Description

SHORT Finish Line (FINL)

Now seems as good a time as any to post a short idea on a mall-based retailer. The Finish Line (FINL) is: on the wrong side of big picture retail trends (bricks and mortar/mall retailer); on the umpteenth iteration of a turnaround plan; facing increased competition in its core running shoe franchise; being disintermediated by its suppliers (NKE, UA increasingly selling DTC), and provides an option on the implosion of the basketball shoe “bubble.” We see downside in the stock to sub-$10 as flat comps in 2017-18 coupled slight margin compression on increased digital sales lead to ~$1 in 2018 earnings and assuming a HSD multiple for a struggling retailer. We view the risk to the short as the company earning the ~$1.75 contemplated by consensus in 2018 and trading at a mid-teens multiple for a stock price in the mid-$20s.

Short Investment Type: 1) Secular decliner 2) Failed turnaround

Key Issues: 1) Shift in consumer buying habits from brick-and-mortar retail to DTC/online 2) Competition from specialty running stores in the Company’s primary product category 3) Store closure customer recapture rate given overlap with FL in malls they are exiting 4) Sustainability of margins amidst marketing/turnaround investment

Thesis

FINL’s 30% recovery from early January lows represents a short-lived pop based on perceived sandbagged guidance and hope that this turnaround will be the one that actually fixes the brand.  Bulls focus on new management as a driver of the turnaround and a very easy Q3 comp (due to a huge supply chain-driven miss in 2015) as reasons to buy the stock now.

Unfortunately, for the bulls, “new” management are almost entirely internal promotes that had a heavy hand in the Company’s 2015 missteps and the sandbagged guide is more than priced into the stock with FINL’s PE multiple re-rating from ~10x to 13x during the first 4 months of 2016.   The reality is that FINL is still a secular decliner whose business is being pressured by shifting consumer preference away from mall-based retail to buying online.  With NKE (77% of revenue), UA, and Adidas increasingly selling DTC and sales heavily weighted to running (40%) where specialty stores and online offerings such as Zappos are gaining traction, FINL’s competitive headwinds are even more pronounced than the average brick-and-mortar retailer.

We are particularly bearish on the most recent turnaround plan as it pumps significant capital into refurbishing retail stores, which fails to address the true issue – competition from customers and other online retailers.  The Company is closing 150 underperforming stores (20% of base) over the next 4 years, leaving a $150 revenue hole to fill through increased comp sales and ancillary business offerings (namely Macy’s and JackRabbit).  Management expects to recapture at least 50% of closed-store revenue with “loyal” consumers driving to a different mall-based location or buying online from FINL.  We beg to differ as the bulk of malls in which FINL is closing these stores are also occupied by primary brick-and-mortar competitor FL.  We expect these customers to either start buying from FINL’s customers directly or continue shopping at their “home mall” but just buying shoes at FL this time around.  

Finally, we believe ancillary business, most notably JackRabbit, have proven to be money losing ventures, which the Company will have to either scale down or shutter in the next 12-18 months.  When bulls can’t latch onto these other sources of revenue as growth drivers, we believe the market will give up on FINL forever, driving the multiple to rerate to high single-digits on declining earnings.

Business Description

FINL is a premium retailer of athletic footwear, apparel and accessories operating under the Finish Line brand name, Finish Line at Macy's (branded shop-in-shops that exclusively provide athletic footwear in Macy's), and the Running Specialty Group (aka JackRabbit). Finish Line consists of 591 mall-based stores (47 states) and an E-commerce site while the Macy's business includes 392 Macy's stores and fulfillment of athletic footwear for Macy's.com. JackRabbit is comprised of 72 specialty running stores and websites that provide performance running shoes (footwear ~50% of net sales), as well as an assortment of performance apparel and accessories within an enhanced service environment.  The concept is currently a money loser for FINL.

