Description

Writeup Foot Locker (FL)

• Foot Locker is the rare retailer built to survive a pandemic like Covid.

• A misunderstood yet strong and durable business model.

• Trading at under 4x normal earnings ex over $6 per share in net cash ex Covid. 

• We think the stock should rise more than 80% over the next 18-24 months, with room for further upside

Built to survive the Pandemic:

The first thing that we ask in a retailer in the current pandemic-stricken uncertainty is, can it survive the pandemic?  We see two desirable ways survival can happen in a favorable and predictable manner.  These are 1) a rock-solid balance sheet built to last through the downturn and/or 2) vendors who will give credit to support a retailer; Foot Locker (FL) has both of these.  Without either of these a retailer is left to count on other sources of capital and thus depend on the capital markets and banks at a time of extreme weakness.  FL has as strong a balance sheet as one can see in retail it went into the Pandemic with $907 mln of cash on the balance sheet and total debt and preferred of just $122 mln.  We estimate even under a 16 week full store closure, while still paying minimum rent requirements, FL would have cash outflows of under $400 mln (see Exhibit 1 below), with over 70% of that due to changes in working capital.  We note that FL did not pay rent on all of its stores while it was closed, which makes sense given its stores in malls beyond being closed by the government, the mall itself was closed.  There is likely a lot to be ironed out here but there should be some savings from FL.  Plus stores are not going to be closed a full 16 weeks, as many state are already lifting restrictions.  However even under these dire circumstances, FL should still be left with over $500 mln in cash on the balance sheet, and this cash could then be used to mitigate any losses in a slow business environment.  

The second way a retailer could survive is to be supported by its vendors, and that is more difficult and extremely unpredictable for most.  Retailers are facing three major problems now: 1) the losses from closed stores, 2) the cash drain from payables being taken down, and 3) the uncertainty surrounding the reopening of the economy.  The biggest problem for most retailers here is the potential for a cash drain as suppliers pull credit.  Most retailers who had healthy businesses going into the pandemic should survive if they can get credit extended, but this can be a tricky dance if you have a large web of suppliers.  As from the vendor’s view, its customer only survives if enough vendors step forward. While this occurrence would be the most beneficial outcome to all parties, if not enough vendors step forward then the vendors who do will lose.  FL has essentially two large vendors with Nike compromising 66% of sales and Adidas a distant #2, followed by New Balance and Under Armor.  Not only does FL avoid the problem of having to gain the full confidence of a large number of vendors but both Nike and Adidas view FL as their most preferred retailer and a valued partner.  FL quite simply is nearly assured of getting credit from vendors if needed.  

A good and misunderstood business:

With a cursory glance, FL looks like a lot of failed specialty retailers of the past and a company that could easily be disintermediated by the internet.  However, a deeper look at the industry reveals unique features that have and should continue to allow FL to produce good returns and endure.  Across other lines of apparel, especially in mass apparel, retailers combat each other with different pricing strategies, usually with sales.  This means it’s not uncommon to see a supposedly $30.00 shirt selling for $19.99 at one retailer and on sale for $14.99 at another down the block.  The apparel producers lost their ability to control pricing years ago.  But sneakers are different; their pricing is tightly controlled by the handful of behemoths who dominate the industry.  So the price of the Nike sneakers in one store is nearly certainly the same price as another store, with very few markdowns.  This is beneficial to all parties, but especially the brands.  This strategy has allowed Nike to maintain and grow the power of its band over decades.  There are some luxury brands that have maintained their brand for longer periods, but Nike is the lone example of a company that also offers a spectrum of lower end products.  Brands that penetrate down market seem to always damage the prestige of their brand, for examples look at Coach bags about a decade ago.  What could ruin the sneaker retailer model is the internet.  Which is exactly why the brands have not sought mass internet retail.  Nike ended a brief extremely limited deal with Amazon.  Essentially, Amazon does not really bring anything to the table for Nike or the other major brands.  Amazon sometimes brings customer awareness, but the major brands already have this and logistics (shipping).  Both Nike and Adidas have built out logistics that give comparable logistics for their products to what they can get through Amazon.  What Amazon also brings is a less controlled environment, which breeds fakes which might be Nike’s biggest enemy.  Amazon also does not do a good job of telling the brand story.  While Nike does distribute through TMall in China, it only does so because its brand is not as strong there and the network of retailers was not developed.  In order to further control the market both Nike and Adidas have made dramatic cuts to the number of retailers they do business with cutting small accounts and increasing larger ones such as Foot Locker.

FL is the biggest independent sneaker seller in the U.S. by a fairly wide margin.  Interestingly, the company doesn’t get preferential pricing, instead it gets access to a better assortment.  The way the sneaker industry works is that retailers get essentially the same pricing.  The hottest very limited releases, such as a 10K limited special Jordan collaboration with a designer, are done through the brand apps.  Larger hotter releases is where Foot Locker gets a large allocation.  Its closest competitor, Finish Line, gets a little less.  Then for more mass market styles, Dicks gets in the game, and at the low-end mass market is Kohls.  FL does get allocated lower end sneakers, but the lower-end retailers do not get allocated the high end as FL does and certainly not in as large amounts.  

