Description

Foot Locker (FL) seems a bit too cheap. Below are FL’s valuation multiples:

LTM P/E: 14.5x
LTM P/E excluding cash: 12.9x
FY 14E P/E: 13.9x
FY 15E P/E: 12.5x
LTM EV/EBITDA: 6.8x
FY 14E EV/EBITDA: 6.7x
FY 15E EV/EBITDA: 6.2x
EV / Revenue: 0.8x

These valuations are too low for a well-managed retailer dominant in its market niche growing nicely and generating substantial cash flow that is being returned to shareholders via share repurchases and dividends. 

Foot Locker is a 3,500-store athletic footwear retailer, the largest of its kind by a factor of three (the next largest pure play comparable is Finish Line). Throughout the 1990s and 2000s, the company grew quickly but beginning in 2006, comparable sales endured a 4-year decline. In 2009, current CEO Ken Hicks joined the company from JC Penny and has overseen a turnaround. He shrunk the store base by 2-3% annually, closing unprofitable stores and re-focusing management on ROIC and cash flow generation. FL has since produced fifteen straight quarters of SSS growth that management expects can be sustained by store remodels and the addition of more private-label apparel (24% of mix) into FL’s locations. At its current price, the business generates a 5 – 7% free cash flow yield, and can sustain double-digit earnings growth as management expands FL’s presence internationally.

Foot Locker owns five standalone concepts in addition to their namesake brand, some of which are shrinking while others are expanding. The Lady Foot Locker banner has been particularly challenging. The business continues to lose money and dampen FL’s overall margins. Management has aggressively closed unprofitable stores with plans to supplement the women’s channel with the SIX:02 concept. The more promising growth trends lie in FL’s already successfully banners, including the Kids and International businesses, both of which generate positive comps.

Approximately 30% of FL’s stores are international. This store count roughly breaks down as 800 stores in Europe, 100 in Asia, and 100 in Canada. Management intends to utilize its internationally domiciled cash ($543m as of Feb 2013) to invest in growth abroad. In July 2013 Foot Locker announced its first acquisition in five years with the $84m buyout of Runner’s Point, a 200 store athletic footwear business based in Germany. FL paid just 0.4x for the incremental ~$250m in revenue, a price afforded given liquidity problems at the family-owned retailer.

Based on our research, we’re not seeing the “retailer-as-a-showroom” threat that has afflicted electronics retailers like Best Buy, where consumers visit a physical store to examine products only to then purchase the products online. An examination of several Nike brands (65% of FL’s sales are Nike-related) showed identical pricing in the store, on nike.com and on amazon.com. There will be some consumers who may purchase online without visiting stores, but many shoppers want to visit the physical stores to try on the shoes before purchasing. 

Our comparable companies analysis set includes non-fashion footwear retailers such as Finish Line, Brown Shoe Company and Genesco; sporting goods stores like Dick's, Hibbet Sports, and Big 5 Sporting Goods Corp, and fashion footwear retailers such as DSW, Wolverine World Wide, Steven Madden, and Skechers. FL trades at a 1x to 2x lower EBITDA multiple than these companies, and 2x to 6x lower P/E multiples. 

Financial Performance:

FL generates healthy free cash flow, with cash flow from operations of ~$400 to $600m annually, compared to an enterprise value of ~$5.5bn.  FL’s performance this year has been healthy relative to other retailers, with positive same store sales growth as opposed to some of the negative comps that other specialty retailers have been experiencing. Management has guidance of mid single-digit SSS and double-digit earnings growth for the current fiscal year.

The company’s FY 2016 strategic plan targets $7.5bn in sales and 11% EBIT margins. When Hicks joined in 2009, he set a 5-year plan for 2014, and was able to achieve many of his operational targets several years early. A track record of strong execution by management make me optimistic that Hicks’ 2016 targets can be achieved. If free cash flow is devoted to share repurchases or value-enhancing acquisitions, an upside scenario could see a 2015E P/E multiple of 8x - 10x, too low for a company growing steadily like FL. If FL was instead re-valued by the market at ~16x - 18x P/E, we could see a doubling of FL shares over the next several years.

The company lays out its 2016 plan here: http://www.footlocker-inc.com/pdf/2012/pr_2012_fl_Investor_Meeting30612.pdf

Highlights include:

- sales per sq foot goal of $500, which is approximately the level they are currently achieving
- EBIT margin goal of 11%, which compares to 10% today  
- 60 to 70 new stores worldwide 
- page 44 of the presentation show the company's potential expansion opportunities in Europe, where penetration is materially lower than in the U.S. 
 

Capital Allocation

The company’s capital allocation plans seem sensible, although the company remains overcapitalized with its current net cash position. In February 2013, the company announced a $220mm capex program for 2013, which compares to cash flow from operations of $400m to $600m annually. The capex program includes store remodels and new formats and other technology improvements / investments. Due to the acquisition of Runner’s Point, FL did not repurchase any shares in Q1 2013, but in Q2, FL repurchased $100mm of shares. Foot Locker has a history of increasing its dividend payments to shareholders (excluding the financial crisis when the dividend was suspended), but has only recently started buying back shares. It increased its dividend by 11% in Q1 2013. The dividend payout ratio could continue to rise; it is currently ~30% of FY2013E earnings. There exists upside to the extent that FL becomes more aggressive with its share repurchase and reduces its cash balance to less than $500m.

Risks: 

Nike-Branded Stores:

Approximately 65% of Foot Locker’s sales are Nike-branded. The bear case argues that an expansion of Nike standalone stores and a build-out of its online channel could make Foot Locker less relevant ten years from now. While this will occur to a degree, I think the current valuation is low enough that the stock should perform well even as Nike's own direct channels gain market share from FL. 

Nike has 550 outlets, 33 branded regular stores in the U.S. and 59 in international markets. Nike values its retailers, and Foot Locker’s $3bn of Nike sales contribute over 10% of the brand’s overall revenue. Nike works with its distributors to create unique marketing strategies, “Working with our wholesale partners, we create unique experiences like the House of Hoops for Basketball with Foot Locker or the Nike Track Club for runners with Finish Line or the Field House with Dick's. These category experiences allow us to create a more differentiated premium experience for our consumers and importantly, a more distinctive position for our wholesale partners” (NKE 2013 Investor Day).

Foot Locker also enhances NKE’s revenue by allowing it to market incremental color schemes that might otherwise be crowded out on Nike’s platform. Instead of marketing twenty different colors of Air Jordan’s at once, Nike can focus on core colors while parsing out bright oranges or neon blues to its retail partners. Foot Locker’s blog, Facebook page, and Twitter feed generate hype around these limited releases. In exchange, Nike grants exclusive assortments to premium channels like Foot Locker and Finish Line. Analysts estimate that approximately 50% of FL’s assortment is exclusive, limited-release, or private label products. By contrast, low-cost, non-valued-added channels like Amazon and Zappos are last to receive shipments of marquee shoe styles.

High Margins: 

FL's margins are as high as they've ever been historically, so earnings growth through margin expansion is not a part of my upside case. In terms of whether margins may decline to historical levels, the business appears to be performing well, so margin contraction does not appear to be a risk in the near- to intermediate-term. 

Catalyst