Footwear accounts for ~88% of concept sales, with apparel/accessories accounting for the balance (12%).  The company considers itself the leader in specialty running footwear with 40% of sales skewed to that market, and relatively less basketball exposure than its primary mall-based competitor Foot Locker (low-20% vs. 30% at FL).

A growing portion of sales have shifted online which comes at a higher margin (15% vs low sds) for FINL.  In addition, the Company’s diversification into Macy’s and JackRabbit have provided an additional growth stream over the past 3 years.

Recent Stock Performance (i.e. the reason FINL needed several turnaround plans)

Finish Line has been a secular decliner for some time as consumers increasingly shift footwear purchases away from mall-based retail to online purchases (both DTC purchases from Nike, Under Armour, Adidas and through websites such as Zappos).  In addition, FINL’s relative greater exposure to running hasn’t served it well amidst an emerging specialty running store trend – stores that carry a greater mix of running-specific brands compared to FINL that is heavily-weighted to large footwear companies NKE, UA, and Adidas/Reebok.  As a result, the Company has stopped and started “turnaround” plans several times, which is reflected in consistent spikes and then rapid declines in the Company’s share price.  Management consistently fails to deliver upon “this time will be different” promises.

Detailing the Turnaround Plans

On the Q1 2016 Call in June 2015, management laid out a turnaround plan, which it subsequently revised 3 quarters later on the Q4 call (see below).

The Original Turnaround plan - 5 Pillars

To simplify our plan of attack we have broken down our key areas of focus into five pillars. They are: one, strengthening customer engagement; two, enhancing our merchandise offering; three, elevating our service levels; four, transforming our supply chain; and five, evolving our leadership structure. I will touch on each of these pillars and then I will discuss how we are applying similar actions to enhance sales and profitability at our other two divisions, Macy's and Running Specialty Group.

Discussing the supply chain initiative: Q2 2016 Call (September 2015)-stock was down 20% despite in-line quarter based on inventory build and comp growth that was 800bps below FL driven by softness in performance running

Shifting to supply chain, the multi-year investments we have made in our infrastructure to support a more robust customer experience is now taking shape. As expected, we reached a critical milestone earlier this month, when we went live with our new order and warehouse management systems, that will benefit the Company and our customers well into the future This powerful new supply chain helps flow product faster, while driving efficiencies in our direct-to-consumer business to improve order routing and fulfillment. It allows us to better manage inventory and improve in-stock levels, so we have the hottest products in the right locations, when and where our customers are looking for them. We are now in a much better position to enhance our omnichannel capabilities, giving us a powerful advantage that we plan to fully capitalize with our new system.

And then…Q3 happened.

Turnaround initiative #4 - the company’s supply chain renewal – drove a disastrous inventory stocking issue.  On the Q3 call in January, after missing the quarter badly and paying the price with the stock down 10%, management described the supply chain problem as transitory.

The Blow-up - Q3 2016 Call (January 2016)- stock was down 10% on a disastrous supply chain implementation

As you know, we went live with our new warehouse and order management system in September to drive efficiencies in our direct-to-consumer business through improved auto routing and fulfillment, as well as better inventory management and improve the in stock levels at retail. However, in October, we began experiencing issues with the flow of fresh inventory into our stores, as well as significantly reduced stability to fulfill online orders as the new system was unable to process freight at the volumes necessary to support our sales plans. For the quarter, outbound shipments were down 25% compared to the same period a year ago. As a result, inventory of the newest goods in our stores and available for sale online was below last year's third quarter by an average of $41 million or 14%. This lack of inventory had a significant impact on our ability to convert traffic into sales. Third quarter traffic was flat compared to last year, which was consistent with first half trends but conversions dropped off in Q3 as we didn't have the fresh receipts on shelves that our customers were looking for. At the same time, digital sales were flat, after being up 23% in the first half of the year due to a lack of new products available on our site. In addition, we experienced processing issues for orders that we did receive, which led to cancellation rates that were 50% higher than normal. We estimate that the total impact to our top line was approximately $32 million in lost sales. This includes a comp decrease of 9.8% for October and November combined, which was a significant deceleration from the 1.3% comp increase we posted in September. The impact to our bottom line was a loss of approximately $0.42 per share.

