The long-term short call is one of the more powerful ones in retail, though such TAIL calls are far from linear. This will be a ’three steps forward, one step back’ call for 1-2 years, as the natural ebbs and flows of even the best/worst retailers offer temporary windows challenging conventional wisdom — we’ve said this all along. That said, we still take very seriously our fiduciary responsibility to Hedgeye customers to navigate the TRADES and TRENDS that build to the TAIL duration. Did we think they’d beat this quarter and we’d take a step back? Definitely not. We thought the opposite — so at a minimum we need to drill down on what changed and why. The comp was strong, and it warrants some serious thought on our part as to where we could be wrong. So that’s what our team did over the past two days.
We’ll outline the ‘what’s changed’, 'where we were wrong last week', and ‘what’s not fully appreciated’ part of this call later in this note. But to be crystal clear, when all is said and done, we still think the TAIL call here should result in close to $3 in earnings power (Street is at $5.22 in 2-years) and financial returns being cut in half from 28% today to the low-mid teens over 2-years. How does that happen?
1. Nike and Foot Locker play nice in public, but behind the scenes things are getting fierce. FL is not getting the incremental growth in allocations it once did. Foot Locker Nike sales ratio peaked at 73% in 2014, went to 72% last year, and we think is trending closer to 70% today, That’s manageable…
2. ...but the problem is that said ratio is headed to 60% — a level it saw just 2-3 years ago. Regardless of what Nike and FL say on conference calls, Nike is growing around FL, and the numbers are indisputable. More Nike for FL equals greater traffic, higher ASP, better conversion, and huge incremental margin. That should start going the other way.
3. FL has among the lowest SG&A ratios in all of retail. Why? because 3/4 of sales come from the mother of all brands that serves as its own traffic driver. FL is shifting incrementally to Adidas and UA, both of which are lower ticket and less profitable. And importantly, with such a huge Nike presence, FL needs to spend close to nothing on advertising relative to the financial impact of having such great product. That is changing. A 19% SG&A ratio is targeted to 18%, but it could (and should) just as easily go to 22-23%, which cuts margins by more than a third — not including the e-commerce investment.
4. FL needs to hire a world-class e-commerce organization to prevent itself from being disintermediated. That is very very expensive. Same goes for fulfillment ops, and having the content to back up such an investment.
5. As Nike moves forward with full-scale US-made customization of product, FL will want a piece of the action. It will have to front the capital cost to get Nike manufacturing technology, and will still only get the technology in question in at best 5% of its stores. But still, that will solidify Nike’s position in this relationship (even with a lower FL/Nike sales ratio) by keeping FL right where it needs it to extract more of the consumer margin to its own P&L, not FL’s.
6. But McGough, how could you say that? Nike NEEDS FL to sustain its wholesale model. Yes, that’s right. But Nike does not need FL to be at 72%. 50-60% is fine — and arguably still too much for a healthy relationship.
7. Working capital should bloat as FL carries more brands. More SKUs to manage. More closeouts to manage. Less buying power from being in bed with one vendor. GM under pressure as well.
Capex should grind much higher than we’re seeing today. Without it, FL can’t sustain a dramatically better growth rate in e-commerce.
8. Oh, and by the way, there’s zero square footage growth, and international growth efforts are sputtering at best.
9. So the only sustained growth here is if the cycle does not roll, people start buying more pairs per capita per year (which has been between 0.8x-1.2x per cap per year since 1988 — so lets not bank on that changing). We basically need higher ASPs — again — without the benefit accruing to the content owner. Good luck with that for FL and anyone else that sells shoes.
We challenge anyone to find us a fully valued stock (17x earnings and 7.1x EBITDA) that did not go down precipitously when returns were cut in half, and consensus estimates prove aggressive by as much as 30% for next year. The only stocks that would prove us wrong are take-out candidates. And mark my words, no strategic buyer or private equity investor that can even spell ‘due diligence’ would take a look at buying this outright. If anyone is reckless enough to buy it, then we'd love nothing more than to debate the pathetic merits of such a transaction in any public forum with the moderator of their choice. I don’t mean to sound arrogant there, but taking-out Foot Locker is as absurd as the occasional rumor of Nike buying UnderArmour.
The TREND call should definitely support that premise/math directionally, particularly with ERODING incremental margins with greater capital intensity (i.e. lower returns). As a kicker, we’re looking at no more QTD guidance from the company (a wise move by management, we think) at a time when the Street is largely playing a wicked game of ‘extend the trend’ in its financial models and that the strength we’re seeing today remains in place — or stronger — pretty much in perpetuity. We’re probably looking at Short Interest at about 5% after last week’s rally, and everyone we talked with who buys into the disintermediation theme largely ran for cover on this print.
