FL: The Footlocker Wish List

Foot Locker remains one of our top ‘bench’ ideas headed into 2010. No, the timing still is not right, but the fundamental story should begin to align – for the first time in a long while. There’s still a wall of silence from FL on its strategy. Here’s our initial wish list.

 

On our 4Q theme conference call (if you missed it, let us know and we’ll get you the slides/replay), we mentioned that we were warming up to Footlocker.  We still are. And while we definitely don’t have all the answers on this one, we continue to dig deeper in an attempt to figure out the potential for a turnaround.  Importantly, there seems to be a fair level of interest (and intrigue) with our focus here.  Not because Foot Locker is a screaming buy at this very moment, but because it has fallen off of so many people’s radar screens over the past couple of years.

 

In absence of answers, we do have plenty of questions.  And based on the FL-related inquiries hitting my inbox, so do you.  I’m get the same simple question from anyone who is even remotely interested in understanding what’s going on at Footlocker.  What can they possibly do to fix this business?  Not having done a ‘double secret one-on-one’ we have no special “insight” into recently hired Ken Hicks’ game plan, but here’s an initial wish list for what should be key to improving the future of the chain:

 

  • Right-size the store base and optimize the portfolio by brand.  With 8 sub-brands (Footlocker, Footlocker International, Lady Footlocker, Kids Footlocker, Footaction, Champs, CCS, and Eastbay) there is ample opportunity to put the right stores in the right place.  Historically, the focus has been overly centered on the total portfolio and a modest amount of store closings in any given year.  Recall that past management was very much in favor of “addition by subtraction”, which resulted in a 3-4% per annum reduction in square footage over the 2007-2008 period.  Many conference calls of yesteryear touted the 50bps annual benefit the company could achieve by simply closing stores. Closing a large amount of stores may or may not be the right answer. After all, one might argue that mass store closures would take away some of the leverage FL has with vendors and landlords as an 800lb gorilla.  But with a 30+ point margin spread between the least profitable and most profitable stores, doing the analysis is a start.

 

FL: The Footlocker Wish List - fl store growth

 

  • Focus on the product.  Sounds simple, but it’s not.  When 60+% of your merchandise comes from one vendor (Nike ranges from 44% to 78% of total sales depending on the nameplate), it seems to me that this is a “buy” and not a “sell” mentality.  Ken Hicks brings a substantial amount of experience to the table in areas of sourcing, branded apparel and footwear, large chain store operations (Payless), and private label/exclusive brand development.  All of these areas are key to the future of Footlocker in my view.  Better brand balance (less Nike, more of everything/anything else), improved product mix utilizing apparel to drive higher gross profits, and increased use of exclusive product offerings to drive pricing power and differentiation should all be considered.  The days of trying to cross sell 5 for $20 tees with marquee Nike’s must come to an end.

 

FL: The Footlocker Wish List - nike footlocker

 

  • Europe probably doesn’t need as much fixing.  The non-US operations are in a different state at this point.  The brand is better positioned overseas, with product more skewed towards the premium level. Competition is more confined to local and regional players and the business exists outside the “mall”.  Quite simply, if it ain’t broke don’t fix it.  The US needs the most attention and at this point shareholders should recognize where the low hanging fruit exists.

 

  • This is not a financial engineering/restructuring.  With $438 million in cash and $138 million in long-term debt, there isn’t much to worry about here when it comes to liquidity.  Yes, the company has over $4 billion in operating lease commitments (that Wall Street loves to forget about) but that’s the price of admission when you operate in a mall.  An important consideration is that Foot Locker has among the shortest implied lease duration of most mall retailers. Not a bad place to be when the commercial real estate market is crashing and setting up for rate resets. The real focus here is on productivity and on profitability.  Both of which are achievable with the current balance sheet.  Are the stores tired? Yes, and maybe refreshing the in-store experience is part of the plan.  If it is, I don’t see it being at the top of the list or requiring substantial amounts of capital.

 

  • Seeds planted for limited, but some growth.  In the near to intermediate term I would be surprised to hear much about growth.  This is clearly a margin recovery story.  EBIT margins are likely to end the year below 3%, but were in the low 7% range from ’03-’06.   With a strong and well capitalized e-commerce platform, a growing International business, and the seeds planted for a new concept in CCS there will at some point be an opportunity for Footlocker to use its cash flow for new projects.  It just won’t be anytime soon.

 

So what’s next?  Hicks is expected to unveil his plan in the Spring, with the reporting of 4Q results.  We won’t be surprised when some combination of the abovementioned strategies will be employed to begin the turnaround.  Neither should you.  The question here is not what ideas will be communicated but rather if and how well they can be executed.  For us, the change in leadership alone is likely to be biggest single factor in the process.  At least to start.  No one needs to be buddies with Ken Hicks or get that exclusive early access to recognize that this company needs a new strategy, implemented by a new leader.  The old rules of bigger is better no longer apply.  Collaboration with Nike and Under Armour and Adidas and others will be key to this new focus.  Bullying suppliers and being overly reliant on one brand is no longer an option. 

 

It’s time to start paying attention to Footlocker as it remains one of the few retailers with a sizeable revenue base and a reason to exist, that has not benefitted from cost cutting and inventory cuts like the rest of retail. 

 

You’ll be hearing a lot more from us on this name headed into ’10.

 

Eric Levine

Director