Foot Locker - Out Of The Penalty Box And Back In The Race

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About: Foot Locker, Inc. (FL)
by: Deep Value Dividends
Summary

FL is a leading sneaker retailer and has been steadily building an economic moat.

FL’s balance sheet is solid, and the company’s existing debt burden and dividend payout ratio are low.

FL has room to maneuver in the face of competition from Amazon while it continues to grow its dividend.

FL’s shares are undervalued and poised for an upward mean reversion.

What is Foot Locker's business model?

Foot Locker (FL) is a leading athletic shoe (aka sneakers) retailer and operates over 3,300 stores throughout the US, Canada, and Europe. FL has been branching out into athletic wear as well. FL runs a variety of stores including Foot Locker, Kids Foot Locker, Lady Foot Locker, Champs Sports, Footaction, Runners Point, Sidestep, and SIX:02. Go to any mall and I'd be amazed if you didn't see at least one of these stores. FL also has a direct to consumer segment which is responsible for selling its products online.

Despite taking a hit during the 2008 recession, FL has experienced incredible growth by capitalizing the popularity of sneaker culture - a fashion trend focused on sneakers that emerged in the '80s and is heavily associated with basketball and hip-hop music. Following the success of Nike's Air Jordan sneakers, there has been an exponential increase in the variety of sneakers available. And with that variety, came a subculture of sneaker aficionados and collectors. Hip-hop culture's embrace of sneakers as a fashion accessory imbued sneakers with credibility as status symbols. Today, sneakers comprise a $17.5 billion/year industry in the US alone, with an additional $1 billion secondary market for collectors and traders. There is big money to be made in shoes.

In 2016, approximately 91% of FL's merchandise came from their five top suppliers - a trend that is likely to continue for the foreseeable future. Most notable, approximately 68% of FL's merchandise came from just one supplier, Nike (NKE). When broken down by operating division, anywhere from 48 to 76% of FL's merchandise was supplied by Nike. For all intents and purposes, FL is a Nike retail store. But given Nike's commanding 50% (approximate) market share, this fact is less surprising than it first seems (see the 2016 Annual report for more information).

At first thought, there is virtually no barrier to entering the sneaker retail industry. All you need is a storefront, sneakers, and a cash register. However, suppliers (e.g. Nike) allocate high profile and high demand merchandise to retailers of their choosing in order to keep margins high and prevent dilution of their brands. This arrangement has worked well for FL in the past, but a new challenger is emerging - namely Amazon (AMZN).

In July 2017, Nike began selling its products on Amazon. At present, this is only a pilot program and is limited to a select few Nike products, but Nike has already stated that it hopes to expand the range of products available on Amazon in the future. This deal isn't just about increasing sales, it's also about protecting Nike's brand. As part of the deal, Amazon will more aggressively drop the ban-hammer on merchants engaged in price gouging or peddling counterfeit sneakers.

So where does this leave FL? Will Amazon eat their lunch and kick their corpse to the curb? Let's revisit that question after we take a look FL's stock and get a better feel for the current status of the company.

Is Foot Locker making money?

When evaluating a company, I start with the income statement. Following the 2008 recession, FL's revenue, operating income, and net income all show consistent increases. Similarly, free cash flow has been steadily increasing over the last 10 years as well.

As an investor, the below graphs are a thing of beauty, but the Nike/Amazon deal has the potential to throw a wrench into the works.

Note: Trendlines are shown in red. Data were pulled from Morningstar. I made the graph myself.

How efficient of a business is Foot Locker?

Retailers with efficient business practices and solid economic moats stand the best chance of holding their ground against a big threat like Amazon. In this section and the next, we'll examine FL's efficiency and profitability.

To evaluate FL's efficiency, let's begin by looking at gross margin (shown as % revenue). The two dotted lines represent rules of thumb for the presence of a competitive advantage (otherwise known as an economic moat). Values below 20% (yellow dotted line), suggest that a firm is in a fiercely competitive industry. Values between 20% and 40% (green dotted line) suggest a highly competitive industry, and values above 40% suggest the presence of a potential competitive advantage.

