Description

Thesis:

We think Foot Locker (FL) is a short.  The market has applied an unrealistic multiple to its business model, which we view is at peak SSS growth and operating margins (the CEO said as much when at the 2015 investor day he targeted a 12.5% operating margin – FL is currently at 12.3%).  We believe FL is at significant risk of lower same store sales (SSS) and compressing operating margins over the next 12 - 36 months given the inherent cyclicality of athletic footwear and apparel (despite sell-side protestations to its secular tailwinds) and given the secular challenges of brick-and-mortar retail distribution of 3rd party consumer goods.  

FL is overvalued on an absolute basis, trading at 16x and 20x our 2016 P/E and FCF/share estimates despite significant cyclical and structural headwinds over the next 12 – 24 months, which we outline below.  In our base case, we think shares will trade at $52 one year from now (22% lower than current levels) based on 13x our 2017 adjusted EPS estimate of $4.00.

Business Overview:

• FL is one of the largest athletic footwear and apparel retailers in the world, with 3,400+ stores across 23 countries in North America, Europe, Australia, and New Zealand.

• Current store concepts include Foot Locker, Champs Sports, Foot Action, Lady Foot Locker, Kids Foot Locker, Six:02, House of Hoops, Eastbay, Sidestep, and Runners Point.

•  International markets drive 30% of sales, mostly across FL’s 600+ stores in Europe and 90+ stores across Australia and New Zealand.

•  Sales have steadily shifted from brick-and-mortar stores to online, with 12% of sales now driving through the latter.

• Footwear represents 79% of sales with the remaining 21% from apparel and accessories.

• Nike products drive roughly 73% of sales.

Cyclical headwinds:

Nike basketball shoe demand decline: Based on our channel checks we think NKE basketball will face some challenging comps in the coming quarters.  NKE supplies 73% of FL’s products and basketball shoes represent 30-40% of FL’s revenue (our estimate).  NKE’s basketball segment, which has produced DD% gains for 14 consecutive quarters, created an entire sub-industry of “sneakerheads” in which NKE intentionally under supplies retail outlets with highly promoted shoe styles that sneakerheads (primarily young males) purchase at retail price at FL (and other wholesale distribution points like Finish Line and Dick’s) and then resell on various online sites such as eBay for a material premium.

Our contacts estimate this arbitrage value exceeded $250mm in 2014, which in turn has driven oversized demand for these shoes at FL’s retail stores (their primary wholesale distributor).  Recently however, we think that demand for these shoes, specifically Retro Jordans and other marquee basketball shoes, have slowed significantly.  NKE releases Retro Jordans every Saturday morning at 10 AM EST and typically sells out these shoes almost immediately.  Lately, these shoes are not selling out and have become widely available both in FL stores and via online distribution at retail prices.  Secondary prices of these shoes on eBay have correspondingly compressed from previously much higher levels.

We have also noticed that demand for shoes associated with older players like Kobe Bryant, LeBron James and Kevin Durant have also declined materially over the last few months.  These “old school” shoes are being replaced by shoes marketed with younger players like Stephen Curry and Kyrie Irving.  This transition from “old guard to new guard” affects FL’s sales and margins in several ways:

• The new guard shoes are priced $80-$100 less/pair which lowers both sales and margins.  More broadly, NKE’s average selling price (ASP) has enjoyed high single-digit growth over the past several years, which has shown signs of slowing in recent quarters.

• FL’s inventory of old guard shoes has increased, which will either compress their margins as they sell the shoes at a discount or lower sales as they “put” the shoes back to NKE or both.  On their most recent conference call, NKE highlighted gross margin pressure that resulted from excess inventory in North America.

• FL recently placed the LeBron shoe styles on sale before the NBA All-Star Game (which breaks with prior practice).  Finish Line also discounted LeBron shoes.

European sales headwinds: Western Europe represents 30% of FL sales and has outperformed recently with the last three quarters SSS growing low to high DD growth.  We think this has resulted in part from the influx of Chinese tourists visiting Europe because of the depreciation of the Euro vs. the Yen.  We believe this demand has declined as the Yuan has declined over the last 6 months.

