|Shares Out. (in M):||134,000||P/E||0||0|
|Market Cap (in $M):||9,757K||P/FCF||0||0|
|Net Debt (in $M):||-919||EBIT||0||0|
Foot Locker, Inc. (FL) is a liquid large cap global retailer of athletic footwear and apparel that trades today at a cheap 11.3% EBIT/TEV yield.
While FL’s target customer has traditionally been the sneaker aficionado (think Air Jordans), it also caters broadly to the active lifestyle customer, offering “athleisure” clothes designed for workouts and sports that can also be worn casually. Today, the brand is about more than shoes for running and basketball; it is about style in fitness, and a passion for culturally resonant products.
FL operates 3,363 stores, across multiple formats, primarily in malls and urban retail areas, and has ~16k full-time and ~34k part-time employees. FL also has a growing Direct-to-Customer segment, which sells merchandise from leading athletic brands over the internet. Footwear sales comprise approximately 82% of revenues, with apparel and accessories making up the remaining 18%.
In February last year, MiamiJoe78 wrote up FL as a short. Maybe he is still right, so let’s examine the bear case.
The bear case is fairly obvious. American retailers are under siege and signs of the retail apocalypse are everywhere. A-M-A-Z-O-N.
Last summer, Sports Authority was liquidated in bankruptcy, closing 450 stores. At last count, there have been 10 retail bankruptcies this year. Last month, RadioShack declared bankruptcy for the second time in 2 years. Last week, Payless ShoeSource declared bankruptcy. Ralph Lauren is closing its flagship Fifth Avenue Polo store.
Credit Suisse estimates that US retailers are on track to close almost 9,000 stores this year. The next highest total in the past 20 years was during the great recession, when retailers closed ~6,000 stores.
And the carnage could continue. CoStar Group estimates nearly 1 billion square feet of US retail space may need to be closed over the next few years, representing ~10% of the US total. Malls are overbuilt. Amazon and mobile shopping continue to eat bricks-and-mortar retailers alive.
The CEO of Urban Outfitters recently referred to a retailing bubble, and said, “like housing, that bubble has now burst.” Apparel stocks such as Urban Outfitters, American Eagle and Lululemon are plumetting to multi-year lows.
“Why, Jamal, why?” you might ask. “MiamiJoe78 is a nice guy. And smart! Plus, you wrote up Urban Outfitters last summer which is down big, and now this?!”
A Contrarian Play – It’s Gotta be the Shoes
If you have ever wanted to be a true contrarian, here is your chance. And if you need a one word summary for why things might be different for this retailer than the other Wall Street whipping boys, that word would be “sneakers.”
It’s hard to overstate the passionate intensity of “sneakerheads,” who fuel the growth of FL’s core ~$28bn domestic retail sneaker market, and an international market worth ~$55bn, which is roughly the GDP of Panama. There are titanic brand forces at work here. Consider that Lebron James’s Nike deal is worth > $1bn.
FL is a leading exponent of global sneaker culture through a consistent stream of events, promotions, athletes and celebrity endorsers, and branding partnerships featuring hot products, all with a connection to local community and global culture. It’s fertile ground for any retailer, since the global sneaker market is a branding bonanza.
Need some fresh ideas for the brand? Look no further than the new crop of pro sports draftees. Last year, before the NBA draft even took place, eventual #1 pick, 6’10” Australian NBA rookie Ben Simmons had already appeared in a Foot Locker ad, been featured in a Showtime documentary, and signed a $7.5mm deal with Nike. Last year, Nike signed 15 members of the rookie NFL class.
There is no shortage of professionals to choose from. Tennis players, golfers, soccer players, baseball players, and more. Last fall, you could have seen GQ’s Man of the Year, Usain Bolt, when he visited the PUMA Lab at Foot Locker’s flagship store in Times Square to promote his shoes.
