Newsletter Value Investor Insight carried an interview with Spencer Capital Management hedge fund manager Ken Shubin Stein in its February 28th edition. Since November 2000, Spencer Capital Management has earned a net 24.1% compounded annually, vs. an annual 2.1% loss for the S&P 500. Here's what he had to say about Foot Locker (FL):
You described earlier your affinity for retailers. Tell us about Foot Locker [FL].
KSS: By a large margin, Foot Locker is the largest seller of athletic sneakers in the world. Two-thirds of their revenue is domestic, 26% international and 7% direct-to-customer.
This is a case where there’s a structural expense built into the company that’s decreasing slowly over time. In the late 1990’s, they had pursued a strategy to increase their store sizes, opening superstores that turned out to be way too big. Sales per square foot plummeted. The problem with something like this is that once you’ve built out a new footprint, it’s hard to reverse. You have to close stores, negotiate out of leases or wait until leases roll off. That takes years and affects operating margins all the way through.
This is a structural problem with clear and achievable solutions, but with a time frame necessary for it to work out that is longer than most people on Wall Street are willing to wait.
Are they having execution problems?
KSS: In fact, they’re executing quite well. Through renovating, relocating and resizing underperforming stores, they’ve increased sales per square foot to $355, up from $316 in 2002. Trailing twelvemonth EBITDA was more than $570 million, versus $425 million in 2002. They’ve paid down debt and now have net cash on the balance sheet.
Is anything else weighing on the shares?
KSS: Profit margins in Europe are under pressure, as the market has become acutely promotional in the past year. We’re always asking if problems like this are temporary or permanent, and we believe this is temporary. Foot Locker has a real advantage in being the market leader with a much better balance sheet. As competitors capitulate because they can’t afford the excessive promotion, Foot Locker can either grab market share or just benefit from a return to normal pricing. People are also worried about the competitive threat of the Internet. If you think about the shoe-buying process – especially for kids, but for adults as well – there’s good reason to expect that the human behavior of wanting to try shoes on first is not going to change quickly.
With the stock currently at $23.50, what upside do you see?
KSS: Over the next three years, we’re assuming 1-2% annual expansion in retail square footage and 1-2% year-overyear growth in same-store sales and direct-to-consumer revenue. As the storerenovation process winds down, we expect operating margins to increase from around 7.5% now to 10% in three years. If that happens, they’ll be earning $2.40 in annual free cash flow in three years and will have produced over $900 million in additional free cash from today.
If you assume they just hold the free cash and put a 15x enterprise value to free cash flow multiple on the shares, you get a share value of $43. If they did the $500 million share repurchase we think they should, the shares would be worth $48.
We see this as both safe and cheap. The free cash flow yield is over 8% and growing, for a dominant specialty retailer with a strong balance sheet and shareholderfriendly management. They’re highly likely to improve operating margins over the next three years and, while we don’t build this in, they have tremendous growth opportunities in Europe and, especially, Asia, where their footprint is small.