Tourism spending in Europe slowed dramatically in October to +1.6% from DD growth in previous months, driven in large part by significant drops in spending by Chinese (+23.5% in October vs. 49.2% in September) and Russians (-44.2% in October).  Tiffany & Co, Michael Kors, and Burberry have all reported slowing growth in Europe, and Chinese tourist agencies reported a fall in travel inquiries to France, the most popular tax-free shopping destination.  Conversely, premium retail stores in Japan are experiencing a boost in sales from Chinese tourists as the Yen has weakened.  We expect both the Yuan and Chinese tourism in Europe to decline further in 2016, a significant impediment to FL’s 2020 plan which calls for 7.5% annualized growth in Europe and 150bps in margin expansion.

Structural headwinds:

Disintermediation from vendor DTC: NKE, which supplies 73% of FL’s products, has fueled much of its own growth through its DTC channel.  NKE’s .com business alone is growing 50% y/y with a company goal of $7bn in online sales by 2020, equivalent to FL’s total business today.  Under Armour, another major vendor for FL, has also invested heavily in its DTC business, which currently drives 30% of sales, up from 6% 10 years ago.  The below graph from BB&T highlights this dramatic shift away from wholesale towards DTC across several of FL’s suppliers, including Nike, Under Armour, Puma, and Adidas.  DTC (primarily online) offers higher margins and higher growth than wholesale.

Despite its continued position as NKE’s most important wholesaler, FL has been forced to respond to the DTC competitive pressures:

• FL has historically charged online shoppers for shipping on its most popular basketball shoes.  It recently offered free shipping which matches NKE, UA, etc.

• Online footwear purchases continue to gain market share from physical retailers as online retailers offer free shipping, free returns, shoe customization, greater variety and obviously, convenience of shopping from your desktop or mobile phone

Challenge of the mall:  FL stores in the US predominantly populate malls (both strip and larger malls) while its main suppliers are focusing their physical stores on single site, urban locations or suburban factory stores.  The demise of mall based retail shopping is not a new thesis, but it continues to represent a major headwind for mall-based business models.  Walmart in January announced the closure of 269 locations alongside other retailers including The Gap and American Eagle.  Spending in stores on Black Friday fell 10% from the previous year.  In spite of this headwind, FL has grown SSS extremely well, but we think its future growth will decline as consumers pass over the inconvenience of a traditional mall versus more communal shopping experiences.  Of the 1,085 existing malls in the US only about 457 are high quality (class B+ or better).  20% have troubling vacancy rates greater than 10%, up from 6% in 2006, and not a single enclosed new mall has been built in the US since 2006.

The below graph from Prodco highlights the mid-single digit decline in foot traffic at retail stores since 2012:

Against this unfavorable backdrop, FL has prudently trimmed its square footage with flat to negative growth over the past 8 years.  Additionally, FL has been rolling out a store refresh initiative since 2014, which is both costly and hampers sales growth during the remodeling phase at each store.

Ultimately, FL’s effort to counter the secular decline of shopping malls has been valiant, but not sustainable in our view.  The company’s near-term growth story is in part driven by square footage expansion predominantly in international markets, which will need to more than offset the continued declines in the US to achieve its 2.5%+ in square footage expansion in the next several years.

Incremental cost to offer omnichannel:  We think FL’s current EPS calculation doesn’t properly account for the additional costs to offer customers an omnichannel experience along with a more unique physical retail experience.   We believe FL’s reported GAAP D&A over the last few years consistently underestimates the cost to run both an online channel as well as refresh its stores to fit the latest styles of its suppliers (primarily NKE).  The table below shows the difference in D&A and CAPEX over the last 5 years.  Useful life for FL’s technology investments is estimated between two and seven years; for furniture, fixtures, and equipment between three and ten years; and for buildings a maximum of 50 years.  However, we believe useful life of FL’s investments is shortening given the company’s current store refresh and relocation strategy, which accounts for roughly 76% of CAPEX.

We think a more appropriate metric to measure FL is FCF/share (CFO – CAPEX), since we cannot determine a specific-enough average life for FL’s investments.  We have blended EPS and FCF/share, with an 85%/15% respective weighting, to arrive at an “adjusted EPS” for 2017 of $4.00.

To underscore our point, FL announced plans to increase capital spending at the fastest rate in five years, investing in store remodeling and other initiatives to improve productivity and online operations. Annual spending is expected to reach 3.8% of sales based on 2016 consensus revenue, up from the projected 3% in 2015 and 2.7% the previous year. The company has used remodeling and branded shop-in-shops to draw incremental traffic and increase sales per square foot in existing stores.

