Since Ken Hicks became CEO around two years ago, Foot Locker (FL) has experienced a bit of a turnaround story. Since the start of 2009, the stock has gone up by 192% and continues to succeed in a difficult market. Add a dividend yield of 2.9%, and Foot Locker is very much a defensive play for investors concerned about a double dip. However, what makes Foot Locker an attractive investment is not so much its solid and improving fundamentals, but rather, that it is an attractive takeover candidate for sportswear powerhouse Nike (NKE).
In an earlier article, I argued that the potential buyout of Under Armour (UA) would be positive for Nike. I am now of the opinion that acquiring Foot Locker would be even more value accretive to Nike.
Firstly, from a value standpoint, Foot Locker is far more undervalued than Under Armour. Brand appeal and product offering is roughly the same for both companies, but Foot Locker comes out as the cheaper candidate. While Foot Locker trades at a respective 14.6x and 11.8x past and forward earnings, Under Armour trades more than double that, at a respective 58.4x and 37.8x past and forward earnings. Moreover, in terms of returning cash to shareholders, Foot Locker offers a 2.9% dividend yield while Under Armour offers no dividend yield.
Secondly, Foot Locker has a fair amount of net cash at hand, $545M, or 15.8% of market value. When you consider that Nike's net cash position, $3.2B, is only 7.1% of its market value, the acquisition can prove beneficial in better capitalizing the firm going forward. Under Armour, on the other hand, has $41.7M worth of net debt. While both firms are attractive and would be value-creating acquisitions for Nike, I find that Foot Locker remains the safer of the two. Analysts currently rate Under Armour a "hold" and Foot Locker a "buy".
Foot Locker operates roughly 3,426 mostly mall-based stores in a few regions (the United States, Canada, Europe, Australia, and New Zealand) and could benefit from the kind of global footprint that Nike has. Despite macro headwinds and a difficult NBA backdrop, Foot Locker has experienced solid demand for its athletic footwear. In particular, the basketball and running product segments have remained strong in terms of demand and will be easily driven by product releases. At the same time, the company is investing more in high margin opportunities, scaling back excessive promotional opportunities, and reinventing its supply chain. Foot Locker could benefit from the economy of scale that Nike would offer and Nike could benefit from the improving demand and revenue synergies that Foot Locker would offer.
At the second quarter earnings call Chairman & CEO Ken Hicks noted:
As is evident from the excellent second quarter results we announced yesterday, we continue to have broad-based success along a wide range of the athletic footwear and apparel marketplace, and we're showing that we can sustain our performance over time. As Lauren mentioned, we produced double-digit comps in both of the last 2 quarters but perhaps more importantly, we've now posted 6 consecutive quarters of sales and profit increases.
These trends are likely to continue onto the the third quarter and will be enhanced by improvements in margins. From 2010 to 2012, I model gross margins increasing by 290 basis points to 32.9%. As the company starts to better coordinate inventories with suppliers, the bottom line is poised for strong gains through cost decreases. In addition, the roll out of House of Hoops and revenue growth in Mizono, Brooks, and Saucony remain catalysts over the next few years. Foot Locker achieved success in marketing for Champs Sports in the second quarter and this will likely noted in the third quarter as well.
Consensus estimates for EPS are that it will grow by 55.5% to $1.71 in 2012 and then by 11.7% and 13.6% in the following two years. I anticipate revenue growing by a CAGR of roughly 7.3% over the next three years, while decelerating over this time. In conclusion, I recommend the stock both as a safe investment against a stagnating economy, as well as a lucrative strategic bet. I believe that the reward far outweighs the risk given the solid fundamentals backed by stellar management.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
