The Finish Line (FINL) is an interesting story of a company in transformation, that has taken its hits (and rightfully so), and could now be poised for a move to the upside.
We will go into more detail throughout this report, but I would like to give a high level overview of the company and the investment thesis before we begin: The Finish Line is in the middle of a massive capex plan to grow the company through several different initiatives including a partnership with Macy's (M), investment in e-commerce and omni-channel retailing, growth of an acquired specialty running business, and in-store improvements and enhancements. This being said, the company has had several missteps in this strategy over the past 12 months, putting downward pressure on its stock price.
As we go through this article, I hope that each investor takes the time to understand the fundamental question of this investment: Do you believe that the company is making the right decision to invest in these various growth strategies, and do you believe they will make the returns necessary to justify both the effort and cash outlays? If you do not believe in these investments, I would look for another company to invest in, but if you believe these moves will be successful, then you could see hefty returns over the next 2-3 years.
Now, lets get into the details of the story…
Company Overview and Competition
The Finish Line is one of the nation's largest mall-based specialty retailers, focusing on athletic shoes, apparel and accessories. As of the latest 10-K, the company operates 651 brick and mortar stores under the Finish Line brand and 27 specialty running stores. The company also maintains an e-commerce business through the company's website, finishline.com, and its partnership with Macy's e-commerce site. The company is highly leveraged to the running category, as 57% of sales come from this category. The company also recently entered the specialty running store business.
When it comes to competition, one must look at Foot Locker (FL), which owns the Foot Locker, Champs, and Foot Action brands (pretty much the rest of the mall-based athletic footwear space). The key difference between the two companies is their focus - where The Finish Line focuses on the running category, Foot Locker and its collection of brands is more leveraged to the basketball category.
Another competitor to focus on is Dick's Sporting Goods (DKS), which sells about $1.2B in footwear annually (Note - as a percentage of sales, the footwear category has increased from 18% in 2010, to 19% in 2011, to 20% in 2012 for DKS). As Finish Line moves harder into the e-commerce space, they will compete against Amazon.com (AMZN), owner of Zappos.com.
Massive Capex Plan
The company has about $225MM in cash on the balance sheet and no debt outstanding, but they are beginning to spend this money. Over the past 12 months, the company has announced a massive, multi-year growth plan. We will go into greater detail on the individual pieces of the plan, but for now we will break down where the money is being spent.
The company recently broke out the spending for the next fiscal year:
Macy's Partnership - $17MM - used for shop construction and back office support
Technology - $35MM - To be used on digital, store technology, and merchandising/supply chain/CRM software
Running Company - $7MM - $15-20 new stores and regular capex
Brick and Mortar Finish Line - $24MM - 20-25 new stores, 10-15 relocations, 1-5 remodels, and 10-15 refurbs
So what does this all mean? First, we cannot value the company on today's cash balances because the company will face "cash burn" until the capex plan is completed. Cash from operations will basically match capex until the end of the major investment plan, meaning the company will use its cash fortress to payout the dividend and buy back stock. Second, we will have to compute a "normalized" capex level for the company after the current capex plan is completed.
One of the larger growth platforms of the company over the next 3+ years will be its new partnership with Macy's. There are approximately 450 locations where Finish Line will operate leased department store space inside Macy's stores, where they will focus on athletic footwear exclusively. There are approximately another 200 stores where Finish Line will manage the athletic footwear assortment and inventory, without the staffing or branding provided in the leased departments. Finishline.com will also be linked with Macys.com, providing another avenue to draw business to Finish Line's growing e-commerce campaign.
As of the date of this report, Finish Line has taken over ownership of the athletic footwear inventory at all Macy's doors and launched its digital presence on Macys.com. They will also begin rolling out Finish Line-branded shops to Macy's stores nationwide. Expectations are to open 20 to 30 shops each month and have a presence in approximately 450 Macy's stores by the end of 2014. On a run-rate basis, this transaction will add $250MM to $350MM in revenue (17-20% of current sales) and $.30 to $.35 in EPS (20-23% of current EPS). Finish Line has currently opened 3 of the new concepts to date and are "really pleased with the initial results." On Macy's Q4 call, Macy's CFO Karen Hoguet stated, "The Finish Line partnership is bringing added credibility to Macy's as a destination for this category, and we're very excited about the very early results in our first store they converted." Finish Line management is excited about the transaction as well, and calls it "probably the most exciting thing Finish Line has done in 30 years."
