Sports Direct pays the price for high street shopping spree

Sports Direct has built up investments in several of its struggling high street neighbours like Debenhams, GAME Digital and House of Fraser. We have a look at why the company pursues this strategy and ask whether it should stick to selling sportswear.

Sports Direct
Source: Bloomberg

‘I note that various commentators in the past have sought to portray Mike Ashley as a so-called “pantomime villain”. However, since Mike became chief executive, the company has initiated a process of transformation to the benefit of all stakeholders,’ - Sports Direct non-executive chairman, Keith Hellawell.

Sports Direct's latest annual results were not welcomed by investors as the company paid a heavy price after the value of its investments in its high street neighbours sank amid a sector-wide struggle for retailers. With the sportswear retailer increasingly dipping its toe, or sometimes its whole foot, into other businesses and partners, questions are being raised whether Sports Direct has forgotten the basics and what its purpose is.

Mike Ashley, the billionaire who bought Newcastle United Football Club after pocketing $1.8 billion by taking Sports Direct public in 2007, is not shy of drawing attention. But both Ashley and his company have remained stuck under the spotlight since he took over as chief executive in September 2016 following the shock resignation of long-time CEO Dave Forsey.

Although Ashley has never been renowned for what would be classed as ‘shareholder engagement’, relations with the company’s independent shareholders has deteriorated over the last 18 months. The founder has happily overruled fellow investors using the controlling stake he has maintained since Sports Direct listed, having twice re-elected chairman Hellawell despite calls for him to be ousted by the company’s institutional investors, while also drawing criticism about involving family members in the business.

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Much of Sports Direct’s story over recent years has been stained by high-profile accusations that its warehouse workers in the UK faced Victorian-like working conditions and findings that staff were not even being paid the minimum wage. A report by the Guardian in December 2015 revealed the controversy over working conditions at its facilities and that, coupled with a profit warning the following month, pushed Sports Direct out of the FTSE 100 at the end of the first quarter (Q1) of 2016, despite Ashley personally overseeing a review of the firm’s employment practices and a pay rise for staff.

When it joined the blue-chip index at the end of Q3 2013, Sports Direct was running on the momentum built up over previous years, delivering consistent lifts in revenue and profit each year. But its financial performance has deteriorated since 2016, with its latest results suggesting Sports Direct is only getting itself into further bother.

Sports Direct maintains growth thanks to premium goods and overseas expansion

Sports Direct’s core business of flogging sportswear and other sporting goods had been performing relatively well, with its UK retail business proving to be the most reliable and resilient part of the company until sales fell in the most recent year by 2% to mark a rare decline.

Read more on how the UK retail sector is performing and what the trading opportunity is

But Sports Direct has managed to find growth abroad: revenue from the US and Asia increased seven-fold last year and its Premium Lifestyle business (home to upmarket brands like Flannels, Cruise and Van Mildert) has also returned to substantial growth after a volatile few years. That, twinned with lower costs, has helped to more than offset tighter margins to keep profit moving in the right direction.

Sports Direct kept up that trend on an underlying basis in its most recent financial year, reporting a 58% year-on-year jump in profit to £152.9 million from £133.7 million. But at a reported level, Sports Direct’s pre-tax profit plunged for a second consecutive year.

Sports Direct profit dives for second straight year despite revenue growth 

  2018 2017 2016 2015
Revenue 3360 3245 2904 2833
Gross profit 1335 1331 1285

1241

Operating profit 217 160.1 223.2 295.6
Pre-tax profit 77.5 281.6 361.8 313.4


Sports Direct pays the price for investing in high street neighbours

This is because there is another side to Sports Direct. The business has long invested in peers and rivals in the retail space, having previously held a substantial stake in the likes of JD Sports before selling up the last of its shares in 2016. This strategy of investing in other retailers has only been expanded since Ashley moved from chairman to chief executive, and is essentially an extension of the billionaire’s aggressive tactic of snapping up shares in businesses he wants to influence.

