coming years. After all, just last year Ollie’s traded below $60/share and it reached $38 during the March market route. Ollie’s is an antifragile business with a sustainable business model and a meaningful competitive advantage that will be in replication mode for years to come. I’ll keep Ollie’s on my shopping list to pick up at the right price.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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