Conclusion: We remain confident that Foot Locker will prove to be one of the best multi-year shorts in retail. The company is likely to earn about $4.20 this year, which we think will prove to be the high water mark in this economic cycle. We think that emerging competition from its top vendor, Nike (≈80% of sales), will stifle growth, and leave the company with an earnings annuity somewhere around $3.50-$3.75 per share. Is that worth $61? Not a chance. Not for a company that is Nike’s best off-balance sheet asset. And definitely not when the Street is in the stratosphere approaching $6.00 in EPS (#NoWay).
But as we know, multi-year stories are not linear. We’ve been asked many times this week what we’d do ahead of the print. First and foremost, we’re confident enough in our long term short call that we’d definitely have at least a partial position into the event. Keeping in mind, however, that the stock is off 27% since the Sept peak. Short interest has climbed to 10%, Nike got public about its DTC goals (i.e. compete with its wholesalers), SKX, DKS, FINL have blown up, and it’s pretty clear that inventories are high in the channel. The P&L will have to show meaningful signs of stress in order to get paid tomorrow. Betting on that does not seem like good risk management to us.
But despite this quarter probably being a push, it’s really important to remember that consensus estimates in years one through three are high by $1-$2 per share. That ties into historical context. How many times did people say “damn, I missed my shot” as FL went from $5 to $10. Missed it. Then again when it went to $25. Missed it. $25 to $50. Missed. $50 to $75. Same…
We’re confident that people will be inversely ‘Missing It’ on the way down.
So our positioning into the numbers: We’re short it. On a good print, which is very possible, we get much heavier. On a bad print, we also get heavier.
DETAILS ON THE QUARTER
Revenue: Comp expectations for the quarter sit at 6.3% which assumes a 170bps sequential deceleration in the underlying trend. Because FL reports a constant currency comp, Fx isn’t an issue. Category softness during 3Q earnings season to date has been focused primarily in sports apparel which is more levered to weather patterns and mid-tier athletic footwear (i.e. Skechers and Merrell). Apparel and accessories represent just 20% of FL’s mix (compared to DKS at 36%). And, the likes of SKX and Merrell don’t have shelf space at FL. Top line strength is directly dependent on the strength of the basketball and to a lesser extent running categories which have been running in the double digits for each of the past eight quarters for basketball, and five for running. We think this trend slows -- and not because we’re making ‘the tough comp’ or ‘top of the sneaker cycle’ call. The crux of it is that FL has taken NKE as a percent of sales from 50% to nearly 80% over the past 8 years, and we think that Nike is going to add $10bn in e-commerce sales in five years (blowing away it’s $7bn goal). And, we’ve started to see an inflection in the e-comm trends with NKE showing considerable strength over the past quarter as FL and DKS weakened considerably. We saw that reflected in the 3Q print out of DKS earlier this week when the company posted the lowest e-comm growth rate at 18% since 3Q11. Based on what we see, FL looks just as bad.
Gross Margin: FL is sitting a peak gross margins, as the company has been able to offset Fx dilution with better markdowns and leverage on the occupancy line due to mid-to-high single digit comps. At 33.4% on a TTM basis FL sits just 10bps shy from the low end of its 2020 guidance which called for GM to be in a range of 33.5%-34%. In contextualizing this across the broader space, here are a few things to keep in mind. a) On its last call NKE cited high inventories in the US channel that would persist for at least another two quarters, something we haven’t heard out of the company in over a decade. b) UA is sitting on elevated footwear inventories that are one of the biggest drivers of the -100bps GM guidance for the 4th quarter. c) SKX called out a stuffed wholesale channel and as a result saw the sales to inventory spread fall to -11% from +6% in the third quarter. d) That’s evidenced by the -8% sales to inventory at FINL and -6% sales to inventory spread at DKS, add to that the fact that DSW just bit the bullet and took down 4Q numbers by 67% due in part to weak sell throughs and the need to balance on-hand inventories. Each data point alone isn’t a smoking gun, but the broader context paints a bearish picture for #FootwearRetail1.0 -- where FL is the biggest player.
SG&A: Fx has been a considerable tailwind for the past four quarters as the SG&A benefit from Fx exposure has more than offset the gross margin pressure. We’ve seen the spread between reported and constant currency SG&A widen as far as eight percentage points. The company starts to lap that benefit in 3Q15, and then in a big way in starting in 4Q15. FL needs low single digit comps to leverage on the expense line. That equates to a lot of leverage when the company is comping in the HSD range, but on the margin as comps slow to the mid to low single digits the flow through doesn’t look as appealing. The company is within spitting distance of its long-term SG&A targets of 18%-19% and sits at the low end of any specialty retailer we can find. For a name just off peak multiples with comps slowing as it turns from a square footage consolidator into a square footage grower, that doesn’t add up to an accelerating EPS growth rate.
Expectations: Sentiment for FL is at 5 year lows with short interest as a % of the float marching from 7% to 10% since mid-October. Since the company reported earnings in mid-August the stock is off 15% vs. the RTH at -1%. But, that hasn’t been reflected in the consensus numbers where comps and earnings estimates have marched up by 20 bps and $0.01, respectively. There has been a lot of bad news in athletic/footwear land from the likes of SKX, DKS, FINL, BGFV, etc. when coupled with the price action in FL leads us to believe that expectations for tomorrow’s print are well in check on the comp side of the equation (a number FL has beat in 19 of the last 20 quarters).