Sports Direct steps up strategic investments

Company April 2018 April 2017
MySale Group 4.8% 4.8%
Debenhams 29.7% 16.8%
Findel 29.9% 29.9%
Goals Soccer Centres 18.9% 3.8%
Iconix Brand Group1 8.9% 11.4%
French Connection 27% 11.2%
Finish Line2 19.3% 7.9%
House of Fraser 11.1% 11.1%
GAME Digital 25.4% 25.8%

1Iconix Brand holding represents total economic interest
2JD has since acquired Finish Line and Sports Direct no longer holds any shares in the business

The UK high street has been pummelled over the last two to three years due to a plethora of issues: tighter consumer spending, lower footfall, increased competition online and the growing cost of running a traditional bricks and mortar operation, to name a few. Mike Ashley has never liked to keep all his eggs in one basket and this environment has presented opportunity for those that have faith in the longevity of the high street, like Sports Direct, to invest in the downturn and wait for the eventual recovery. 

But these investments means Sports Direct’s exposure is two-fold: its own stores suffer from the current climate and it owns a share of other retailer’s woes. During Sports Direct’s financial year the share prices of both Findel and French Connection both enjoyed significant rises, but all its other investments lost value. MySale Group shares dropped 18% in value, five-a-side operator Goals Soccer Centres dived 34%, GAME Digital fell 17% and US clothing retailer Iconix Brand Group all but collapsed after a whopping 87% drop. But it was its stake in Debenhams that dragged down its results at the end of the financial year 2018, with the department store’s several profit warnings sending its share price plummeting by over 54% in the year to April 2018 before taking a nosedive further south. Sports Direct’s stake in the department store was worth £85 million less at the end of April 2018 than it was a year earlier, eating more than enough profit to offset any progress made by its core retail operation.

Sports Direct’s investment activity eats up cash as debt continues to rise 

(£, millions) 2018 2017 2016 2015
Net cashflow from operations
326.2 257.4 65.7 237
Net cashflow from finance
259.2 (128.7) 188.4 (226.9)
Net cashflow from investments
(364.7) (239.4) (97.9) (77.9)
Including:
       
Sales of listed investments
20.9 190.2 181.3 51.7
Purchase of listed investments
(287.1) (24.7) (89.2) (50.4)
Income from investments
34.2 0.5 2.8 2.9
Purchase of property, plant, equip
(204.2) (413.5)

(207)

(97.3)
Sales of property, plant, equip
69 2.4 44 21.2
Proceeds from asset sales
0 109.5 0 0
         
Cash
360 204.7 233.7 78.3
Borrowings
(757.1) (386.8) (333.8) (138.1)
Net debt
(397.1) (182.1) (99.6) (59.7)


Additionally, the year-on-year performance is harder to compare as Sports Direct booked a profit from selling-off the Dunlop brand in 2017, which hurt revenue for its licensing division in the most recent year while at the same time reducing operating costs. 

Sports Direct spends heavily on new strategy and share buybacks

Still, as well as spending material sums investing in other businesses, Sports Direct has also been spending to restructure its retail business and, more controversially, buying back large amounts of its shares. Sports Direct has spent over £265 million repurchasing its own shares in the last two financial years and another £450 million has been spent on property alone as part of its ‘elevation strategy’. 

The strategy aims to raise the company’s sports retail proposition. Like-for-like (LfL) store sales, measuring the performance of mature stores by excluding new openings and online operations, grew 7.4% in the 2015 financial year but slowly grounded to a halt, declining 0.8% in 2016, holding steady in 2017 and falling 0.6% in 2018. Its European retail operations also reported a 2% fall in LfL growth. 

This highlights the need to shake up its model. Sports Direct operates several brands that all operate their own network of stores. But rising business rates and other costs such as labour, coupled with falling footfall, means operating such a large fragmented network is becoming increasingly unsustainable for the retail sector. Sports Direct’s strategy is consolidating that network to save on rent and costs to form larger, flagship stores that aim to be the ‘ultimate shopping destination for the lifestyle consumer’, while retaining the long-term ambition of selling more premium products to become the ‘Selfridges of sportswear’, as Ashley puts it. While it has long stocked third party products from big brands like Nike and Adidas, these tended to be products with a lower price-point, but now it has products on the shelves as pricey as £250.

