Conclusion: We expect a solid beat driven by strong domestic sales through Q1, which should offset continued weakness in Europe. Near-term the stock is at a precarious level as it is just below a convergence in both its TRADE and TREND lines. The percent move down on a penny miss will likely exceed stock upside on a penny beat. If we’re wrong on the quarter, Friday won’t be fun. But we have enough confidence in the FL story to use that as an opportunity to get in to a name that ran-up 35% leading up to its analyst day back in March.
FL Risk Management Levels
TRADE (3-Weeks or Less):
We’re at $0.81 for FL headed into Friday’s print before the open ahead of Street estimates at $0.74E.
- April sales in the Athletic Specialty channel came in better than we expected up +8%. This implies the Feb-Apr quarter was up a robust +12.5%. Based on the Hedgeye FL Comp index below, which has proven to be a strong indicator, we expect comps up +9% vs. +6.7%E to drive sales up +11% vs. +6.7%E.
- Offsetting strong domestic sales will be European weakness, which started off the quarter down HSD. Our sense is that trends out of Europe likely deteriorated further during the quarter and will come in down low double-digit resulting in a 3-4pt drag on aggregate comp. This offset is the reason why we expect FL to underperform our comp index for the first time in the last seven quarters and is the greatest variable regarding Q1 comps. If Europe came in down HSD in the quarter, we could see FL post a double-digit comp and upside to numbers.
- Assuming robust top-line sales, we are modeling +100bps of gross margin improvement driven primarily by occupancy leverage up +90bps and a +10bps contribution from merchandise margin. We are also modeling SG&A up +7.5% considerably higher than consensus (+2.5%E) reflecting 9% growth in core SG&A including $8mm in incremental marketing spend offset by a $3-$4mm reduction in Fx.
TREND (3-Months or More):
The company is focused on driving both growth and operational improvements over the intermediate-term in the form of store presentations and net growth (primarily in Europe) for the first time in five years. We think the biggest opportunity is in the women’s and apparel businesses. We like to see FL driving store growth in Europe when it should be able to strike favorable lease terms; however, near-term it will likely moderate new store productivity. In addition, with tough comps again next quarter, we think upside earnings surprises will be limited for another quarter before easing in 2H. The risk would be if higher pricing out of Nike sticks with FL, but not the consumer, or that the pressure we expect to see in the mid-tier softlines space bleeds into the athletic specialty channel. But we don’t think either of those is likely.
TAIL (3-Years or Less):
After delivering on his 5-year plan 3-years ahead of schedule, Hicks recently outlined his latest 5-year plan in March. The focus will remain on the next leg of improving apparel assortment and mix, growing the international store footprint (more productive than domestic base), and expanding its digital platform. Some of these efforts (i.e. women’s, apparel, and kids) are likely to gain traction sooner than others, but the bottom-line is that we like the earnings visibility here over the next 12-24 months. We’re shaking out at $2.40 for the year above the Street at $2.28E and $2.75 for 2013 vs. $2.50E.
The biggest risk here is definitely the Euro, not from a translation standpoint as much as what would fundamentally change in the business if a draconian break-up of the Eurozone comes to fruition. Remember that FL is a pan-European retailer, with a common banner in each country. That’s a double edge sword. On one hand, it makes it easier to assort, operate and serve stores in each country. One currency certainly has made that easy. We’re not going to make a call on FL via ‘Euro Break Up Risk’. But from a risk management perspective, just keep in mind that it is a quarter of profits that could be under fire from multiple Macro angles that management has never had to consider.
Below is our key takeaways following FL’s investor day on March 6th regarding our intermediate-to-longer term view:
We attended FL’s headquarters analyst meeting to review Ken Hicks’ report card on the 2010-2014 Plan and to walk through his goals for the next 5-years. We came away with essentially the same view that we walked in with. The stock has a favorable risk/reward profile and trades at a reasonable multiple if not at a discount, but faces increasingly tougher comps in the 1H at the same time growth out of Europe is slowing limiting upside surprises to earnings over the intermediate-term. As a result, we think there will be a more attractive opportunity to get involved in the stock at lower
Not surprisingly, many of the key initiatives of Hicks’ new 2012-2016 Plan were layovers from two years ago given the opportunity for further progress. The two new initiatives include an increased focus on both the customer as well as high-growth businesses (i.e. Women’s, Apparel, Kids, & Team). The bigger callout on the day was the introduction of Hick’s
long-term targets (see below), which were higher than we expected suggesting $3.50 in earnings power at a 14% CAGR over the next five years.
