Positive on FL, Negative on SKX

I continue to gain confidence that we’re going to see a reversal in margin trajectories between Foot Locker and Skechers. Though clients know my thinking as to why, there have been 2 nuggets in as many days that strengthened my view that SKX margins are heading lower by at least 3pts, and FL is going up by about the same.
1) FL: Industry sales trends continue to look good in aggregate. But when peeling back the onion and seeing which channels look good and which look bad, it is clear to me that the strength is in the athletic specialty channel, and weakness is confined to channels that are overweight low-profile (i.e. National Chains).

FL reports EPS after the close tonight. The company has missed each of the past six quarters. Not a great track record, by any means. But expectations look like they’re in check, and I think that inventories are under control. I still like the margin leverage on this name as traffic picks up and the major brands (esp. Nike and Under Armour) get into the ring and duke it out with running and basketball offerings over the next 12 months. There’s enough juice here to sidestep industry margin/sourcing pressure for at least a few margin points.

2) SKX: This Skechers situation is fascinating. After upping the bid and getting shut out twice, Skechers management is still trying to get sucked into this black hole by publicly pursuing HLYS. I won’t elaborate again on my thoughts (check out my 8/13 post “Deal or No Deal, The Damage is Done”) other than to reiterate that this is the last straw for a company that is over-earning in the wrong part of its cycle.
Share gain is coming from the right place for FL, not for SKX.

DKS: ‘Easy Comps’ Are Meaningless

I have had a dozen people ping me this morning asking ‘so, are you still the perma-bear on Dick’s?’ The short answer is ‘No!’ I am not a perma-bear/bull on anything. Yes, I have been very negative on the Dick’s story for the better part of a year – and have had very good reason. I don’t think that Wall Street appreciates the impact that the confluence of aggressive lease acquisitions and several material changes in the sporting goods retail space will have on DKS organic cash flow trajectory. I step back every day and retest my thesis, search for facts that could prove me wrong, and see how all this synch’s with market expectations. So far I have come up dry, and this quarter did nothing to change that. As I posted on 7/28, “Prepare to Whack-A-Mole” on a sandbagged 2Q. We’re still a buck or two away from the point where Keith’s models suggest playing that game. But stay tuned…

First off, let’s face some facts, this was a lousy quarter. Square footage up mid-teens, but comps down 3.7%, new store productivity eroding, and total sales netting out to a +7% rate. Gross margin rate down, SG&A deleverage, EBIT margins off a full point, and earnings down 6%. Yuck!

Yes, there are one-off things you can point to like cycling the impact of Heelys, and weakness in golf (temporary?), both of which hurt sales. But let’s not forget that in 2H DKS cycles Nike’s ACG launch, as well as exclusives from Adidas – and I’m pretty confident that these guys won’t be anywhere near as generous with terms as they were last year. Also, Under Armour is getting tighter with the mall retailers at the same time it is doing more business with Sports Authority.

TSA, in turn, is opening stores left and right (11 on 8/16 alone – and will add 37 this year) and is growing its footprint. Dick’s is expanding its reach as well into markets like Texas and Arizona. Is it a coincidence that the competitive landscape is getting tighter at the same time comps are weak and new store productivity turns down? No way folks… Moving into more expensive markets, with a less efficient infrastructure, and a lesser-known brand is rarely a good near-term event. Check out my 5/22 DKS post “Drink Facts, Not Kool-Aid” as to why I think that the lease structure for DKS is misaligned with economic reality.

I still think that the right margin rate for this company is about 4%, a far cry from the 6% it is likely to report this year. My biggest worry is that the company will pull another dilutive deal out of its hat and mask the true erosion in organic cash flow and returns.
This chart is a bit messy. It is going to get messier as footprints increasingly overlap.

WRC/DKS: Sales Nugget From DKS 2Q Call

Interesting comment just made by DKS CEO about no pick up in business from the Olympics, and no change in sales rate for Speedo.
Q: "A strange question, but with the Olympics going on, are you selling, first of all, more Speedo swimsuits, but are you in general seeing an impact, or do you normally see an impact from the Olympics?"

A: ED STACK (CEO): First of all, we have seen no significant change in the sale of our Speedo's. [Second] I think there may be some indirect component on a go forward basis and I think these games have done really exciting for people to watch and has gotten people maybe more interested in sports at least for this period of time, but we don't think that it has had an impact on our business.