Read more about Nike vs Adidas in the battle for sporting supremacy

JD Sports still leads the way when it comes to premium

However, Sports Direct has a long way to go to becoming the leader in this area as JD Sports has maintained its grasp both at home and abroad by specialising in premium sportswear, high-end leisurewear and trainers. Ashley once promised to ‘finish off’ JD Sports and for years his company was outperforming its rival by combining low-margin products, its higher-margin own brands like Lonsdale and the apparel and footwear that customers most wanted from the likes of Adidas and Nike. But JD’s relationship with the biggest sporting brands has been more stable over the years, giving it access to higher-tiered products that has helped drive its success in the premium ‘athleisure’ space. Based on the current picture, some will think it’s bizarre that JD was once being pressured to be more like Sports Direct.

Sports Direct rolls-out new store model

The latest example of Sports Direct’s new store model is its new 100,000 square foot store in Thurrock that combines multiple brands including Sports Direct, USC, Flannels and Everlast Gyms. A total of 15 new generation stores were opened in the last financial year, of which five were regional flagship stores. Meanwhile, 32 stores were shut with only eight of them being relocated to fit the new flagship model, demonstrating how much consolidation is occurring in the business. This shake-up though, in addition to its new London headquarters, is why spending on property has been higher in recent years and this year it is looking to spend another £300 million and open 10 to 20 new generation stores in the UK and Ireland, with another six to 12 Flannels stores to bolster its growing Lifestyle brands. That is a large expansion of its premium-geared stores bearing in mind it only has 34 luxury stores at present, 21 of which are existing Flannels stores. 

This is part of a wider trend in the retail space and an example of the benefits that owning or having interest in other brands can yield. Combining brands into one space to offer more to customers was the reasoning behind Sainsbury’s move to buy Argos, and other retailers like Next have previously said it was considering introducing restaurants, coffee shops and other concessions as a way of boosting footfall and sourcing new sources of revenue.

Read more about Tesco and Carrefour teaming up to take on Sainsbury’s-Argos-Asda

The other half of the programme is equally if not more important than revitalising its stores and brands. Those retailers that are unable to effectively compete online are those being hurt the most at present. The revival of its Premium Lifestyle business comprised of Flannels, Cruise and Van Mildert has largely been down to improvements to the online offering. Websites for its core brand, USC and Flannels underwent ‘significant enhancements’ in the last financial year.

Who is leading Sports Direct’s ‘elevation strategy'?

This effort of revamping Sports Direct’s retail business is being led by ‘head of elevation’ Michael Murray, who also operates the property side of the business. Murray’s role at the company has been justifiably questioned. He is engaged to Ashley’s daughter and he is hired on a consultancy basis rather than being given a board position or senior manager role. Its most recent results revealed he was paid £5 million for his work based on an ‘independent property valuation’ that establishes the ‘value created by Michael for the group’. That’s more than the average wage of a chief executive of a FTSE 100 business.

But Murray does seem to be left alone to do his job. The Financial Times reported Ashley admitted he ‘didn’t have anything to do with Thurrock’ – its new mega-outlet flying the flag for its new store model – adding he ‘didn’t even go there until after it opened’.

That follows on from other controversial payments and appointments by Ashley. Shareholders blocked Sports Direct’s attempt to pay the CEO’s brother, John Ashley, £11 million worth of back pay for when he worked at the company before leaving as IT director in 2015. With the CEO having proven his ability and willingness to sway a shareholder vote on his own, the fact Ashley abstained from voting on the issue and over 70% of independent investors rejected the proposal shows the divide between Ashley and his fellow shareholders.

Sports Direct: strategic investments are ‘integral’ to strategy

‘Strategic investments are an integral part of the group’s overall strategy. Against a backdrop of a challenged retail market, we believe innovative strategic partnerships will help to differentiate our offer and enhance the consumer experience. We look for ways to extend our reach into new retail channels and geographies, as well as selectively grow our market share,’ – Sports Direct.

Ashley has long tried to squeeze out value by using his portfolio of businesses and interests to help the others. The owner of a sportswear retailer purchasing Newcastle United is not coincidental - fans were in uproar when Ashley decided to temporarily rename St James’s Park to the Sports Direct Arena to help fund the cash-strapped club that he has had up for sale since October last year.