But there are risks involved with the transaction. This is again another way that management spreads its resources thin (more on this in a bit). Furthermore, the upfront costs involved with the transaction are eating into the company's fortress of cash. Additionally, there's no guarantee that the Finish Line brand will resonate with Macy's customer base as Finish Line's management hopes. It could also be said that Macy's is doing the transaction because it has not done well selling athletic footwear in their stores, and, as we have seen with a Macy's competitor, it is very difficult to change consumer behavior. There is no guarantee that bringing in an athletic footwear company will change where customers buy their running shoes. But it is more square feet in the mall for The Finish Line, and a good consumer demographic to focus on.
Overall, I think this is a great transaction for The Finish Line. As we noted above, inside the mall Finish Line competes for dollars with the multiple brands of Foot Locker. The ability to gain more presence in the mall, inside the walls of possibly the most popular big box mall retailer, will provide a great opportunity to not only increase sales, but also build brand image and loyalty with new customers. This could translate into new sales inside the brick and mortar and e-commence businesses in the future.
It's also a great partner to have in the company's push to become an omni-channel retailer. Macy's has done a very good job in its transition to omni-channel and it seems to be resonating with their customers (possible new customer for Finish Line). Plus, it's always nice to have a management team like the one Macy's has in your corner.
Technology & Omni-Channel Investment
To really understand the company's investments in technology and the omni-channel, you must understand the company's stance on the future of retailing. Over the past 12 months, CEO Glenn Lyon has been very open on his opinion, such as his comment on the last quarterly call: "I think that anybody who doesn't recognize that the Omni channel experience isn't at the center of the universe will be proven wrong 5 and 10 years down the road, if they don't make the investments to stay current, especially with the core customer that we talk to."
The company believes this part of the capex plan is a necessity to stay competitive. The investments in this category include: iPads and point of sale devices to check inventory and provide a faster shopping experience, a new digital website, investment in the mobile shopping space, and supply chain management software necessary to act as a multi-channel retailer.
Overall, I think this is more of a defensive move, but a necessary one. When we look at the investment we need to ask ourselves: Was is a good use of capital compared to other possible uses? (i.e. more share repurchases). I would answer this question with a resounding yes because even though it may not produce much benefit, I believe not doing so could permanently impair the value of the company.
The Running Company
In fiscal 2012, Finish Line acquired The Running Company stores, a specialty running company for active and competitive runners. At the time, the running specialty segment was estimated to be a $1 billion market. In early fiscal 2013, the company made a $10 million strategic investment in the running specialty business Gart Capital Partners (GCP), a team with a demonstrated track record of success in retail rollups. Finish Line owns 51% of the joint venture. GCP has the right to "put" and FINL has the right to "call" GCP's 49% interest in 2017. Also, as part of the transaction, GCP issued to the Company a $4 million related-party promissory note which is collateralized with GCP's interest in the venture.
In the latest investor presentation, the company laid out plans for the business that included adding approximately 20 new running specialty store locations through organic growth and acquisition per year and long term goals for the business. These goals included taking sales from $150MM to $250MM, growing the store base from 135 to 190 stores, and increasing operating margins from 4% to 12% - all by Fiscal Year 2016. When diving through the numbers, they are projecting adding approx. $.20 to $.30 cents of EPS through the transaction (13 to 20% of current EPS).
The Running Company is a true runner's store, tailoring to the need of competitive runners and an active running lifestyle. I like the concept - like a Lululemon (LULU) for runners (lifestyle brand), and the acquisition price was appealing. But there are risks involved.