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YUM – KFC’s Rising Prices In China Anger Consumers

The China Daily reported today that KFC raised its prices in China for the second time this year due to increasing commodity costs. The first price increase was implemented in March and menu prices increased between 0.5 yuan and 1.5 yuan. The magnitude of this second price increase is even greater, ranging from 0.5 yuan to 2.5 yuan. For reference, the price of a medium coke is now 6.5 yuan, up from 6 yuan (an 8% increase).

One KFC customer responded to these recent price increases, saying “Its products are quite small in size, and not worth the money if prices continue to go up.” On its 2Q earnings call, YUM management stated in reference to China, “In 2008, as an example, we will meet or exceed our profit targets despite unusually high commodity inflation. We have been able to pass on strategically targeted price increases while maintaining transaction growth.” YUM raised its prices in China by 6% in July 2007 prior to the 2% price increase in March 2008. Before this most recent price increase, prices in China were running up a little over 2%. This price vs. traffic relationship is one that I have talked a lot about and if customers begin to think the price increases are too great, YUM’s traffic growth in China will begin to suffer. These issues could be further magnified by the fact that YUM’s China division is facing more difficult comparisons in the back half of the year with management commenting on its last call, “Also, while we expect China to meet or exceed our full-year profit growth targets, we cannot expect mid-teens same-store sales growth and 30% to 40% profit growth to continue.”

Charting India: Going Back To The July Lows?

India's Sensex Index got pounded in Asian trading overnight, closing down another -3%. After making a valiant effort to breakout through my model's resistance line at 15,211, the Indian market closed at 14,239 and now looks very ominous as a result.

Asian economic growth is slowing, big time.
  • The BSE Sensex Index looks ripe to test its July lows near 12,500.
chart courtesy of

LDG, Part V: Numbers Don't Lie, People Do

I don’t need to sit across the table from a CFO in a conference 1-on-1 to get the inside scoop on how it is managing its growth trajectory. I have a much better source – it’s called a balance sheet. Better yet, it is in the notes accompanying the balance sheet, where we find some very large obligatory payments that are treated by most on Wall Street as if they don’t exist.

Well, that’s something we just can’t let fly here at Research Edge.

I’m referring to the minimum rent obligations on a go-forward basis, which gives us some pretty solid insight into CVS leading up to its decision to buy Longs Drug. Why does this matter? Because aside from discretionary SG&A spending, these minimums represent the single most meaningful place a retailer could go to manipulate reported margins. Every CFO will argue with me on this, and give you fluffy reasons as to why they don’t do that. But the option is there.

How? There are 2 main ways this can manifest itself. 1) A retailer could guarantee a landlord a steep escalating rent structure in order to outbid a more profitable competitor with deeper pockets, 2) The retailer could sign rental agreements with much longer property lead times, taking on the risk from the landlord that the quality of the location does not pan out as planned.

Why? This usually happens when one of two factors exists – and both are bad. The first is when a management team is super bulled-up on its growth trajectory and thinks that it can fund a high hurdle rate for growth in rent payments regardless of the macro environment. These companies don’t ‘do macro.’ This includes Whole Foods and Dick’s (check out those charts). The second is when a retailer sees a growth or margin trajectory eroding, and management starts pulling levers to keep its margins high, instead of investing in better and more profitable growth platforms. This is Circuit City, DSW, and you guessed it, CVS.

Yes, lease escalators are in place for everyone. Including the likes of Wal*Mart – and especially CVS and LDG. But all leases that come due each year are backed out of this minimum. Hence, when it all nets out, no retailer should have minimum lease obligations 3-years out that are higher than they are today.

That’s where CVS looks so fascinating. The chart below shows the ratio of year 0 to year3 payments for CVS vs. LDG. As reference, $100 in rent today and $50 minimum in 3 years would equal a 200% ratio. That’s good. Unfortunately, both of these are sitting at about 100%. There are other small format retailers that operate near 100%, so I won’t dwell on absolute levels. But what concerns me more is the trajectory of CVS’ numbers.

Check out my Partner Tom Tobin’s 8/19 post on the secular slowdown in pharmacy revenue. We saw growth in Rx spend per capita peak in 2006, and then trend downward. Tom’s analysis builds a pretty strong case that it will continue eroding from here. Ironic that this is the precise time we began to see CVS’ longer-term rent minimums head higher relative to current payments (i.e. CVS either getting overly bullish or overly scared). Then by the time ’07 rolled around, the ratio continued to drop dramatically to what I’d call an unsustainable level, and CVS went ahead and bought Caremark in a transformational acquisition. Now it is sitting there almost 2 years since the announcement, and it needs yet another margin kicker. L-D-G.

Brian McGough
Director Of Research

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