JD Sports is a British sportswear chain known for its inspiring management and the support of its reference shareholder, the Pentland group (57% of the capital). The latter also is the owner of the brands Lacoste and Speedo.

 

Chart JD Sports Fashion Plc

Although it's less meteoric than at Superdry or Primark (both already presented in our Stock Picks section), the growth profile of JD Sports is just as excellent: the turnover went from £592 million in 2008 to £3.16 billion in 2018 (in other words 18% of annualized growth), while the net result, well-reconcilable with the cash profit, went from £24 to £236 million during that same period (in other words 26% of annualized growth).

This expansion of profitability clearly illustrates the operating leverage that characterizes retailers, able to rapidly sublimate or lower the profit due to the slightest variation in turnover. Naturally, this model is a source of risk and opportunity at the same time, depending on the company’s good fortune.

In line with the other investments made on behalf of the 4-Traders portfolios, JD is exceptionally well-capitalized: the £972 million of current assets alone (a good half of which consists of inventory and the other half of cash and cash equivalents) cover all £792 million of liabilities.

When it comes to the cash-flow, we observe that the management of the need for working capital is remarkably well-optimized - an unusual performance during a period of growth since this usually forces companies to use their cash to issue new shares.

 

JD pays a modest dividend (£15 million) and mainly reinvests in sales surfaces and other fixed assets (£183 million). These flows are easily covered by the operating cash-flow of around £280 million over 2017 and 2018.

Over the past ten years, the company auto financed its growth without getting into debt or diluting its shareholders via new market calls - a performance that clearly highlights the British know-how when it comes to the retail business.

Sports Direct International is the historic competitor of JD Sports. With a little over £3 billion in sales, the two rivals (founded in the early eighties) are similar in size but position themselves differently: Sports Direct is known for its affordable prices, JD for its more sophisticated merchandising (which, at comparable volumes, leads to better margins).

Sports Direct seems less well managed, with important growth investments lacking in profitability over the previous financial years. These difficulties lead to questions because they could be illustrative of the questions that await JD in the near future - Sports Direct has already reached its critical mass a few years ago. 

JD is operating 1237 stores and generates two-thirds of its turnover in the UK (and the other third elsewhere in Europe). As its markets are mature and saturated, the company now has to transport its growth drivers abroad to truly take things up a notch.  

An acquisition of a considerable size imposes itself - and this was exactly what the news that broke in March 2018 was about when we learned that JD had acquired the American company Finish Line, a business with 500 stores and 400 mobile points of sale.

Certainly, the United States is the biggest global market for sportswear - an attractive perspective - but British companies regularly encounter problems there. Without wanting to say anything about JD’s chances of success in this new geography, the difficulties encountered by its big rival Foot Locker remind us that one has to play tight in this enormous but ultra-competitive market.

Finish Line has been acquired for an amount of £400 million, a multiple of exactly 10 times the operating profit of the company - a valuation that a priori is reasonable, illustrative of a moderately optimistic context.

A noteworthy particularly: with 9.9% of the capital, historic competitor Sports Direct is the second biggest shareholder of Finish Line!

Other diversification efforts abroad have been undertaken in parallel: the consolidation of branches in Spain and Portugal, the opening of new stores in Australia and in Malaysia, a joint-venture in South Korea, etc. 

In 2017 JD has also acquired GO Outdoors, a British company of 58 stores specializing in outdoor camping equipment, for £128 million. This amount represents a multiple of 21 times the operating profit - a valuation that seems high for a company with a modest growth (since Go Outdoors has been founded in 1998), but we think that the management of JD has identified promising synergies. If this isn’t the case, the value destruction will be significant. 

This external growth strategy is new for JD. Therefore we don’t know yet if the management will be as brilliant at it as it was with the company’s organic growth strategy. In general, acquisitions in the retail industry are arduous: if the mix of cultures doesn’t work out, or if one of the two brands weakens or a geography slips away, it’s the entire structure that suffers from it - due to the high operational leverage we mentioned earlier.

JD currently trades on the exchange for £3.8 billion, a multiple of 16 times its most recent net result. This valuation is surprisingly reasonable for a company that’s growing but the market undoubtedly distrusts a ‘traditional’ retail activity in the light of the Amazon era and the difficulties that similar companies are dealing with.

In many ways, the situation at JD reminds us exactly of the situation at JB HiFi (presented here a while ago): a success story, the reaching of a ceiling, a transformative acquisition - and a bet on the success of that acquisition.

A constant growth trajectory over the next financial years - in particular, thanks to the company’s overseas activities - will have a positive impact on the valuation of the group.

If on the other hand, the opposite occurs the investment thesis will have to be reconsidered.

Translated from the original article.