Sneaker branding continues to evolve. In recent years, the sneaker has become a fashion status symbol associated with many non-athletes. Last year, for example, the rapper Kanye West left Nike for Adidas for a reported $10mm, and a chance to launch the “Adidas + KANYE WEST” Yeezy brand. Why is a rapper getting a sneaker contract? When you have a guy who can sell out shows at Madison Square Garden and has 27 million followers on Twitter, it doesn’t remotely matter if he can’t hit a jump shot. People still want to wear his shoes.
And most people don’t buy sneakers for actually playing sports anyway. The Sneakernomics blog at Forbes used data from the NPD Group to estimate that 75% of athletic shoes are used as casual sportswear, rather than in actual sports contexts. So sneakers are about status, and maybe a dream.
The typical FL store visitor is younger, at 14-25, and sees sneakers as a way to participate in global style and culture. They want to “be like Mike.” They identify with Lebron James, Kevin Durant, and Kobe Bryant. They camp out at the stores before big releases, when their passion can lead to a feeding frenzy effect, when new product “drops” arrive, occasionally triggering near-riots. We are talking deep passion.
These are the same teenagers who show pictures of their sneaker closets on Instagram, and who have created a thriving sneaker collector sub-culture. UK-based hip hop DJ Kish Kash has said, “I don’t know how many pairs I own – I stopped counting at about 2,000.” But that’s not unusual.
Consider that the resale market for sneakers is now > $1bn. Check out Campless, which measures price, volatility and dead stock statistics for sneakers in the aftermarket. Here is a TED talk about it:
Thus, FL is not really a “shoe store.” It is a kind of cultural phenomenon, which differentiates it from other retailers. By combining athletics, hip hop culture, fashion, recognizable brands, limited release scarcity, and the network effects of social media, FL is able to drive positive mall traffic when practically every other retailer is suffering declines.
A word on bricks-and mortar. It’s not a stretch to say that for some shoppers, a purchase like this can have an emotional component. Maybe some customers enjoy spending time with their friends, and/or they enjoy the immediate gratification of seeing the product and then wearing it out of the store. Some people prefer the ritual and to see all the brands physically, rather than on a static web page.
FL has built a culture around the in-store experience, and some customers enjoy the personal connection with the sales associates in the zebra-striped referee outfits who really know and understand the products and trends.
And then there is fit. People won’t want to buy a pair of shoes that don’t fit. Maybe those Nike Kobe’s run large, or wide. So when you shop online, you run the risk of having to return the shoes via UPS. That’s a hassle.
None of this is meant to suggest that FL is immune from the laws of Amazon physics. Sneakers will increasingly be sold online. But we think there is reason to believe that the factors mentioned above might slow the transition to digital distribution more so than currently expected, at least relative to other types of retail.
The Trend is Your Friend
As we know, trends are fickle. As the screenwriter William Goldman, writing about Hollywood trends, put it: “Not one person is the entire motion picture field knows for a certainty what’s going to work. Every time out it’s a guess and, if you’re lucky, an educated one…Nobody knows anything.”
Yet we do know a few things. There’s something special about the sneaker. Some people still enjoy shopping in a store. Pro sports keep growing, renewing star rosters, and reaching new markets. Fitness culture is in ascendance. The lines are blurring between athletics and leisure, as sportswear merges with fashion. Street culture and hip hop are merging into mainstream fashion culture.
We also know that Foot Locker, being ground zero for many of these trends, is good at making educated guesses, and has done a phenomenal job historically of taking advantage of the zeitgeist. Last year is an example of strong execution in a challenging environment.
FL has two reporting segments: Athletic Stores, and Direct-to-Customer.
FL employs a variety of retail store formats, including Foot Locker, Kids Foot Locker, Lady Foot Locker, Champs Sports, Footaction, Runners Point, Sidestep, and SIX:02. Store count growth was approximately flat last year. The Athletic Stores posted YoY comparable store growth of 4.3% last year.
Footlocker.com and other store banner brands, and international affiliates, via internet and mobile sites, represent the direct-to-customer business. FL has done a good job building digital sales, with the direct-to-customer business growing steadily over the past 8 years, from 8.4% of sales in 2009, to 13.2% of sales in 2016. Last year, direct-to-customers grew by 8.3%.