This might seem like a fit inside the Finish Line business, but The Running Company customer is very different from the traditional Finish Line customer, and the business will be run by external management. Also, there seems to be some deterioration in the growth of the running category (more on this later), but we should note that The Running Company is a little more insulated from this risk. What's more important is again, the Finish Line management seems to be all over the place in their growth plan. I will give management the benefit of the doubt as they specialize in the running category, but this is the part of the growth plan I am still on the fence about. It seems more like a reach for growth (like they need another avenue?) than an acquisition they can monetize more efficiently than a standalone entity could.
Returning Capital to Shareholders
Management had been aggressive in its share repurchase campaign during FY2013, buying back 3.9MM shares (approx. 7.5% of the total float). Management has put share repurchases into this year's guidance, but plan to be far less aggressive as they guide to about 1MM in share repurchases in FY2014 (slightly higher than 2% of the company).
Management also increased the dividend in the last quarter by 17% to $.07/quarter (currently a 1.3% yield). Increased capex will keep share repurchases in the 1MM share/year range for the foreseeable future, or at least until the Macy's deal and digital investment is completed (say about 2-3 years). If all goes well, 2015 could be another year of aggressive share repurchase as I project the company could buy almost 10% of the outstanding shares in that year once the aggressive capex plan winds down.
Management Miscues and Risks
FINL sounds like a no-brainer so far. 6.0x EV/EBITDA for a company with almost a quarter of its market cap in cash, no debt, store growth and e-commerce opportunities, returning cash to shareholders, and a partnership with Macy's that will increase EPS by 20%.
Usually in these instances, there is a reason for the company's low valuation, and in the case of Finish Line the reason can be found in repeated management miscues over the past 12 months. Taposh Bari of Goldman Sachs could not have said it any better in his Q&A on the latest quarterly conference call:
Taposh Bari - Goldman Sachs Group Inc., Research Division:
So Glenn, I have a question for you. In terms of the feedback we get from investors there are -- I think a lot of opportunities here, particularly with Macy's, I'd say the one common thread continues to be I guess a lack of confidence in the execution profile.
CEO Glenn Lyon did not shy away from the fact that the management team may have been "overly ambitious" with both the variety and speed in which they have rolled out their growth initiatives, but instead stressed the importance of the overall plan and focused on the speed in which they recognized the problems. Mr. Lyon then laid out plans to slightly slow down the pace of the initiatives to get the company closer to the conservative style it was founded on.
We know the multiple baskets Finish Line currently has its eggs in (Digital, Remodels, New Stores, Macy's, Point of Sale devices, Omni-Channel), but let's spend a little more time on the miscues that resulted from management "spreading themselves thin."
Running Comp Declines
As we noted earlier, running shoes make up 57% of FINL sales and have far more leverage to the product than any of their competitors. On the Q3 Call, FINL management highlighted a multi-year customer shift away from running towards basketball, sending shares lower. On the latest call, it was highlighted that the intensity of shift Finish Line saw was not industry wide, but in fact related to company specific execution. Now let's note, even FINL competitors have called out that running will be a single digit grower in the future while at the same time the industry has seen +20% growth in the basketball category, but the realization that Finish Line had company specific issues in the running category is alarming, and this could be another sign that management could be sacrificing its bread-and-butter while chasing growth elsewhere.
In 2012, as part of Finish Line's massive capex campaign, the company highlighted a move to a new e-commerce site. On the Q3 call, CEO Glenn Lyon stated that part of the sales drop they saw was related to mis-execution on the new site and that they would be transitioning back to the old site.
The third component of our underperformance was the decision to launch a new e-commerce site ahead of the holidays. As I said earlier, digital sales for the quarter were up 25%. However, we believe the new site, which came online November 19, cost us approximately $3 million in lost sales for the third quarter. Following the launch, it became apparent that the customer experience was negatively impacted, evidenced by a decline in several key performance factors -- indicators. Therefore, we made a strategic decision on December 6 to transition back to our previous site given the importance of the selling season.
"This has generated improved results versus what we experienced during the 3-week period the new site was live. Our specific plans for the future of our website will be determined in the upcoming months."
