FL: Lease Optionality

It’s common perception that leases for mall retailers have zero optionality. I agree from an asset sale vantage point. But there’s more wiggle room with accounting and margins.

The wiggle room Foot Locker has with its real estate profile over the next five years should not be underestimated. I think that this provides the company with some downside margin support to the extent that I am wrong in my view that margins will recover over the next 12-18 months due to stronger business levels over a leaner cost structure.

Specifically, FL’s operating lease commitments decline to 55% in five years. Seems intuitive given that FL is a zero square footage growth retailer and leases are coming due faster than new ones are being signed. But the reality is that there’s no shortage of retailers that have a severe (negative) mismatch between growth and rents. There’s Dick’s, DSW, Whole Foods, and CVS, to name a few. Foot Locker is at the opposite end of the spectrum.

Think of this ratio as you would a discount rate on retirement assets. A company can choose to account for them with a high expected rate of return, hence requiring lower annual accruals and setting a high hurdle going forward. Or they can do the opposite and go with an ultra-conservative rate, booking higher annual payments but depressing margins. That’s Foot Locker.

I can’t ignore the fact that minimums coming down so much outlines how many of FL’s leases expire over 5 years – which means that management will need to be smart about whether it renews, relocates, or shuts down. The company’s history is spotty at best in that regard.

But my point on this one is that if FL so chooses, it can more aggressively tackle its leases and pad its margins. It won’t be pretty, but it’s an option. Other companies don’t have that option.

I’ll take conservative lease accounting at trough margins over aggressive accounting at peak margins any day.
FL's year 1 rent payments divided by year 5 contractual minimums are far more favorable than peers.