Last year, overall sales were $7.8bn, representing YoY growth of 4.8%. The company has stated its long-range goal is to achieve $10bn in sales by 2020, representing a ~6.5% CAGR going forward. Currently, approximately one third of FL’s stores and a number of direct-to-customer sites are outside the US, chiefly in Europe, Canada and Asia. The resultant foreign currency fluctuations (e.g., Euro, Canadian Dollar, UK Pound, etc.) had a negative effect last year, and excluding this effect sales growth was 5.2%.
Thus, overall, the picture is of solid, if unspectacular sales growth, but certainly better than many retailers. We think much of this is due to FL’s strong positioning in the sneaker market. For 2017, the company projects mid-single digit comparable sales gains, consistent with recent history and the 2020 plan. It also projects double digit EPS gains, based on continued margin growth, better order planning to reduce markdowns, additional operating efficiencies, and reduced share count. We believe these goals are achievable.
Economic Franchise Value
Taking a step back from granular store comp and EPS figures, we argue that FL’s ability to create excitement and a culture around the products it sells represents franchise value, giving the company a sustainable competitive advantage that is reflected in a few key long-run accounting metrics.
Geometric ROA and ROC
We like to examine longer term geometric returns on assets and capital, since they demonstrate long term trends, and reward stability while penalizing volatility as compared with arithmetic returns. Generally, we believe stocks that generate strong and stable returns on assets and capital over a sustained period are more likely to possess a durable economic franchise.
FL has averaged a geometric ROA of 11.2% over the past 8 years, which is better than 83% of our investable universe (> $2bn mkt cap), and indicates a consistently efficient use of assets. In the last three years, for example, the company grew sales per gross square foot from $490 in 2014, to $515 in 2016. The company has said its long-run objective is to achieve $600 per square foot.
FL has generated an 8-year geometric ROC of 15.2%, which is better than 81% of our investable universe, and indicates that FL has earned consistently high returns on its invested capital.
Cumulative Free Cash Flow Versus Assets
FL has more than doubled free cash flow over the past 8 years. The sum of its free cash flows over this period equates to 78% of the value of its assets, a ratio that is better than 85% of our investable universe. We see impressive free cash flow scaled by assets as another indicator of FL's impressive franchise value.
FL has grown its gross margins in 7 of the past 8 years, from 27.4% in 2009 to 33.9% in 2016, representing a CAGR of 3.1%, a growth rate that is higher than that for 78% of the companies in our investable universe. This growth in gross margins suggests FL has some pricing power in its markets, consistent with the existence of a franchise.
Recent Operating Momentum
FL’s 2016 ROA and ROC were 17.0% and 23.1%, respectively, with both metrics higher than for 2015. Also during 2016, gross margin increased 14 bps to to 33.9%. Trends in FL's long-term franchise metrics appear to have remained in place over the TTM.
Liquidity metrics also showed favorable trends, indicating financial health. During 2016, the company decreased its leverage, increased its current ratio, and returned capital to shareholders, paying out $147mm of dividends and repurchasing $432mm of stock. Notably, the Board announced a new 3-year repurchase program totaling $1.2bn, representing a 20% increase over the prior repurchase program.
FL’s franchise value is based on its ability to create and leverage brand value within the global sneaker industry. Despite headwinds for retail generally, FL has weathered the storm, maintaining and growing key vendor partnerships, increasing comps, growing its digital business, generating operating efficiencies, and repurchasing stock. These trends are all consistent with the longer-term fundamentals.
FL’s strong long term (8-year) geometric ROA and ROC, margin growth, and ample free cash flow indicate it has consistently created value over time, and possesses a durable economic franchise, with a vibrant and dynamic global sneaker culture as its foundation.
Based on its EBIT/TEV yield of 11.3%, it is cheaper than > 95% of our investable universe of stocks greater than a ~$2 bn market cap. That is inarguably cheap. We believe at this price, the high quality of the FL franchise represents good value.
- Continued success of sneaker culture, and global branding efforts
- Slower than expected transition to "Amazon takes over the world" scenario
- Additional operating efficiencies
- Share repurchases