Takeaway: The short has been working. At 4x (declining) EBITDA I’ll look to add more short side on strength.

While I’m pleased with today’s stock reaction given we have FL as a Best Idea Short  -- I’d be remiss to still call FL a ‘raging short’ with the stock under $40 and at just 4x a reasonable EBITDA estimate. Should the stock have been down today? Definitely. Expectations have clearly risen in recent weeks for a 5-6% comp and a headline EPS beat – so that was in line. But then the company backed off the 4Q guide due to continued weakness in apparel as well as a launch calendar that’s not robust enough to allow the company to comp against last year's huge 9.7% level. Backing off a quarterly guidance policy for a company that inherently has extreme volatility in the quarterly model certainly didn’t help the cause. But unlike other retailers where there is a gaping hole between estimates and financial reality, that’s not the case at FL. Don’t get me wrong, I don’t think EBIT will sustainably grow again at this company – I’m modeling a 2% comp over a TAIL duration, which is hardly conservative given that Nike is reducing its ratio of higher priced shoes into FL (its keeping those for itself) – and still get to a negative EBIT growth rate every year.  Yes, I’m saying that EBIT shouldn’t grow again at this company. The big saving grace with this model is 5-6% EPS growth from share repo, which is realistic even with the top and the middle of the P&L under pressure. All in, I’m looking at a mid-high single digit EPS miss on a roughly $5 per share earnings annuity over the next three years. If a recession hits, all bets are off. But could this stock tread water as stock repo offsets operational weakness and volatility over a TREND duration? Probably. I’d look to get heavier short side if it comes out and prints a mid-single digit comp in a given quarter due to an ‘all stars aligned’ product launch calendar giving hope to investors that this is a 10%+ EBIT grower again – something I’d bet against any day of the week barring Nike doubling down on its commitment to take up its ratio of product inside the store (not going to happen). Not my highest conviction short down here given how it’s worked out. But I’m interested in getting heavier on strength.   

FL | Deserves To Be Down - 11 22 2019 FL Fin Table

What Happened

5% headline EPS beat.  Stock was only up slightly in the pre-market as the market was likely expecting this kind of number given the stock move and some signals of near term sales data being positive. 

Guidance sent the stock lower however. The company is revising EPS to up mid-single digits for the year from up high-single digits, with the 3Q beat.

As much as we might think lofty expectations are not actually priced in (i.e. everyone expecting a miss), downward EPS revisions just about always mean a downward moving stock on the day.

The company is bagging quarterly guidance, opting for just annual updates, which can’t instill confidence in investors.

Revenue

Comps were very strong up 5.7% accelerating from 0.8% on a tougher compare. Management was confident in its release calendar and product flow, and in 3Q it looks like FL was right. 

Comps are being driven entirely by ASP (likely from higher ticket Nike momentum), with traffic down LSD (same as last Q) and ASP up HSD. Stores were up 4.7% with DTC up 11.4%.

Footwear outperformed (HIBB saw the same) basketball accelerated form last Q with Men’s BB up DD% against down MSD% last year.  Apparel was down HSD alongside accessories, given the amount of Champion product in FL lately, that’s a negative for HBI. 

4Q comps look less bullish, with the company guiding to flat.  Though on top of the 9.7% comp last year, flat would still be a 2 and 3 year acceleration. But slowing is slowing.

Gross Margin

Gross margin up 48bps accelerating from down 15bps last Q on a similar compare.  Margin flow through is expected given the comp performance (60bps of occupancy and buying leverage), and the company has been in a clean inventory position.  Apparel weakness (mix impact) was a slight drag (10bps).

Inventories again remain healthy, at flat vs sales up 3.9%.  Yet the company is now guiding gross margins down in 4Q, mainly because of the lack of comp leverage, still expecting some negative mix impact on merchandise margin.

SG&A

SG&A grew 3.3%, similar to last Q on a lower growth comparison.  That made for leverage of 12bps, which is only the 2nd quarter of leverage (along with 4Q18 9.7% comp) in the last 11.

FL continues to put dollars into digital and employees, though signaling that the growth rate peaks could be in.  Setting that expectation is bearish from where we sit, as our contention has been that for about a decade that FL underinvested in the business while letting an increasing Nike penetration drive ASP (and comp) higher and higher getting significant margin expansion from SG&A leverage.  Now we should see a long term trend towards the opposite as Nike invests to grow around the wholesale channel, gradually reducing its % within FL. 

FL specifically signaled higher minimum wage and benefits for employees, we think that pressure will continue, especially if comps revert lower meaning less commission comp for top employees.

Investments

FL has made many investments in smaller businesses over the last year or so.  This quarter there was a small stake ($3mm) in Network “an exciting new video, e-commerce and content platform.”

FL is casting a rather wide net in many different businesses, which seems to be by design, likely looking to strike gold in one of them and ride a future retail wave. 

We’d argue the investments are coming given the pressure the company sees in its core business over the long term.  Perhaps it’s too little too late, or maybe it’s the right way to gain some long term value vs simply executing the core strategy.