This was the most bearish that Foot Locker management has been on Nike in roughly 56 quarters. Yes, that’s 14 years…but who’s counting? No this is not a clash of the two 800lb gorillas like in 2002 arguing over FL’s order cuts in the wake of the Vince Carter Shox appealing to virtually nobody except Carter himself (not even in the Raptor’s home market of Toronto). But at least to us, FL management was super cautious on Nike. At first it was the discussion about how Basketball was down mid-single digits in the quarter. And mind you, basketball is 40% of the revenue, and Nike has a 95%+ share of FL basketball. That’s about 38% of FL revenue base that was under pressure. But then we heard CEO Johnson talk of the ‘big turn’ at Adidas, and how he would like more product from both Adidas and UnderArmour.
Then one thing became abundantly clear to us…
As FL took its ‘Nike Ratio’ (the % of product it sells that is Nike) from 40% to 73% over this economic cycle, it lost the ability to think and act on its own. You heard it in management’s tone “we WANT more Adidas and UnderArmour, but Nike won’t let us.” Our sense is that FL wants maybe 50% of its store to be Nike, but unfortunately it has to take a lot of Nike’s junky product (yes, Nike makes some junk) and excess inventory in order to be assured premium allocation of the good stuff.
Well…that’s all fine and good if FL is comping high single digits, EPS is growing 30%+, AND as a kicker, minimal SG&A investment and capex are needed given that Nike is giving them the growth for free. As such, ROIC went from 5% to 28%, and the stock went up by 5x.
But, Nike stuffing FL with swooshes is absolutely NOT ok, when comps decelerate, FL’s most profitable business is down, it’s missing out on hot product from other brands that are gaining momentum, expenses pick up – causing FL to delever SG&A in a 1Q for the first time since the Great Recession, and EPS growth slows to the lowest rate since 4Q09.
Even though we think FL is a solid short, we absolutely believe that the company has a good management team. A good management team, however, will look at its brand portfolio, and take action when 72% of its business belongs to a brand that is changing up the footwear distribution paradigm. It’s got to be clear to FL management that this dependence on a single brand is no longer working – at least if it wants to accelerate growth and returns. The risk there is that FL cuts 2-3% of expected sales, and then Nike responds by cutting 10% -- and giving the increment to DKS in order to stabilize that part of the wholesale channel.
All in, we give FL all the credit in the world for its comments. But the reality is that it sticks with 70%+ Nike and faces an eroding earnings algorithm, or it diversifies away from Nike and faces potential business risk. Sure, FL is down today in an up tape. But this short call is far from over. Estimates remain too high, and we think we’ll see multiple compression repeatedly over the next year.
FL remains on our Best Idea list as a Short.