We think this story will mutate into a full-on Bear within two quarters, and more likely by the end of the year. Here’s your chance to short more of one of the most structurally-flawed names we can find — but one that is temporarily suggesting, to skittish/scared investors, otherwise. We think that if RNOA goes from 28% to 14% in 2-years and EPS loses $1.50 instead of gaining $1.00 over 2 years (a massive $2.50 delta) then we’re looking at something closer to a good ol' zero square footage growth retailer with eroding comps, peak margins, meaningfully higher SG&A and working capital requirements, that has 72% of its product coming from one vendor that says all the ‘pro-Foot Locker' things in public, but truly does not care if its FL business shrinks by 2,000bps over 3 years (or sooner). When a 40+ year paradigm of designing, sourcing, manufacturing, distributing, selling and marketing shoes is being turned on its head — there is absolutely no way Foot Locker, Finish Line, Hibbett and any retailer other than Dick’s (a temporary winner) will come out in its happy place.
If we’re right on the model, we’re looking at nearly 50% to be made on the short side — 9-11x a $3 EPS number, which assumes 4x EBITDA and an 8% FCF yield which given the downside to earnings we see from here is the most important metric. That’s about $35 downside. If we’re wrong, and the economic cycle does not roll, the brands don’t disintermediate traditional/dinosaur distribution, and we don’t see any channel conflict between Nike and FL, then the best we get to is an irrational mid-teens multiple on $5.00 in EPS, or about an $80 stock. That’d hurt…but we don’t think we’ll see it. All in, we got $13 up, and about $35 down. We usually like 3 to 1 for the optical margin of error on a bold call like this. But that’s close enough.
BOTH SIDES OF THE ARGUMENT
So let’s pick apart the bull and bear arguments — at least how we see ‘em. The punchline for us is that the fundamental fat-tailed short call is very much in tact. The stock rallied 11% on the day after a 5% run the week into the print. That’s $1.1bn in added market value for an improved TRADE duration, which is far too much given our certainty that the financial return metrics in this model — more capital for lower incremental EBIT — and long-term earnings power is 35% below what the street is modeling. When a stock rallies on a good print that otherwise does not change the underlying short thesis, we’ll begrudgingly pay the price on that day (as we did last week) but we will not count the cost. This call will turn out to be a winner — far more than the mediocre 12% decline relative to the market since we made it a Best Idea almost exactly 1yr ago.
HERE’S WHAT HAPPENED IN THE QTR THAT HIT OUR THESIS WHERE IT HURTS
1. Ok…time to get real. This print was one heck of an effort by the company to torpedo our FL Short Thesis. As fundamentally flawed as this business model is, we have always thought the post-Hicks legacy management was very good at managing this model. This quarter they did that. Golf clap — a big one. Score one for a very good management team on this print. We hate shorting stocks of good management teams. But good management teams in flawed business models usually lose out in the end.
2. The top line was killer. A +5% comp — when even decent retailers are selling their soul just to put up a +1% in this environment makes it very tough for a lot of shorter-duration funds to stay negative on this —and we completely understand why. It’s equally frustrating and perplexing. Here’s an interesting way to look at it: When we look at the actual comp vs the QTD comp reported on the conference call two months earlier, this quarter showed the biggest positive inflection this decade. Now…keep in mind that the delta was negative in 2Q last year. 1Q of this year was a mere 1% positive delta.
The confusing (or important) data point for us is 1Q — why was it so weak? It basically means that either 1Q or 2Q was anomalous, or it tells us that this rate of strength we saw this summer is simply not sustainable. One thing we’ve learned is that when there are extremely volatile swings like this relative to plan — good or bad — it is almost always a negative event. Consistency and predictability are great; that allows retailers to manage the business well on a consistent basis. We’re seeing increased volatility. Which is bad any way we cut it.
3. E-Commerce Was Relatively Weak. Our traffic indicators showed weakness for FL domains, and on a relative basis the muted 7.1% growth and 2 year slowdown underperformed the rest of the industry while it was dwarfed by NKE. FL B&M stores therefore accelerated and did so with the benefit of positive traffic company wide. Positive traffic is not something we'll bank on in the long term for a retailer that has a significant majority of stores within malls posting negative traffic.
4. Leverage Works Both Ways. The biggest validator of our thesis is that the 5% comp actually resulted in SG&A DE-leverage to the tune of 13bps — and that’s despite the fact that gross profit grew at 110bps better than sales. So we ask…how can a company comp so strong, but fail to leverage SG&A and have it result in a positive delta as it relates to margins? Simple. It doesn’t. By our math, FL would have needed a 5.5% comp to leverage SG&A. What would have happened if it only comped 3%? How about flat? How about -5%? It’s happened before, and mark my words, it will happen again. We think that people too easily forget that the tremendous leverage on the upside to EBIT growth, as FL has routinely put up 30-40% EPS growth on a 10% comp, has been cut dramatically. Run the math…all it takes is a down comp 1 or 2 quarters in a row and EBIT will contract by just as much as people were so surprised to see it expand over the past economic cycle.