Shortly after the Q3 call, it was announced that Christopher Ladd, chief digital officer and executive vice president, would be leaving the company. On the Q4 call, management highlighted that there would be a write-off of the new digital site.
I am happy to see the proactive nature management has taken, and the stellar growth continuing in e-commerce, but it's another ding in the armor of a traditionally strong management team.
New Concept Stores Gone Wrong
Another piece of the capex plan was to roll out new concept stores. On the company's latest quarterly call however, management highlighted that the new concepts were not performing as strong as expected and that capex would be better spent on small remodels inside the current store base. Remodels will include painting, changes to flooring, and back-of-the-room investment.
Additionally, the company will continue to grow the store base, but the majority of store openings will be outlet stores. It should also be noted that the store-inside-a-store concepts (Nike (NKE), Under Armor (UA), etc.) have had strong performance and will continue to be rolled out as well.
Again, some proactive moves after seeing problems, but this step-back on new concept stores highlights yet another management miscue.
The company saw a 140 basis point decline in operating margins over the past 12 months, driven by a 150 basis point decline in gross margin, partially offset by a 10-basis-point improvement in SG&A. Management also expects operating margins to contract in fiscal 2014 from current levels, with much of the contraction driven by the margin profile of the Macy's start up. They "will continue to be faced with comp sales and gross margin headwinds, particularly in the first half," but expect to get some of it back in the 2nd half of the year. Also, note that markdowns on inventory will put downward pressure on margins in the short-term.
I will give kudos to management for their quick reaction to the problems associated with the new Finish Line website, but this is only one piece of a much bigger problem. It was not only the user experience of the new site that was to fault for the performance, but also the timing of the switch. Also, the company has done little to calm the dears investors have in regards to the other execution issues at the firm.
Management has been given a little bit of a pass because of its overall performance since 2008, but the leash just got a whole lot tighter. If the firm continues to see missteps in its growth plan, you could see a larger shakeup in management (more on this later).
From a valuation perspective, I like to look at the long-run earnings power of a company based upon normalized fundamentals. Right now, the company is in a period of increased investment and integration, but as an investor what I care about is: When the planned changes are finished, what will I be left with? With this in mind, I have chosen to value the company 3 years out, post the increased capex plan.
As we talked about earlier, cash flow from operations will basically be equal to annual capex throughout the remainder of the capex plan, meaning the company will face cash burn as they return capital to shareholders. This would include approx. $30MM in dividend payments and $45MM in share repurchases (1MM share repurchases per year for the next two years). That would leave the company with $150MM after the capex plan is completed. It also means that the company can self-fund all programs, so just as today, there should be no debt on the balance sheet.
From an earnings perspective, I would like to make sure I still get a good return on my investment even in a conservative scenario. I will now break down the revenue and earnings for each of the company's segments:
- The Finish Line - Because of management miscues, I am assuming flat comps in the brick and mortar business over the next 3 years, marginal growth in the e-commerce business, and revenue growth from total sq footage growth attributable to new stores (3.5% annually). That gets us to about $1.6B in revenue in 3 years. A 9% normalized operating margin that gives us $125 MM in EBIT and about $1.73 in EPS.
- Macy's - Even though I am a fan of both Macy's and this partnership, management execution forces me to be conservative and use the low end of the guidance for the transaction. This gives us $250MM in revenue, $20MM in EBIT, and $.30 EPS.
- The Running Company - I am less bullish on this transaction and will again use the low end of the guidance range. This gives us $250MM revenue ($100MM incremental), $15MM EBIT, $.20 EPS. Note - Finish Line owns 51% of the partnership, so we will add $.10 to EPS.
We should also highlight normalized depreciation, capex, and free cash flow. For FY 2013, FINL expects Depreciation of $36-$38MM. Taking into account a growing store base, I am going to use $40MM in depreciation. For "normalized" capex, I will remove the Macy's and technology investments as those initiatives will be completed, but keep the capex for the Brick & Mortar and Running Company stores as they are attributable to store growth and maintenance. That would get us to $31MM in normalized capex.