Naturally, we take a critical look at targets like this and ask if we think they’re achievable. However, given Hick’s track
record at JCP and now FL, where he hasn’t missed a number, perhaps the better question is WHEN, not IF these goals will be met. Here’s a look at the latest key objectives compared to the 2010 plan as well as the key takeaways from the
- There are multiple operational systems that the company currently has in various stages of testing and implementation that are at the core of the first initiative in Hicks’ new plan. These include systems for planning product allocations, labor management, measuring shelf productivity, as well as heat mapping technology for use in tracking traffic flow. We think each will play a role in not only improving the customer experience, but also driving incremental sales productivity and margins (objective #5). The potential timing of these systems are less certain, but the labor management piece will be rolled out this Spring and is expected to start yielding results as early as this fall.
- Customizing locally relevant assortments is another key element to better address customer needs from urban to suburban locations down to specific differences in cross town purchasing preferences. While there are systems currently in place that enable management to tailor assortments, improved data mining from additional tools will increase the impact of these efforts and productivity particularly as it relates to apparel product assortments (think colorways, team preferences, etc.).
- We think the high-growth opportunities with the greatest upside are women’s and apparel. Management sized each as an incremental $100mm opportunity along with kid’s and Team. It’s important to note that these aren’t mutually exclusive efforts. In fact, Hicks suggested that women’s stores will start to look more like an apparel store than its traditional footwear format. This could translate into a mix of 75/25 apparel to footwear shown in store resulting in sales of roughly 50/50. Whatever the mix shakes out, Hicks stated emphatically that FL will significantly step up its commitment in apparel. In addition to working with a new design firm to test formats, Lady Foot Locker will be undergoing transformational change in 2012/2013.
- Besides ramping net store growth for the first time since 2006, FL is also testing new store formats at Champs, Lady Foot Locker and Kid’s Foot Locker. New store formats at Champs include a change in presentation with apparel on the walls and footwear on floor on bleacher-like shelving. Make no mistake, it’s not a coincidence that FL is taking a page right out of Nike’s retail efforts. One of the pleasant surprises in terms of unexpected detail on the day was slide #32 showing apparel/accessories penetration as a percent of sales at 24% today compared to 31% back in 2003. While the firm’s selling strategy was decidedly different then and referred to as ‘when they sold cotton by the pound,’ if management can get apparel share up 3pts it would equate to nearly $200mm in incremental revenues.
- The growth opportunity in Europe remains a key element of management’s brand expansion strategy. This includes both stores in new underpenetrated markets in Eastern Europe as well as a new banner concept altogether. The company is currently testing a new banner called the Locker Room in the UK that features performance product (e.g. cleats, sticks, uniforms, shoes, etc.) in a larger 4,000 sq. ft. footprint compared to the average 2,900 sq. ft. European store with two more slated to be open in time for the 2012 London Olympics in July and August. The majority of FL’s new store growth (60-70 net openings annually) will continue to be European based.
- Within stores, House of Hoops remains an important brand expanding initiative. There are now 50 House of Hoops shops up from just 10 at the start of 2010 and management sees an opportunity for over 100+ in total globally with the potential to add an incremental $50mm. Assuming a similar rate of growth, House of Hoops rollouts could add 40-50bps to top-line growth in each of the next two years.
- With a strong balance sheet including $850mm in cash at year end, it is clear that management is committed to investing in growth, but at a measured pace. While the company could accelerate store openings, it plans to thoroughly test new formats before committing the capital to support it. Importantly, the company just raised the dividend by 9% and announced a new $400mm SRA where it can put excess FCF to work.
All in, there were few surprises. There is clearly a substantial opportunity for further development of initiatives that
are already in progress, which should ultimately help to drive earnings towards $3.50 overtime.
In the meantime as we look out over the next twelve months, year-end results came in right in-line with our expectations.
The two biggest deltas were a stronger than expected start to Feb up mid-teen on a tough comp and incremental weakness in Europe (down -9% in Q4). Net net, we are shaking out at $2.25 in EPS for this year. We like the name over the long-term TAIL duration (3-Years or Less), but think that the later could limit upside surprises to earnings over the intermediate-term and present a more attractive opportunity to get long FL stock.