FL’s advantage is born not just from its store size but also its service and ability to showcase the brands.  Many FL stores now have a Nike expert who knows the brand extremely well, including the history. They would know the book Shoe Dog and much more.  Of course the better allocation drives more visits, which of course reinforces the better allocation and makes the brand the priority visit.  When you think about the better selection and same prices, it seems like a minor miracle that the competition survives.

Valuation:

FL had EPS of $4.87 last fiscal year adjusting for changes in share count, a slightly elevated tax rate and some reversion to recently higher margins. We think that earnings power is closer to $6.00.  We believe that we will see a return to this in 2022 (FY2023).  FL also has $7.65 per share in net cash on its balance sheet.  Even after the pandemic that should be $6.23 per share.  Valuing FL at just 8X earnings plus net cash yields $54 per share.  Conservatively assuming another $1 per share in earnings gives us a $55 price target in 18-24 months (as much time for investors to have confidence in the earnings).

There could be even more upside to shares.  First, we would point that pre Covid retailers were trading for much lower multiples than the market as investors feared disintermediation from digital and the risk of these becoming zeroes.  That fear has obviously increased during the pandemic as retailers go bankrupt at an accelerated rate.  But post-Covid the field of retailers will narrow considerably, and this group will be seen as strong and durable given what it has just survived, therefore much higher multiples are possible.  

FL’s strong balance sheet has served it well in the pandemic, but it is likely far too conservative.  The company leaves a large cash pool for opportunities likely a large acquisition (which will not likely be a brick and mortar retailer).  While it has bought back shares and has been more aggressive as prices got lower, there is a lot more room to be aggressive.  While FL may not add debt by itself, it is entirely possible in a post-Covid market that private equity will step in if the company’s multiple remains depressed.

Risks, disintermediation from the Brands and the Pandemic:

Both Nike and Adidas have their own stores along with online and apps, so why do they need FL?  The brand stores and digital channels are for fans who know what they want.  In fact the brands have largely hit saturation with their own retail push.  But there is another customer who is choosing between brands and thus selling into broad retail is necessary.  From the industry insiders we spoke to the core sneaker shopper is becoming less brand loyal.  This customer is finding people on social media and looking to mimic their style.  This also makes it easier for this customer to go straight to Nike or Adidas apps, sites and stores.  It seems that thus far as the brands have ramped up their digital offering they have done so largely at the expenses of less favored retailers.  We expect that to continue but incrementally this will be minor hit on FL sales and profitability.  However, this will only be a small hit to FL.  Magnitude is unclear but chopping 1% a year off its sales growth for the next five years seems about right.  FL also gets 16% of its sales and growing online, which mitigates the risk of further digital sales.  Lastly, FL gets a large % of its sales in cash.  The company doesn’t give the exact number out other than saying it is high.  The core customer age here is 16 to 20s, lower income, and thus they might be unbanked.  

As for the industry in general, Nike has dominated for decades.  It seems to be the result of a host of factors, but it’s tough to say what makes it that durable.  It’s possible that we see a Warby Parker of sneakers but that would likely be small in terms of the industry.  Look at Warby Parker--the company has done great, but it really hasn’t dented Luxottica’s business model.  We believe that the industry structure should remain largely the same for the foreseeable future even if one of the other brands would somehow eclipse Nike.  We view FL’s model as a servicer of the industry as similarly durable.

The Pandemic is another risk, as we stated above, but FL has the ability to easily survive the duration of the store closings during the pandemic.  Long-term we see some mall closings, possibly as much as 200 though possibly lower, and this could lead to several hundred store closings (given it has multiple stores per mall).  The company will likely make up for these closings by shifting to whatever new shopping areas open up from the changes to the local retail landscape.  We would also note that the company has had a history of closing stores and maintaining sales.  In FY2000 the company closed over a third of locations and sales only fell 6.4%.  In recent years the company has had about 2% annual decline in locations while sales have grown.  We think that long-term by 2022 the company’s earnings should revert to what they were in the past.  

However, it is unclear how much a post-store-opening-world will affect its sales and earnings in the period that immediately follows.  FL’s core customer is lower income so clearly more impacted, but it is actually better off on unemployment for a while.  When we return to full employment, your guess is as good as mine.  The product’s demand is we estimate about half replacement (wear and tear) and half fashion.  I am comforted by FL’s long history of positive earnings.  Even during the crisis the company still produced net income and that was with a business model that was based on more mass appeal rather than the hardcore customer and that had lower margins.  Taking a view that the hit to margins is 50% worse than the fall during the crisis, which seems like a conservative yet possible view, we believe FL could still make close to $1.00 per share.  We believe that Fl will be profitable post reopening and could certainly withstand a worse environment than we foresee for years.  For the ability for FL to survive a downturn, look at 2003 when Nike stopped selling to FL. For a period this would seem like a disaster, but do you know what Foot Locker did that year?  The company still made money!

Catalyst

Return to normal operations

Stock Buyback

We would note that earnings are out tomorrow in the AM but this idea is not based on short-term earnings