Shares of athletic footwear retailer Finish Line (FINL) soared after the firm announced lackluster fourth quarter results. Revenue fell slightly on a reported basis, though when adjusted to reflect a comparable selling period, revenue ticked up 4% compared to a year ago - still slightly below expectations. Earnings per share fell 6% year-over-year to $0.76, but were up about 3% when excluding the extra week of fiscal year 2012's fourth quarter.
Same-store sales increased just 0.7% year-over-year, driven by a 21% increase in digital sales. We were disappointed in the huge divergence between Finish Line and rival Footlocker (FL), which posted same-store sales growth of 7.9% in its fourth quarter. Footlocker's superior basketball product allocation from Nike (NKE) has helped the company ride the basketball shoe tailwind to superior fortunes. Unfortunately, Finish Line decided to bet on the running category, just as basketball re-established itself as a growth engine. We believe management should have seen this trend coming, so it makes us question management's ability to execute going forward. Management acknowledged this error, and provided some interesting insight into the footwear category, saying:
"During FY '13, we reinforced our leadership role in running through a tremendous assortment of innovative products from the likes of Nike, Brooks, ASICS, Mizuno and Adidas. For the year, running comps increased just over 2%. This comes on top of a 3-year stack comp of 54%.
"The performance of our basketball business, which increased 21% on a comp basis, was a major highlight for 2013. The fourth quarter marks the 9th quarter in a row where our basketball business has grown double digits. Much of this year's gain came from Brand Jordan and Nike, both of which had multiple compelling product introductions that infused excitement into the category and helped us drive traffic into our stores and website. Additionally, with the launch of its Derrick Rose signature series, Adidas also posted a strong increase year-over-year."
In our view, it's clear that Nike is the current leader in footwear, so anything Finish Line can do to improve its relationship with the company will be a net positive. In Finish Line's defense, the firm received a large allocation of Nike's new Flyknit running products which have been selling well, according to management.
Gross margins declined approximately 200 basis points year-over-year to 35.1%, driven by lower product margins and occupancy deleveraging. Finish Line's gross margins still exceed those posted at Footlocker, but management suggested that gross margins will be under pressure during the first half of the year, so we could see some convergence between the two industry leaders.
SG&A declined 90 basis points as a percentage of sales to 21.4% as the firm leveraged occupancy expenses with sales growth. Again, management anticipates some deleverage in fiscal year 2014 as the firm invests in long-term lease renewals in high performing locations, e-commerce improvements, and the company's new partnership with Macy's (M).
Speaking of which, we believe positive commentary about the Macy's partnership altered the consensus view on the company. There was a little bit of skepticism surrounding Finish Line's targets for sales and EPS contribution, which management has suggested lies around $250 million to $350 million and $0.30 to $0.35, respectively. Critics previously raised concerns that Finish Line would not provide these new "shop-in-shops" with good products, but CEO Glenn Lyon hammered home the point that Finish Line's key suppliers were excited to push new product through the Macy's channel. With the support of Nike, Adidas, Under Armour (UA), New Balance, and others behind the project, we believe the odds of success look high.
Looking ahead, the firm anticipates earnings per share will increase and a mid-single digits pace driven by a modestly positive same-store sales growth rate and 10-15 net new stores. The Macy's relationship could add $130 million to $150 million in incremental sales, and is expected to be modestly accretive to earnings. We believe guidance was conservative, and we see some upside if the company is able to wrestle more premium basketball product from Nike, albeit at a lower margin.
On the capital management side, capital expenditures are anticipated to be relatively flat at $80 million to $90 million, even with $18 million of capital invested in the Macy's partnership. We think the firm's e-commerce business will go through an overhaul in fiscal year 2014 so it competes better with the likes of Footlocker and Dick's Sporting Goods (DKS, which have fantastic e-commerce businesses. Finish Line could also repurchase up to 5 million in stock, and it will continue paying its $0.28 per share dividend.
Overall, we think Finish Line's capital management has been fantastic - the firm sports a solid cash balance of $227 million versus no interest bearing debt-and has focused on returning excess cash to shareholders. Our skepticism surrounds the firm's ability to execute on the e-commerce front - the previous website was a complete flop. We believe the Macy's deal partnership will be highly accretive when fully ramped, especially since Macy's omnichannel retailing strategy has been fantastic. We think shares look fairly inexpensive on both a DCF and relatively basis, and we could consider adding shares to the portfolio of our Best Ideas Newsletter.