While Sports Direct has had little financial success with its investments it argues that it is about much more than just getting a return. Virtually all of the businesses it has invested in partners Sports Direct in one way or another: it works with Debenhams mostly online, is listing its licensed clothing brands to one of Findel’s online shopping businesses, and hoping to open up e-sports zones in partnership with GAME Digital. For Sports Direct, some of these partners will play an integral role in Sports Direct’s future.

Sports Direct pouncing on the demise of Debenhams

Ashley has long had an interest in Debenhams. Sports Direct held a 15% stake in the department store in 2015 before it sold all of its holding in 2016. Then, in 2017, Sports Direct started to build its stake again. It also raised its stake in Debenhams to 29.7% in the 2017-2018 financial year from 16.8% beforehand. The latest transaction occurred in early March when Debenhams shares traded at around £27.34, but shares have been in freefall to hit an all-time low earlier this week of just £11.81.

Sports Direct and Debenhams have been working together for some time. Although this started out by installing Sports Direct store concessions in its department stores, Debenhams is thought to work more closely with the sportswear retailer on their online offerings now. When it made its latest purchase Sports Direct said it was looking to expand its partnership with Debenhams to create ‘huge value for both companies’ by integrating web operations and working together on opportunities outside of the UK. Liam Rowley, who became the firm’s head of strategic investments last year, said ‘Sports Direct can complement Debenhams very well across the spectrum’.

But there is the obvious argument that if Sports Direct is just looking to partner with Debenhams then why has it felt the need to build up such a substantial stake in the business? Its holdings in Debenhams is only a smidgen under the 30% threshold that would require Sports Direct to launch a takeover offer under listing rules.

Despite stating in March that the two businesses had ‘an established and constructive relationship’ the mood seems to have soured since, with the Financial Times (FT) reporting Ashley seems unhappy about Debenhams reluctance to maximise its partnership with Sports Direct. The FT reported Ashley as saying he ‘will be smashing into Debenhams as to why they don’t do anything Sports Direct suggests’ and why the department store hasn’t installed the likes of Sports Direct’s click-and-collect service. Debenhams has seen its value plunge from over £800 million in September 2017 to south of £150 million today, and that could be a catalyst for Ashley to double-down on his investment. The company may try to partner with others, but its investments are the means of getting its way when push comes to shove.

Ashley attempted to upset the purchase of House of Fraser by Sanpower in 2014 in what was thought to be an attempt to get his grasp on a chain of department stores, revealing why he is so keen on Debenhams. And Debenhams is right to be wary that Ashley could turn from passive to aggressive investor after legal proceedings were initiated against House of Fraser in May, claiming Sports Direct has been shut out of a deal between two Chinese companies that would recapitalise the struggling business, with almost 60 shops and up to 6000 jobs being cut, but see a Hong Kong-registered business acquire a controlling stake. 

Sports Direct and GAME look to rising trend of e-sports

Sports Direct invested in GAME Digital in July 2017 and earlier this year announced it was providing the computer game retailer with a £55 million loan facility to help the company roll-out in-store gaming zones that allow customers to pay an hourly fee to try out new hardware and games in an effort to stimulate purchases. E-sports and e-gaming is becoming big business, whereas downloadable games through the likes of Steam and the general retail environment has hurt GAME’s core business. Allowing customers to play a new console or game in-store is nothing new, but encouraging people to play one another feeds right into the hype around competitive gaming and is the real hook to get customers to cough up.

These will be dedicated ‘Belong’ zones (even the name implies unity and comradery for people more accustomed to socialising over a headset in their bedroom) and while the focus is on installing them in GAME stores some will be introduced to Sports Direct outlets, helping broaden its new megastore offering. Sports Direct will also stock games and other GAME products on its own shelves. For Sports Direct the ambition isn’t to just add another service and product to its own stores. The deal has been structured so Sports Direct has invested in the new Belong brand, taking half of the profits from all of the concessions as well as those GAME outlets that operate in Sports Direct stores.

But lending out such sums to a struggling neighbour has been questioned when Sports Direct has seen its own debt spiral upwards over the past three years. Although the loan facilities are set at a variable interest rate, the initial 3% was only about half the interest rate on GAME’s loan facility provided by its largest shareholder, although it had not drawn any funds when it recently expired.