Financials/Valuation:

FL trades at 16x our 2016 and 2017 P/E estimates, multiples that are too high given the company’s limited upside and the strength of headwinds challenging it.  FL has experienced strong SSS comp growth and outperformed its long-term EBIT margin target of 12.5% due in large part to its significant exposure to NKE’s strong performance over the past six years.  EBIT for FL’s brick-and-mortar stores contracted only once in the past 12 quarters, finishing 15% higher in 3Q than a year earlier on a 4% increase in sales.  Financial performance has already benefited from the company’s heavy investment in productivity enhancements through its new hiring and labor scheduling system, and inventory management system, likely exhausting its opportunities for additional operational leverage.

Given the above-mentioned factors, we have modeled revenue growth as well as gross and operating margins below consensus.  We grow sales 2.2% in 2016 and 1% in 2017.  Our sales declines reflect lower SSS growth due to lower basketball shoe sales, disintermediation from vendors’ DTC sales, and declines in mall traffic and Chinese tourism in Europe.  We think gross margins will fall from 33.7% in 2015 to 33.3% in 2017 as the “new guard” basketball shoes pressure ASP downwards.  We think operating margins will decline 0.6% in 2016 and 0.8% in 2017 as SGA increases from heavier investment in DTC and store refresh/relocation initiatives.

Our $4.22 EPS estimate for 2016 is $0.53 lower than consensus and lower still in 2017 as margins continue to decline from ASP deterioration in FL’s basketball segment and increased expenses associated with the buildout of its DTC business.  Adjusted EPS, which blends EPS and FCF/share 85%/15%, is even lower but we believe more reflective of FL’s performance assuming maintenance CAPEX accounts for the majority of total CAPEX.  Conservatively, we gave FL credit for its strong cash position (roughly $900 million) by projecting a buyback program of $270+ million in 2016 and 2017.  We think shares will trade at $52 in 2017 based on 13x adjusted P/E, a more appropriate multiple in-line with FL competitors with similar growth profiles.

Summary:

FL has impressively countered the significant headwinds facing traditional brick-and-mortar wholesalers over the past several years.  Benefiting largely from the multiyear trend of athleisure and success of its largest vendor, NKE, whose global dominance has delivered significant growth and higher selling prices, FL has achieved high single digit growth and close to 500 bps in margin expansion since 2011.

In order to deliver continued growth, FL would need to reverse trends in several of its key segments including women’s and apparel.  Over the past 10 years, FL closed more than 400 women’s stores and will need to deliver strong performance from its new women’s concept, SIX:02, to reverse this trend.  Apparel, another growth segment for FL, offers higher margins than footwear, but has fallen from 30% of net sales 10 years ago to just 21% today.

While FL earnings have impressively grown 30% annually and SSS averaged 7.5% over the last 6 years, the company has historically been prone to cyclicality, posting negative SSS comps in 5 of the 7 years from 2006 to 2011.  Additionally, we think management implied “this is as good as it gets” when they targeted operating margins of 12.5% in 2020 – margins already achieved in 2015.  Based on commentary from the company’s 2015 Investor Meeting, we believe margins have therefore peaked and will decline in the near-term as the company manages the increased costs from operating/expanding its online store and continuously refreshing its brick-and-mortar retail experiences.  We believe this margin deterioration will accompany the structural and cyclical headwinds FL faces and inevitably cause much lower SSS going forward, driving multiple compression.

Risks:

• The secular trend towards casualization and away from more formal footwear could trump the historical cyclicality of athletic footwear and apparel.  As noted above, we believe FL and NKE, its largest supplier, are showing signs of concept fatigue with the move towards lower-priced styles and a faster time to discount.

• The impact of the yuan devaluation could be mitigated by the continued robust growth of Chinese tourists.

• FL’s full-store remodel program could drive sales per square foot higher.  30% of stores have been remodeled and have seen a lift in sales per square foot.  A more complete rollout of this program could drive growth.

• FL’s investments in inventory management have seen days of inventory decline from 106 in 2009 to 94 in 2014.  The company could experience continued operational efficiency in the near-term.

• The market for higher-end basketball shoes could reverse its slowing trend.

• FL’s significant efforts to increase its kids and women segments could prove successful.

Catalyst

• FL reports Q4 2015 financial resutls before market open on Friday 2/26/16
• Other consumer goods retailers report quarterly earnings (DKS reports 3/1/16)
• Color from Chinese tourtist demand in Europe from Euro centric consumer goods retailers/manufacturers/brands
• NKE and UA commentary on their DTC efforts
• Secondary bball sneaker market prices continue to compress towards retail prices
• General online trends v. physical retail (particularly in Malls in US)