Editor's Note: Below is an update from Retail analyst Brian McGough following Foot Locker's 2Q results released Friday.
INVESTMENT CONCLUSION
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 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.
