THE HEDGEYE EDGE
Nike is sitting at an unhealthy 67% of Footlocker’s (FL) sales. The ratio is dangerously high despite having come down from 73% three years ago. The Board’s risk management process should be called into question for even allowing this to happen. Regardless, the reversal of this trend should cost FL $2 in EPS, while the Street is looking for 10%+ earnings growth.
The bull case revolves around ‘the stock being cheap.’ But the numbers are simply wrong. Yes, the stock is trading at just 11x consensus estimates…but all value traps look cheap, until they’re more expensive at a lower price.
INTERMEDIATE TERM (TREND)
The latest guide down is unlikely to be the last. Nike is recovering on its own, but not enough to allow FL to grow. FL’s rents are going up 5-6% despite a lower rent structure for retailers.
Also, the ‘brand heat’ associated with Adidas does not accrue to FL’s benefit. In other words, if you substitute a Nike shoe ($160) with an Adidas shoe ($120), then you sell the same number of units, but at a lower price point. It takes sales lower.
Nonetheless, no story is linear – this will be a two steps forward and one step back story – and Nike will dictate which direction those steps take.
LONG TERM (TAIL)
Nike decided to push product into FL a decade ago, taking the share of Nike product as a percentage of Footlocker's overall sales from 40% to over 70%. Meanwhile, Nike used the excess cash flow to build the infrastructure to ultimately go around Foot Locker with its own Direct-to-Consumer (DTC) strategy.
During that time period, FL’s comp sales, traffic, ticket and virtually all sales metrics were up 5-10% consistently – and all of that happened in a declining mall traffic environment. This drove store productivity from $300/ft to $600/ft, and took margins from 6% to 12%. In other words, instead of using Nike-driven earnings to invest in it’s model, FL ‘flowed through’ the excess earnings to shareholders. That’s fine in part, but not to the extent that FL did.
As Nike takes the FL ratio closer to 50%, we should see sales productivity approach $500/ft, and margins deleverage by 300-400bps. This results in earnings of $2.80-$3.00 while the Street is looking for EPS over $5.00. That’s a severe problem.