In Q4 supply chain issues somewhat normalized but still impacted results and will take until Q1 2017 to fully clear up (reported in late June).

Damage Control - Q4 2016 Call (March 2016)- stock flat despite very attractive 5.8% comp

Starting with our supply chain. We improved our performance significantly in the fourth quarter and are making strides each day to reach peak performance. Direct-to-consumer fulfillment rates in the first 24 hours are at 80% of historical norms, as inventory accuracy and out-of-stock rates have dramatically improved. This compares to Q3 when fulfillment rates in the first 24 hours dropped to about half of our historical output. Fulfillment in the first 48 hours as well as cancellation rates are both nearly on par with historical levels. In addition, our click to door delivery times are now surpassing what we achieved prior to our new system implementation. That said, there is more work to do to get new receipts flowing through our distribution center and into our stores on a timely basis as well as to get our fulfillment rates back to historical levels and beyond. As discussed on last quarter's call, we are continuing to prudently invest in temporary resources to get our supply chain operating with the optimal output. We are moving as quickly as possible so that we can begin benefiting from our new warehouse and order management system as the year progresses… We expect some product margin headwinds to continue, particularly in Q1 related to the supply chain disruption, offset by improvement in the second half of the year.

So what do you do when one of your 5 pillars is a colossal disaster? Well, of course, you scrap the original plan and release a new turnaround initiative as if the 1st plan never existed…

Wait…did we say “5 Pillars”? We meant “4 Key Priorities”

• On the Q4 call, management announced yet another turnaround plan that involved the following 4 Initiatives (vs. the 5 Pillars in Q1 2016):

• Strengthen Engagement w/ Finish Line Consumer

• Enhance merchandise offeringàget the right product on the shelves

• Best-in-class service model - ”rebuild the store service culture that was the bedrock of Finish Line's early success before the surge in digital commerce shifted more of the focus to online”

• Marketing investment through omni-channel/CRMà3 marketing campaigns to increase brand awareness…

• Drive performance/contribution of Macy’s/JackRabbit

• Hire the right leadership team
  •  Promoted former Head of HR (Melissa Greenwell, 8 years at FINL) to COO
  •  Hired a Chief Technology Officer
  •  Seeking Chief Supply Chain Officer
  •  Q3 announced internal promotion of former Head of Strategy, Sam Sato (8 years at FINL) to CEO; former CEO Glen Lyon now Exec chairman

• Create operational model that drivers profitable growth and generates shareholder value

• Remodel 60-70 stores in 2016

We recognize how critical brick-and-mortar is to delivering a premium shopping experience. We have under-invested in our physical presence over the past few years, as we dedicated the majority of our capital spending to essential technology and infrastructure projects. In fiscal 2017, we are commencing a much more ambitious store remodel program than in years past as we work towards bringing a first rate consumer experience to our stores .

• 150 store closures over 4 years (closed 54 in ‘16) - on average $1mm revenue/store, declining growth and margins

We are more stringently evaluating the profitability thresholds of our store base as we continue repositioning the company to best serve our customers, utilizing our advanced omnichannel capabilities. The 150 stores we are looking to close underperform versus the remainder of the fleet. These stores, which represent approximately 12% of our volume, generate annual average sales of approximately $1 million or less than half the company average and have posted sales and profit declines in the mid-single digits on a trailing 12 month basis. We fully expect to recapture a portion of the approximately $150 million in annual sales these stores generate through increased traffic and volumes at nearby locations. and on additional sites. We will be redistributing allocated product to our remaining stores which will help expand store margins and improve flow to our bottom line. Overtime, we believe these measures can increase store contribution margins by approximately 100 basis points…. So the 150 stores that we'll close are -- is a gross number…while they make a little bit of store contribution today, it's a little bit of store contribution, not a lot. We don't need to transfer all the sales or recapture all the sales in these stores in other channel in order to improve the profit margins of the business by the 100 basis points that I talked about. If we even get half the sales transferred, we're going to be ahead of 100 basis points that I talked about, so it's even less than half that we need in order to make the profitability improvement that I talked about come to life. It's just -- again, as we redistribute the product, as we shift behavior of our loyal customers, we create improved leverage on occupancy, an improved leverage on SG&A that will improve our overall and improve flow through to our bottom line, that will create that 100 basis points of profit improvement.

