Description

Company Description
Foot Locker is a leading global retailer, operating 3,614 stores in 14 countries. Through its various retail concepts which include Foot Locker (1,476 stores), Lady Foot Locker (610 stores), Kids Foot Locker (381 stores), Champs Sports (586 stores), Eastbay (mail order), and Footlocker.com it captures roughly 17% of the $17B athletic footwear market. Foot Locker generates 92% of sales from its store-based locations and 8% of sales from its mail order and Internet business. The company generates 84% of revenues domestically and 16% from its international presence. Foot Locker enjoys an industry leading position in all three of its distribution channels of brick and mortar, mail order, and Internet distribution of athletic footwear, apparel, and equipment.

The company has undergone massive restructuring beginning in 1999 as it changed its name from “Venator” to Foot Locker and started focusing on its core competencies. Z closed and divested several concepts and businesses including Burger King franchises, Kinney shoe stores, and California Music Box locations. The company has embarked on improving the productivity of its existing store base by remodeling and repositioning its stores in urban areas. In addition, the company plans on opening 1,000 new stores to drive earnings growth in the existing International and Domestic markets it operates in.

Valuation
Z currently trades at about 10x earnings, which is well below its historical average at 14.2x earnings and below the footwear group that trades around 15x earnings. It is presently trading at 4.5x EV / EBITDA which is inexpensive on a historical basis and as compared its peer group (see chart). The company generates over 200mm in free cash flow and has initiated a quarterly dividend of 3 cents a share. The company has also authorized a 50mm stock repurchase program and has made significant progress over the past several years of cleaning up its balance sheet by reducing debt. In addition, operating margins presently at close to 6% will continue to improve going forward as the company reaps the benefits of closing non performing locations and capturing profitable market share in Europe. Conservatively, assuming mid -single digit growth in sales the company can expect to generate $1.25 in EPS and EBIT of $308mm in 2003. Significant upside can also be realized from margin expansion as Z continues to improve its product mix and a weaker U.S. dollar should also benefit the company as it continues its drive for a larger international presence.

Catalysts
Business Rationalization – Z has committed itself to the athletic footwear and apparel business by divesting and closing other concepts which include Burger King franchises, casual apparel stores, and Kinney shoe stores. This strategic initiative will lead to higher returns on capital and profitability, as the company will be able to leverage its competitive advantages. The company is focused on its core competency and has done an excellent job of cleaning up its capital structure as evidenced by the recently announced dividend of $0.03 per share. Profitability has improved as the company seeks to increase operating margins to 10% and grow sales to $350 per square foot from the current $305 per square foot. Foot Locker will have almost 20% of its store base remodeled by the end of this year and 29% by the end of next year. The company will also close about 6% of Foot Locker’s non performing store base this year.

Improved Product Mix - Management has made the decision to sell fewer sneakers priced at $175 and above, the majority of which are manufactured by Nike. Sales of the high end sneakers have lagged expectations and require large markdowns to sell, as a result Z has started to sell more sneakers from vendors such as Puma and Reebok offering better selling terms to the industry leader. This has and will continue to contribute to margin expansion. In addition, the company has continued to strategically focus its product on customer demand by pushing more basketball and classic sneakers that are appropriately priced through its channels. The company continues to see strong demand for classic sneakers such as Nike’s “Air Force One” well into 2003.



Tactical Expansion – Z plans to open 1,000 new stores over the next several years (300 Foot Locker stores in the US, 350 Foot Locker stores in Europe, 50 Foot Locker stores in Canada an Australia, and 200+ Champs stores in North America), initiating this growth very carefully by tapping into increases in free cash flow. Same store sales have trended up in Europe and for the 3Q02 time frame were up 8 to 10 percent. Domestically they have been flat to slightly positive through 3Q02. Z has only achieved a 6 percent share of an approximately $7B athletic retail market in Europe and expects this portion of the business to enjoy significant top line growth as it expands in this region. Foot Locker plans to open 300 stores domestically by establishing itself in urban locations away from mall based retailing thus enjoying lower occupancy costs. The direct to customer segment should also receive a boost in 2003 as Z has entered into an agreement with Amazon.com to distribute its product. Internet sales for Z were up 28 percent year over year through Q302. The company also enjoys greater margins in the Internet / direct catalog business than that of its core store operations.

Risks
Nike and Marquee Product - In an effort to improve their product mix, Z has made the strategic decision to purchase less marquee product from Nike. Typically, these sneakers usually sell in the range of $100 to $175 and Foot Locker has in the past had to mark these sneakers down drastically to induce purchases thus hurting margins. This decision to cut back on product from the industry leader has not helped relations with Nike and the feud could potentially be an issue for Z. In their latest 10Q, Foot Locker increased the amount of reduced purchases from Nike to $300 to $400 million from $150 to $200 million. This potential rift could hurt Z, as Nike will seek to find other distribution outlets for its high end product thus endangering the company’s market leader position.

Fashion Risk - Z has been selling a wider assortment of products including retro sneakers from a variety of manufacturers. If consumer demand shifts away from these manufacturers in the highly competitive athletic footwear space, Z could be inappropriately positioned for its customer base.

Slump in Consumer Spending – The uneven economic recovery could continue to drive consumers away from the mall based specialty retailers and into discounters such as Wal-Mart for footwear and athletic apparel. Also, an unpredictable terrorism and geopolitical environment could contribute to consumers shying away from malls and other purchases.

Investment Thesis
Z is committed to expanding its operating margins to 10% and has been making significant progress towards that goal with smart, strategic choices regarding vendor product on the shelves. In addition, valuation suggests the stock is a value play with upside potential and limited downside given international comps and a leadership position in its respective industry. The company has mentioned that relations with Nike are improving, but the decision to respond to customer tastes by shying away from marquee product so far has been proven to be a profitable one. Improving margins and a diversified product mix should propel Z to trade at a more comparable historic level of 13x achieving a target price of $16.

Catalyst

See Above