Sports Direct could look to Findel to accelerate transition online

Sports Direct acquired its stake in Findel in 2016 and has maintained it ever since. Findel’s specialities lie in two key areas: online retailing and logistics. It operates Studio, the online and home catalogue retailer and ACE, an online store selling home and garden products. It also has a substantial business supplying goods to the education sector.

In March, the pair announced that Findel’s other subsidiary, Express Gifts, which is one of the largest direct mail order business in the UK that is currently making the transition to online, would explore more opportunities with Sports Direct. Some Sports Direct licensed menswear has been added to the site to test the waters and the sportswear retailer is considering adding its own brands in the future.

With the move to online shopping not set to stop, Findel offers not only the digital capabilities that Sports Direct need but the logistics and distribution network that is equally as important as offering a glossy user-friendly website.

Sports Direct’s stake has been a loaded but unfired gun, and there is potential for the trigger to be pulled. The firm has happily allowed Findel, one of the only investments that has seen its share price heading higher of late, to crack on, but it has now got a more substantial voice at the table after getting Rowley access to Findel’s board meetings as part of the collaboration. While Rowley’s role will not allow him to ‘make or influence strategic decisions’ and see him shut out of Findel’s sensitive matters, his job will still be to represent Sports Direct’s best interests. Whether that means Rowley simply represents an ever-closer partnership between the two firms or as Ashley’s man on the inside keeping a watchful eye can be debated.

Sports Direct hoping not to score own goal with Goals Soccer Centres

Sports Direct significantly upped its stake in Goals Soccer Centres to just shy of 19% in February 2018, having held just 3.8% at the end of April 2017, becoming the single largest shareholder in the company who operate a string of five-a-side football venues across the UK with an early-stage expansion in the US.

Goals Soccer Centres is going through a turnaround plan that seems to be delivering results. Renovated venues and those that have been kitted out with additions like a clubhouse have been generating growing users while its older ones are still in decline, demonstrating that it is heading down the right path. But confidence has been knocked lately following a recent profit warning and the loss of its chief financial officer. There has long been expectations that the company could be a takeover target, with the company confirming press reports in 2017 that numerous mergers were possibly on the table, including with rival Powerleague.

While nothing firm is the pipeline, there is obvious opportunity between Sports Direct and Goals Soccer Centres, with talks that five-a-side pitches could start to appear in Sports Direct stores (it used to have a similar thing in its old stores back in the day, such as a football or basketball court in the middle of the store). Sports Direct could also look at flogging its gear at its partner’s customers, which are the prime target market for sportswear.

Sports Direct: watch strategic investments as closely as you do sales

‘One of our biggest challenges this year end has been an assessment of our relationships with our strategic investment companies. A number of these such as Game and Findel consider us to have significant influence over them by virtue of signalling us as a related party in their accounts. I do not believe that we have significant influence over these companies. I do not believe they apply the core Sports Direct principles of being conservative, consistent and simple,’ – Mike Ashley.

During the presentation of the latest annual results Ashley addressed criticisms that Sports Direct has substantial influence over the companies it has invested in. Speaking to investors, Ashley said, ‘I want a show of hands of those people in this room that disagree that applying our core principles of being conservative, consistent and simple, and thus increasing our significant influence within these strategic investments would be a bad thing? I want to be crystal clear, if you disagree with this put your hands up?’

On the assumption that hands remained down, the CEO went on to say he would be ‘contacting our strategic investment companies in the next few months and urging them to adopt our core principles of being conservative, consistent and simple’, promising an update at its interim results in December. It is clear that any calls for Sports Direct to rein it in and focus on selling sportswear are falling on deaf ears, and that Sports Direct’s involvement in the UK high street and beyond will continue to grow in coming years.

While the latest set of results has made Sports Direct’s investment business the centre of attention and raised questions about what strategy is at play, it is quite clear what Sports Direct and Mike Ashley are trying to do. Having failed (for now) to buy or gain control over his own department store Ashley is looking to build his own, bringing together his portfolio of brands with the intention of adding more to provide an all-in-one home for shoppers – the difference being that all the shops and brands are owned by one company.

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