Of course, there’s one problem with that…Foot Locker

Q: Of the 150 stores, how many are in malls in which there are Footlocker chain stores? And if the percentage is high, why would you expect that shoppers would go to different malls when similar merchandise could be found in the malls that they're accustomed to shopping?

A: Yes, I don't have the specifics in terms of the overlap but we have a high overlap as you know of stores that we operate in versus our primary competitor and the 65% of the sales in these stores are with Finish Line loyalty members. And we know who they are, we talk to them regularly. And through the communication and incentives -- special incentives, we're going to drive their behavior to continue to remain a Finish Line loyalty customer and shop with us, both online, as well as a sister store or a nearby store in the marketplace. That's component #1. The second component is these stores also have key allocated product. And we're going to take the product out of those stores and put those into other stores, the remaining stores in our chain and as you know, that product sells through at very fast rates no matter where it is. And again, we have a high degree of confidence that, that will sell through in the remaining stores that it gets redistributed to. And then again, it will create a better customer experience, a better shopping experience for customers that are shopping those stores.

The Sandbagged??? Guide

In addition to a new turnaround plan on the Q4 call, the Company guided 2017 earnings to 1.50-1.56 (vs. 2016 Adj 1.63) in spite of the below comments on the Q3 call.

Q: So if I take all your -- if I add the $0.42 back and take the low end of the guidance, I think the [2016 full] year [adjusted EPS] is somewhere around $1.60. So you would be expecting to potentially grow earnings pretty solidly in fiscal '17 given everything that you're doing off that base?

A: We'll talk more specifically about the definition of pretty solidly, but we would certainly expect to grow off that base of $1.60.

The market assumes that management has sandbagged numbers going into 2017 and the stock has recovered as a result, trading back to 5-year average valuation levels.

Such a price recovery is surprising, as it seems that most are already keen to the Company’s inability to deliver. At least questions on the last 2 earnings calls have pushed hard against yet another turnaround.

Q: I too have more than one question. I guess, Sam, going into your new role here as CEO, I think what's plagued Finish Line for the past couple of years have been the controls around some of your initiatives that you guys have undertaken, the things that you have not expected, most recently with the supply chain issues. How do you improve upon that? How do we gain confidence that there's going to be a better management focus on making sure that there are backstops so that these things don't happen?

A: We're going to talk, obviously, more deeply about our strategic plan as we get into the new year. But suffice it to say, the execution of our business is, certainly, an opportunity for us. We recognize that. We're working hard to shore up positions like the Chief Technology Officer to ensure we've got the right level of eyeballs on these types of things and to ensure that we've got more better plans and things that will allow us to diminish our risk from an execution perspective as we move forward. So know that we are fully aware of it and recognize that as a big opportunity for us to improve upon.

+++++++++++

Q: I'm really curious about the product and the product pipeline. I know in the past, you guys have talked about you always working with your vendor partners, always trying to get the best product. Why is it different this time? What gives you that confidence that as you step into this current year, that the product is potentially some of the best that you've ever received and give you that sort of confidence and trajectory in where you're going in the business?

