For over a year we have been vocal on how the changing paradigm in how shoes are designed, sourced, manufactured, and sold is radically changing up the Athletic Footwear industry as we have known it for 40+ years. To be clear, this goes far beyond the simple 'content owners (NIke, UA, Adidas, etc...)' win, and traditional distribution loses. Everyone has a license to win, or lose. All it takes is a vision, talent, a boatload of capital, and the mandate to deploy it.
In that context, Nike is the clear winner, which is no surprise. But we think that people grossly underestimate both the depth and duration of its share gain and boost in profitability. Foot Locker is nearly the exact inverse, characterized by declining sales, weaker margins, higher SG&A, more working capital, Capex grinding higher (but not high enough to win strategically), and RNOA going from 28% (where it is today) to something in the low-mid teens. Stocks don't go up when RNOA gets cut in half -- even if they 'look so darn cheap on consensus earnings and trailing cash flow'.
To be clear, this kind of call does not play out in a single quarter. That is not a 'weak conviction hedge' into tomorrow's FL print. Not by a long shot. We fully expect the print to reinforce our 'declining return' theme -- with better than 90% confidence. Could the company find a way to make the stock go up on the day? Of course. Companies always can. But either way, every bit of research in our arsenal says that this is a name we want to be short right here, and right now.
DETAILS
We’ve seen some of of our call play out to date – but only some. Mostly in the stock price…off 7% YTD vs. the XRT +5%, rather than the reported earnings numbers. The call has worked, but not for all the right reasons, yet. We’ve seen multiple compression and now we think it’s time to start seeing it in the form of earnings revisions. Maybe not tomorrow, but certainly before the year is out. This is a 3 steps forward and one step back kind of short – and one that will ultimately lead to earnings closer to $3, which is significantly below where just about anyone thinks they could go.
Thinking about the near-term considerations, we saw the first hiccup from this company three months back in the form of a comp number that slowed by 400bps sequentially on a 2yr run rate and EPS growth of 7%, good for the lowest rate we’ve seen since 2009. It was also a watershed moment in the FL/NKE relationship as management at the former was as bearish on its key partner as we can ever remember. It hasn’t quite been a soap opera since, but there is a slew of data points that we think are particularly bearish for FL. Including…
a) Nike basketball growth went negative for Nike in FY16, though with Jordan the growth rate for the year was 11% down from 19% in 2015.
b) Nike readjusted the price/valuation equation at the tippity top of the pricing spectrum for its KD and Lebron shoes, taking the new model price points down 17% and 13%, respectively. That’s key given that much of the comp number is driven by ASP growth given that FL is smack dab in the middle of the negative traffic mall.
c) Nike wholesale growth went from a pretty consistent run rate between 10-15% to flat in the quarter the company closed in May.
d) Nike incremental wholesale dollars slowed to $431mm in the company’s FY16, 40% the average rate we’ve seen over the past 4 years. Assuming a 20% DTC growth rate for Nike in FY17, which we think could prove to be on the low end, means the wholesale dollars up for grabs are set to be cut in half again.
None of the above is a good barometer for FL. We’re short it. There’s no way FL comes out of this smelling better than it does today. Sales should weaken, gross margins should decline, SG&A and capex will BOTH head higher as FL tries to build up a more successful e-comm business to compete with its existing partners. Management is good at FL, and it will spend where it needs to – and after its Nike business went from 50% to 73% of revs over six years it really did not have to invest at all (hence unsustainably low SG&A). Now that changes.
Near Term Considerations:
After 3 years of nearly bulletproof earnings prints (FL has gone 11 straight quarters meeting or exceeding street numbers), we believe FL will be hard pressed to hit current 2016 estimates. Here’s why:
Revenue
1. Jordan launch timing was the signaled to be the key perpetrator for the negative comp trend QTD and while we aren’t blind to the factor launch timing can have on the weekly cadence of comps, but we think the softness in Nike basketball is a bigger headwind to overcome. The latter part we think helps explain the 500bps deceleration in comps from 4Q15 to 1Q16.
2. In this last fiscal year, NKE reported Nike Basketball and the total Jordan Brand separately for the first time. Jordan Brand grew 18% for FY16 on top of +20% in 2015, while Nike Basketball was DOWN 1% on top of +18%. While we think there is some obvious shift in demand from Nike to Brand Jordan, it’s the aggregate basketball business that really matters for FL. Basketball slowed to negative mid-single digits in 1Q16 vs a tough low double digit compare, and it doesn’t get any easier up against DD growth again back in 2Q15.
3. Comps were negative QTD as of the FL call on May 20th with street expectations for a 3.8% comp in the quarter. That means we would need to see a of 500bps+ intra-quarter acceleration in the trend in order for FL to hit current estimates. If history is any indication, FL has a pretty big mountain to climb. In order to hit a 4% comp this quarter, FL would have to see the biggest acceleration in… well, ever (or at least during this economic cycle). Then, from here, comps don’t get easier.
4. Don’t be fooled by positive QTD sales commentary on the call. August of 2015 was a relatively easy compare at mid-single digits, while September and October compares jump to double digits.
Margin Considerations
Merchandise margin compares get tougher sequentially from 1Q when the company missed comp by 160bps and gross margin by 30bps. ASP resistance has been well documented, and compares aren’t getting any easier from here. That’s an important point, as FL needs a low mid-single digit comp to leverage occupancy and about the same on SG&A. The FX SG&A tailwind is now completely gone with certain investment buckets weighing on 2Q in particular. Rounding it all out, the 1Q sales to inventory spread, though still positive, hit its worst level in 9 quarters. Throw in the liquidation of ~3mm pairs of athletic footwear between TSA and Sport Chalet in 2Q, and we think margins are more likely to surprise to the downside than the up.
