Foot Locker showed us yet again that there are very few fundamental reasons to own the stock. I’m sorry, but ‘it’s cheap’ is a bad reason. The company delivered a 7.7% comp this quarter, slowing from 18.6% last quarter (HIBB embarrassed it by putting up a 21.2% comp). In spite of what was an otherwise healthy comp, earnings only grew by 7%. I’m sorry, but that’s just not how a winning retail model works. We should have seen that comp lever up to something closer to 20%+ earnings growth. The problem is that Nike pushed back this quarter and did not accept product returns for merchandise that would not sell. FL claims that ‘its vendors’ (aka Nike) made up for it with margin allowances, but it was clearly no where in the ballpark to being enough. The reality is that Nike accounts for 71% of FL’s inventory purchases, which is 2x Nike’s share of the industry in aggregate and is a downright reckless ratio for FL. Given that FL had to clear excess inventory against its will, it saw gross margin down 120bp, with 390bp of merch margin pressure mostly from markdown pressure and a margin-dilutive shift to digital (which was up 50%+ in the quarter, slowing from +triple digits last Q). These negative factors were partially offset by occupancy leverage – especially in light of rent concessions that were still offered by landlords during the quarter, but are likely to go away going forward. The lack of flow through just shows the obvious, that Foot Locker will earn whatever Nike wants it to earn. And trust me, NKE’s priority is not the FL P&L. We’ve got FL earning between $3-$3.25 each year over the next three years (consensus is at $4.50). For a business with such a structural embedded business risk – having 71% of sales dependent on a vendor who’s top priority and use of capital is to go around the wholesale channel and sell consumer-direct -- I wouldn’t pay more than 10x earnings for that earnings power. That leaves us with a stock in the low $30s. With the stock trading back below $40 today that leaves us with less downside than when we first made this call. But we still think consensus estimates are headed lower, and will take the stock with it. FL remains a Best Idea Short.
Takeaway: The lack of flow through shows the obvious -- Foot Locker will earn whatever Nike wants it to earn. Numbers are too high. Best Idea Short.
