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Introduction

Foot Locker (NYSE:FL) is a global athletic shoe and clothing retailer, located in malls and stand-alone stores across the USA, Canada and Europe. FL is best known for their variety of athletic shoes and sports apparel. The company offers men's and women's basketball, running and training shoes, and their business model is fairly straightforward as a footwear and sporting goods retailer. From a quantitative prospective, FL shares trade at about 14x trailing EPS and more importantly 10x forward EPS, a discount to the retail and footwear industry. Our report will show that FL shares should move toward our price target due to fundamental reason, such as consumer spending, valuation, performance metrics, online threats and revenue from mall trends. Based on proprietary discounted cash flow analysis done by The Oxen Group, FL shares are reiterated as a HOLD, with an implied price appreciation of 9%.

Profile

According to FL's latest 10k, the company was founded in 1974 and is primarily in the business of selling shoes and athletic accessories around the world, targeting both genders, but mostly men. The company is approximately worth $5B. From a macro prospective, the company is organized in two segments, direct to consumer and retail. Retail is further broken down into the various stores - Foot Locker, Lady Foot Locker, Kids Footlocker, Foot Locker International, and Champs Sports. In terms of selling square footage, the largest and most material stores include Foot Locker USA, International, and Champs Sports. The direct to consumer segment operates the websites for the various stores and EastBay.com.

Thesis

Valuation -

FL trades at a severe discount to apparel companies in the consumer cyclical space, while overall valuation in the apparel industry is much higher than the footwear industry. Foot Locker is interesting because the company can be viewed as a hybrid between footwear and retail.

While the firm isn't in the business of making shoes, it does correlate to footwear more than retail. During October 2012 to January 2013, FL (over a 21 day period) had a solid and steady correlation coefficient of above 0.9 with footwear, while over the same period had a correlation coefficient ranging from 0.85 to -.35. The take away from this little exercise is that FL trades with the footwear sector and not necessarily in the retail sector (where Wall Street places them).

The average forward multiple in footwear is roughly 14.8x and the median is about 13.9x. FL, at 12.6x forward, trades below its industry average and median forward multiple. For good measure, the average forward multiple in retail is 19x. This is a slight discount.

In net margins, FL underperforms footwear. 58% of its footwear competition has higher net margins than it. Additionally, FL is below average net margins of 10.2%.

FL's management, however, outperforms the competition. The firm's ROE is better than 68% of retail and better than half the footwear industry at 17%. Wall Street is expecting ROIC to grow 700 bps by 2014.

Catalyst -

Economic catalysts may move FL. Retail sales trends provide a macro view on the consumer. Retail sales measure the total amount of receipts at stores that sell merchandise and related services to final consumers. This takes into account retail locations and food service. The latest data on this indicator showed that Retail sales in January grew at a mere 0.1% and for prospective in December gained 0.5%. January slowed as a result of the government increasing taxes during a fragile economic recovery and higher gas prices. Taxes are also touched on in the variant section. While these numbers are backward looking, these trends could move FL from a macro prospective down.

We see little catalyst to shares with Americans cash-strapped, European economies weak and the company lacking a strong presence in developing markets.

Economic Moat -

Foot Locker's economic moat is rather shallow. FL discloses in SEC filings that they are in an industry and sector with low barriers to entry. While FL has a jump start on branding and locations, the threat still exists. FL is mainly up against, "athletic footwear specialty stores, sporting goods stores and superstores, department stores, discount stores, traditional shoe stores, and mass merchandisers, many of which are units of national or regional chains that have significant financial and marketing resources." (FL's SEC filing.)

Young males ages 12 - 25 are FL's target, this demographic is subject to quick changes in tastes and presents a risk to FL if stores are not prepared…especially if inventory is not properly managed.

Revenue and EPS Outlook -

FL's Internet presence has been slowly growing since 2009 as a percent of total sales, direct-to-customers has gone from 8.3% in 2009 and up to 9.1% of sales in 2011. Year over year Internet sales during the period of 09/10 - 10/11 had an average growth of 12%. Projecting this average growth rate out to 2016, consumer direct (Internet) may become roughly 13% of sales, much larger than now. A robust Internet presence is vital for the future, especially as many other retail operations are being squeezed by the likes of AMZN and bricks and mortar stores come into question. Yet, even with this trend, we do not see it strong enough to drastically increase our price target.

Further, FL does not have enough original merchandise. The company buys approximately 82 percent of its merchandise from its top five vendors and expects to continue to obtain a significant percentage of its athletic product from these vendors in future periods.

While acting as a middleman does hurt its margins, the company has performed well in the mall space, outperforming peers. According to Integra Retail's information database, the average sales PSF (per square foot) of a US mall is roughly $360 or according to BizStats $391. FL outperforms the average here. The company clocked in at $406 on average in 2011, comfortably above average. So while upside is questionable, downside risk seems limited as well.

The average US mall sales PSF are $514 for men's shoes and $397 for women's shoes. Now, FL is underperforming its competition, for men's sales PSF are more material, accounting wise. The sales PSF, however, has been trending up. Since 2007 sales PSF have been on average up 3.8%.

Price Target Analysis

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

587

602

648

675

719

Taxes

205

211

227

236

252

Depreciation

116

125

135

145

159

Capital Expendit.

-161

-170

-175

-180

-181

Working Capital

90

90

90

90

90

Available Cash Flow

247

256

291

314

355

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for FL: 9.24%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9154

0.838

0.7671

0.7022

*

PV of Available Cash Flow

226

215

223

220

*

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.

Cap Rate for FL: 6.24%

2016

Available Cash Flow

$355

Divided by Cap Rate

6.24%

Residual Value

5,694

Multiply by 2016 PV Factor

0.7022

PV of Residual Value

$3,999

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

$884

PV of Residual Value

3,999

Cash/Cash Equivalents

853

Interest Bearing Debt

133

Equity Value

$5,603

Step 5.

Divide equity value by shares outstanding:

Equity Value

79,025

Shares Outstanding

3,810

Price target

$20.74

Profit/Value Industry Comparisons

Profitability and Dividend:

FL

FL is Better Than X% of Industry

Gross Margin

32.66%

94%

FL

Industry Avg.

Dividend

2.16%

1.2%

Variant

FL's total operating expense has come dangerously close to revenues, as expressed in the chart. This figure includes the cost to acquire merchandise. FL's main supplier is Nike (NYSE:NKE). But a risk to diversifying suppliers includes taste risk. Consumers clearly love Nike, but should FL decide to lower their cost of revenues by purchasing from other distributors/manufacturers sales may slump in retail operations, so a delicate balance must be kept with NKE, for FL clearly depends on NKE.

Higher taxes may also have an adverse effect on FL. We are starting to see the impact of higher taxes," said Robert Dye, chief economist at Comerica in Dallas. Just as the economy seems to be on the rebound and as Europe subsides, leave it to the government to close down the party. Expensive sneakers may be the first thing to go if taxes continue upward under the current administration.

The Bottom Line

FL is an interesting company. Approximately 61% of sales merchandise is purchased from one vendor - NKE. Perhaps if one was inclined to get long/short consumer retail/footwear cyclical, Nike may be a more efficient way to execute, but FL has a few other inputs into its business, for example mall traffic and sales PSF. FL shares are a HOLD according to The Oxen Group.

Source: Brick And Mortar Retail Is Dead: Foot Locker Lacks Upside Catalyst