FL: The Pug of Retail

I think that people generally underappreciate how bigger-picture industry trends have disproportionately beaten up Foot Locker. Some of those are turning, and while it almost pains me to say, this perennial underperformer is starting to look really interesting.

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.

CKR - The Tale of Two concepts

CKE reported consolidates same-store sales increased 1.8% percent in May. Looking at the 2-year trends, consolidated basis same store sales slowed by 110 bps. Carl's Jr. same-store sales improved 4.2%, while Hardee's same-store sales declined 1% percent. Period 4 represented the third straight month of declining same-store sales for Hardee's.
  • Hardee's - the three consecutive months of declining same-store sales are now a trend.It's clear that management needs to reconsider the growth capital being allocated to the Hardee's concept.

BIGResearch Consumer spending survey - stimulus checks

The BIGresearch consumer survey summarizes the pulse of the consumers based on BIGresearch's monthly national Consumer Intentions and Actions (CIA) Survey. Approximately, 6,000 people respond every month.
  • Stimulus Check SpecialHow are consumers planning to use their gift checks from the government? Given that piggy banks have been drained in prior months in order to pay increasingly for food and gas, it appears that more than one in three (31.0%) plan to save their stimulus (24.2%) plans to pay down credit cards, while 16.4% will use their checks to pay down debt (installment loans). However, plans among those who are expecting a rebate check and those who still aren't sure if they'll receive one differ slightly...those who aren't sure are more likely to use the money for savings or gas purchases, while those who know it's in the mail (or already in their bank account) are more apt to pay down debt and purchase necessities like groceries.
  • The Impact Of Rising Gas PricesRecord high fuel prices have drivers feeling deflated as they pump gas in their autos in May...this month, 84.0% contend they have been affected by rising gas prices, up from 82.2% in April, 74.2% in '07, and a new high. To cope, consumers are resorting to taking fewer shopping trips (47.9%), shopping closer to home (43.7%), hunting for sales more often (39.8%), clipping more coupons (34.6%), and buying more store brands and generics (31.0%):

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Global QSR - The global trends are slowing!

We have written about slowing growth in China, Germany and the UK. So what is the first headline we read today? - Consumer confidence in France unexpectedly dropped to a record low in May

Not surprisingly, energy and food costs are to blame for the slowdown in consumer spending.

Think YUM and MCD!

The Mother of All Shoe Stats!

I've been covering this industry for about 10 years. The shift towards 'low performance' footwear (i.e. the kind of sneaker/shoe hybrid that you can wear with designer jeans) has been the big trend for more than half that time. The category just posted its 1st negative month -- ever. Is athletic back?? I won't call it a trend until I see another 2 months. But if this sticks then there are wide reaching implications for this industry. It also suggests that Matt Serra's comments on Foot Locker's conference call about a revival in the mall-based business might actually be true.

Some considerations if this holds...

1) Near-term, industry inventories are clean, which is a positive margin event. But as '09 approaches I am convinced that the world at large is underestimating the negative margin impact from 'everything Asia' (rising inflation and slowing growth). A couple points in share gain of the total footwear market could give the athletic space a well needed shot in the arm to keep margin pressure at bay -- at least to some degree.

2) Foot Locker would be the big winner. By no means could a simple cyclical boost elevate FL's status from the 'bottom quartile' list of virtually every mall REIT. But at 1x tangible book with $2 in net cash on the balance sheet, and margins having gone from 7% to 1% over the past 2 years - even the slightest tweak in top line could be meaningful.

3) Nike risk?? How could Nike possibly be at risk in the event of a strengthening US athletic cycle? Well, it's probably not - if nothing else due to the global portfolio diversification. But in a backward kind of way, we should keep in mind that Nike absolutely dominates US footwear retailers when times are tough. When the environment picks up, the retailers become less risk averse, and are usually willing to push back and try smaller brands.

The exhibit below shows year/year change in low profile footwear units. Courtesy of NPD Fashionworld.

The Channel Is Looking Solid

I've been keeping my eye on the so called 'revival' in footwear industry sales. We started to see it in the higher price points about a month ago, and that has not cooled. Sources in the off-price channel are telling us that they're having a tough time getting their hands on inventory, as 'the channel is just so darn clean.' Some of this is a snap-back from a dreadful 1Q. But what I find so interesting is the uniformity among channels of distribution. Consider the following...
  • 1) Units sold are not knocking the cover off the ball by any means, but this is entirely offset (and then some) by higher ASPs. Athletic Specialty, Department Store, National Chain, and Shoe Chain are all up 2-5%.
  • 2) The National Chain channel is showing the greatest strength in ASP, but there's a dark side to this. My sense is that nearly all of this is driven by Target. My sources indicate that Target is planning its footwear unit sales down better than 10% for the balance of the year.
  • 3) I'm liking these trends as it relates to Payless. This company's margin potential is tremendous, but has been crushed over the past year because an ill-timed (overpriced) acquisition coincided with a meaningful downshift in industry sales. That's painful for a company with zero square footage growth and a highly levered balance sheet. If this turn in industry fundamentals is for real - even for a couple quarters, then 2H numbers could prove to be way too low. That matters at 3-4x EBITDA.

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