A friend of mine has one of those mini Pug dogs - the ones with the mashed-in face and bulging eyes. The kind of dog that's so ugly that it's cute. That's how I increasingly feel about Foot Locker. While the best investors divorce all emotion from investing, I've got to admit that it's extra tough with this one. The company is a perennial underperformer, with one of the worst track records in all of retail. From a GMROI perspective, the only companies I can find that historically rank below Foot Locker on such a consistent basis are Sears and the former K-Mart. Without giving away my age, let me just say that if I was gifted a share of Foot Locker on the day I was born, my cumulative return would have been close to zero. Based on all my 'margin squeeze' preachings, with all the Asian cost pressure coming down the pike, Foot Locker should be a big loser. Then why am I changing my mind on the FL's fortunes? Consider this...
- THEN 1) For most of the past 5 years, almost every last bit of the industry's growth has come from the 'low profile category.' In fact, 5-years ago the industry run-rate was about 220mm pairs of athletic shoes annually. Now we're at about 250. But over the same period, the 'low profile' category added about 30mm pair. In other words, consumption of core athletic footwear simply did not grow. Last I checked, this is about 80% of Foot Locker's business. 2) While FL suffered through the 'low performance' drought, it relied increasingly upon Nike to drive traffic and stabilize comps. As a percent of total sales, Nike went from 40% in 2003 to just over 50% today. Nike keeps a disproportionate share of the aggregate margin in exchange for driving traffic into the retail stores. FL gave up the margin, got the traffic to some extent, but did not convert it to sales. 3) So we're talking a share-losing, zero-square footage growth retailer with a big fashion headwind and a shift in mix towards a lower-margin mix of business consolidated with one massive customer. It's no surprise that Gross Margins went from 27% to 23%, and EBIT margins tumbled from 7% down to 1%.
- NOW 1) As I noted in prior postings, the footwear retail channels overall appear to be very clean from an inventory perspective - as evidenced by 2-5% increase in average selling prices and sharp declines in aged inventory versus last year. 2) The 'low profile' shift is absolutely, positively waning. For the past three months the category grew at a rate less than the total industry, and April marked its first down month -- ever. 3) Even the removal of a fashion headwind could give a modest sustained comp lift. A revival in performance product would be icing on the cake. Under Armour's foray into footwear could be the boost FL is looking for. This is currently a Finish Line exclusive, but will be available at Foot Locker in Fall '08. Then UA follows up with performance running product in Spring '09. What's nice about this industry is that it competes on innovation, not price. As UA and Nike duke it out, Foot Locker is likely to win. 4) Keep in mind that when the environment gets incrementally healthy, FL can shift orders on the margin to non-Nike brands. Assuming no traffic fall-off, this helps FL's margin economics. 5) Despite the margin downdraft over 2 years, Free cash flow margin has held steady at (an admittedly appalling) 2.5% as FL exited bad leases, closed down underperforming stores and converted associated inventory to cash. 6) The bottom line is that the leverage is pretty meaningful at both the operating and cash flow line, and to the extend any of these trends continue, we could be sitting here looking at a 3-4 point margin pop without making heroic assumptions - or about $1.50 in ES power (35% better than consensus).
- BALANCE SHEET CONSIDERATIONS I'm torn on the 'this thing has a great balance sheet' argument. Ok, $2 per share in net cash and tangible book value of $12ps. Not bad at all. But 2/3 of book value is comprised of finished goods inventory. While that's a solid liquid asset, this is carried at cost, and I've seen inventory liquidated for a fraction of cost. In addition, FL has $1.9bn in lease obligations that I'd be remiss to leave off the balance sheet. What I like, however, is that FL's lease terms are about as good as they get. Its annual lease obligations rate declines meaningfully - by the tune of about 60% based on my math. Unlike some other retailers that are pushing out lease obligations to print higher margins today (DKS, DSW, to name a few). The point here is that if for whatever reason FL opted to extend terms on its leases, it can push obligations out and take margins up. I'm not recommending that FL does this by any means - but it is one of the few companies that has the option (others being PSS and HIBB). If there's one think I like in this environment, it's flexibility. This balance sheet has it.