Analyst Downgrade Provides Opportunity in Foot Locker (FL)

There is something about the shoe business that seems to intrigue value players. The steadiness of the cash flow, perhaps the relatively low fashion risk compared to the apparel business, maybe just the understandability and the tangible nature of the business gives it appeal.

I have always preferred companies such as NIKE (NKE) or Reebok (mistakenly) or K-Swiss (KSWS.) Wolverine Worldwide (WWW) has also been an interesting stock at times and if I was particularly venturesome, Genesco (GCO.)

Shoe retailers have been less interesting to me, but I am developing some interest in this area. The consolidation of the athletic footwear retailers has been quite thorough, and essentially the only players left at this point are Foot Locker (FL) and Finish Line (FINL.)

Foot Locker was downgraded by one of the analysts this morning, and this has prompted my interest. The downgrade was based on four observations/conclusions:

* Margins have peaked…low-hanging fruit has been plucked…turnaround is over.

* Competition is increasing from sporting goods retailers as well as vendors’ owned retail networks.

* The European market has become more competitive for what had been a high margin part of FL’s biz.

* Foot Locker’s offering is not significantly differentiated from competitor offerings and relies heavily on product from Nike.

I suspect that there is some truth to the competitive landscape margin pressure issue, but as the analyst surmises, there may still be another 100 additional basis points left in operating margins due to some recycling of unfavorable leases and improved utilization. The rapid growth of brand-owned stores has been a trend for some time and is hardly new. Nike has 240 stores compared to Foot Lockers’ 4000. I recognize that Reebok, New Balance, and Adidas also have a presence, but it is clear that FL is quite dominant.

What was ignored or at least not highlighted by the analyst in this report?

* FCF yield of about 6.5%

* A $150 million share buyback program which replaces the $50 million authorization.

* The buyback is effective with some $35 million purchased in 2005.

* ROIC has been very steady at around 10-11%

* The dividend was cranked up by 20% in November and still represents a low payout ratio.

The stock is down about 25% from its highs reached a year ago. EV/EBIT is only about 9 times. Long term debt is less than 10% of assets. The company has only recently instituted its share buyback program, certainly a step in the right direction. The consensus growth estimate of 13.4% seems high, but even with an 8 or 9% growth assumption and some erosion of operating margins, I still come up with values in the high $30’s and low $40’s versus the current $22-23.

There may be an opportunity for long term investors in this downgrade.

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