Combined, this gets us $2.1B in revenue, $190MM EBITDA, $2.13 EPS, and $105MM in free cash flow. I have used 48MM outstanding shares as I assume 1MM in share repurchases annually for the next two years. If this number is greater, EPS will increase, but our cash balance will be lower.
Below I have shown the valuation metrics used under this conservative "base case" scenario. Note that I have used slightly improved multiples since if this scenario were to play out, there would be less concern over management execution, which would justify this small change in valuation.
|Current Valuation||Valuation Used||Equity Value|
Including the annual dividend, we would get an approximately 40% return over a 3-year horizon under this conservative scenario.
Now, let's assume that management execution improves (see catalyst section below) and the company hits the high end of their projections. That would give us $2.2B in revenue, $240MM in EBITDA, $2.70 in EPS, and $130MM in free cash flow.
Below I have shown the valuation metrics used under this conservative "bull case" scenario. Note that I have moved the multiples to normalized levels because under this scenario, the risks that have suppressed the multiple play out to not be risks at all.
|Current Valuation||Valuation Used||Equity Value|
Including the annual dividend, we would get an approx 100% return over a 3-year horizon under this conservative scenario.
The most important question is: What can I lose on the downside? The downside scenario is that these investments in growth don't work. This assumption would mean that there is no future EPS accretion from the running company and Macy's transaction, and the traditional brick and mortar stores face permanent margin deterioration. That would give us $1.5B in revenue, 7% future operating margins, $135MM EBITDA (using company's estimate for future depreciation), $1.50 earnings per share, and $85MM in free cash flow.
Below I have shown the valuation metrics used under this conservative "bear case" scenario. Note that I have used lower multiples because under this scenario, I believe investors will lose all faith in the current management team.
|Current Valuation||Valuation Used||Equity Value|
Including the annual dividend, we would get an approximately 20% loss over a 3-year horizon under this downside scenario.
I would like to also note something I wrote above - "under this scenario, I believe investors will lose all faith in the current management team." Considering Finish Line has a strong brand, no debt, and would be trading at 5x EBITDA under this scenario, I believe Private Equity firms or activist investors could look at the stock as either a takeout target or an opportunity to bring in a new management team. Using $135MM as EBITDA, a takeout target could easily fetch 8x this amount, or a $26 per share.
Overall, with the valuations I have described above, I would get an almost 2-1 risk/return ratio between my conservative and "bear case" scenarios, with the benefit of a healthy upside scenario if these growth initiatives all work out.
The catalysts over the next 12-18 months will deal with company-specific execution. We will be provided updates on the rollout of Macy's stores, new Running Company stores, margin and comps guidance, and digital sales growth. Right now, FINL is "cheap for a reason," mainly a lack of execution. The ability to calm the market on this execution is the key to multiple expansion, and better yet, stronger earnings power. Investors would be wise to keep up on company presentations and quarterly conference calls for updates on the success/failure of the growth initiatives.
Also note, a rebound in the running category (FINL's largest segment) would also be a catalyst for the stock.
Overall, I believe that The Finish Line is a company that is being undervalued for mishaps, but when you look at the actual opportunities the company is being presented with compared to the risk associated, it becomes a very attractive investment. The Macy's deal has the ability to increase revenues both through the partnership and inside their store base, the company is making the investments necessary to stay competitive in a changing retail landscape, and the valuation of the possible scenarios is attractive. I am using a $27-$31 price target range based upon my conservative scenario. I am using a downside target of $17 and a possible upside target of almost $40.
The Finish Line is currently in a time of transformation and uncertainty, but those can be some of the best times to be an investor. The company has a clear, yet broad strategy to improve earnings power and position the company to have a competitive advantage in the future. Again, the main question you must ask yourself is: Do you believe in this strategy? If you do, as I do, then FINL could be a good stock for your portfolio.
Additional disclosure: I have no position in FINL, but may initiate a long position over the next 72 hours.