A: That's obviously, a great question and one that we anticipated taking, and so I've actually got some prepared remarks that I'd like to share that's much more of a comprehensive articulation of our efforts with Nike specifically but also application across our other brand partners. The work we've done, particularly over the last 6 to 12 months, as I've said, applies to all our brand partners, not just Nike. Our commitment has always been to have the right product our customers are looking for while maintaining this authentic and distinct offering, but one that distinguishes our concept from the competition. Having the latest and greatest sneakers applies to all categories and for Finish Line, our product offering and market leadership will always be led by the running category. And that's what the majority, the work we've done with our brand partners, the past several months has been focused on, reinforcing our leadership position in running while at the same time, creating the appropriate go-forward strategy against all other categories, one that's credible and exciting to our customers. So when we look back on the past couple of years, and really, really, scrutinize our assortments, we believe that our assortments in fact have been on trend and have been comprehensive. The problem was we weren't getting enough of the bestselling or key items. And that's what's changed the past few months following very direct, often and open discussions with all of our brand partners. Our allocations of the hottest products are cross running both casual and performance as well as key basketball and lifestyle products have increased. And this includes more exclusive products and as I've said in my prepared remarks, including more Colorways and exclusive styles of some of the most sought-after sneakers. At the same time, you'll see us elevating our product presentation and go-to-market strategies in our stores and on our digital websites through collaborative effort beyond just Nike like the #tightfortomorrow campaign, I mentioned earlier with UnderArmour. We've shared our partnership with PUMA in the PUMA edge experience, as well as a greater emphasis on the Boost platform by adidas to come as we get into next year. So given all of this, we're confident with the combination of our strong brand partnerships, our consumer-centric operating models, that we're well positioned to compete effectively in the marketplace and drive sustainable growth over the long term.

Highlighting Key Driver Trends

Decelerating (but lumpy) comp growth

Share Loss to FL...

Declining Store Count

Margins Under Pressure

Capital Allocation History

The primary dent in our short thesis is the Company’s unlevered balance sheet.  With leverage, FINL would be a very clear short and a likely bagel.  Management does not have plans to add debt to the balance sheet in the near term.

So at this time, there's no plans to take on debt, to accelerate our share repurchases. Having said that, we are expecting to generate more cash flow in the future as a result of the store-closing program that I talked about, lower capital expenditures that we talked about and all of that provides an opportunity for us to be very aggressive with share repurchases as well as increasing our dividend in a meaningful way each year.

Without leverage to muddy the water, the secular decline of FINL is likely to be a slower drag…hence the numerous peaks and troughs in the stock over the past 3 years.  Management has returned cash to shareholders through steady dividends (2% yield) and buybacks (16% share reduction since 2012).  We do take solace that cumulative FCF generation over the past 4 years is a whopping $19mm with capital expenditures ramping over the next several years to drive the turnaround plan (store refurbishments, etc.) and further stymie free cash flow generation.  FINL does have $765+mm of operating lease obligations, the unwinding of which would get ugly in the event that results deteriorate as quickly as we anticipate they might.

The Basketball Shoe Bubble

The basketball shoe cycle does matter at FINL with low-20% of sales coming from basketball shoes.  However, the Company is already consistently underperforming FL in the category.  On the Q3 call in January, management insinuated that the bubble may be popping but again, that’s not necessarily our bet here.  Our bet is much more focused on running shoes given the Company’s sales mix.  A bubble pooping would just be gravy.

Top performers within basketball included Curry 2 by Under Armour, which has had an explosive debut and continues to be in high demand. Retro product from Brand Jordan remains dominant and the casual style Eclipse continues to be strong. And lastly, Nike's signature Kyrie shoe remains red hot. As I mentioned on our Q2 call, the other signature business, specifically Lebron and KD, have slowed. We're still selling a lot of units but that part of the business has slowed for sure. Retro Jordans at the end of the day, the product sells out. It's just taking a little bit longer than what it has historically but the demand for retro continues to be really high and depending on the retro itself, like as an example the Retro 11 that we released in December sold out as it traditionally does, and so it really depends on the retro style but the sell-through is taking a little bit longer but nonetheless selling out at regular price.

Catalyst

Declining comparable SSS

Earnings misses

Slowdown in basketball category