Currently, FL's gross margin sits at approximately 34%, and has been growing steadily. Digging into the 2016 annual report, the recent improvements in gross margin have been driven by selling more products at full price. This behavior is consistent with a wide economic moat, and an encouraging trend for investors.

Next, we'll look at sales, general, & administrative costs (SG&A; shown as a percentage of revenue). Again, the dotted lines represent rules of thumb for the presence of a moat. Values above 80% (yellow dotted line) suggest a highly competitive industry. Values between 30% (green dotted line) and 80% suggest a moderately competitive environment. And values below 30% suggest the presence of a competitive advantage.

Currently, FL's gross margin sits at approximately 18.7%, and has been shrinking steadily. To quote the annual report "This improvement reflected effective expense management, specifically store wage improvements due to productivity gains reflecting the continued utilization of hiring and scheduling tools." This is corporate speak for reducing the number of hours and handing out smaller raises.

Looking at the earnings before taxes margin, which is a metric that removes the effects of state and local taxes on earnings. Once again, we see a steady increase.

Flipping through the annual report one more time, it's worthwhile noting that both same store sales and sales per square foot have also been increasing. To date, FL has been a very efficient company with a consistently widening economic moat.

Note: Trendlines are shown in red. Data were pulled from Morningstar. I made the graph myself.

How profitable is Foot Locker?

Three profitability ratios are commonly examined when evaluating a company. Return on assets (ROA) measures profitability relative to total assets. Return on equity (ROE) measures profitability relative to shareholder equity. Return on invested capital (ROIC) is considered the best of these ratios and is a measure of how efficient a company is at using its capital.

Like the profitability measures above, these ratios are used to help determine the presence of a competitive advantage and to judge the profitability of FL relative to its industry. The green dotted lines drawn at 10% for ROA, 15% for ROE, and 15% for ROIC are rules of thumb, where values above these bars suggest the presence of an economic moat.

The orange dotted lines represent the industry averages (pulled from Aswath Damodaran's awesome collection of data) for these ratios. For both ROE and ROIC, FL has been beating the industry average for specialty retailers by a wide margin for the past few years. A trend likely to continue if the retail apocalypse is indeed overblown. If the doomsayers are right, then we can expect these ratios to start dropping as FL's competitive advantage is eroded.

But before we get too excited, we need to take another look at that ROIC number. Specifically, we need to adjust it for operating leases, which are the primary financing vehicle used to fund store expansion. Because these are classified as "operating leases" instead of "capital leases" they can be left off the balance sheet, thus inflating ROIC. To their credit, FL provides ROIC numbers adjusted for operating leases. As shown in the graph below (bottom right), FL's adjusted ROIC is still beating the industry average (orange dashed line) and touching the 15% rule of thumb (green dashed line). (Note that the adjusted ROIC numbers provided were calculated using non-GAAP methods.)

In all, I am impressed by FL's business efficiency (graph above) and profitability (graph below).

Note: Trendlines are shown in red. Orange lines represent current industry averages. Green lines represent rules of thumb for the presence of an economic moat. Data were pulled from Morningstar. Lease adjusted ROIC data was pulled from FL's annual reports. I made the graph myself.

What is Foot Locker's debt burden?

Revenue, profitability, and moats all take a hit when serious competition arises or when the economy heads into a recession. But creditors don't care about that. Debts must still be paid. Companies with lower debt burdens have greater resilience and flexibility when hard times hit. With that in mind, we now turn our attention to Foot Locker's debt.

FL's long-term debt as reported on the balance sheet is quite low. The first graph shows a combination of long-term debt and some lease-related debts reported in their annual reports.

However, as mentioned above, FL has operating lease obligations. While these do not appear on the balance sheet, they can be thought of as debt and should be examined as well. In their annual reports, FL provides data on their total debt including the present value of operating leases. This data is summarized in the top right graph in the panel below. (Note that the above values are calculated using non-GAAP methods.)

When compared to their long-term debt, operating leases comprise the bulk of FL's financial obligations. If we look at the graph we see that operating lease obligations have been rising steadily since 2012. This requires some explanation.

In the last five years, FL has not added significantly to their store count. They had about 3,300 stores back in 2012 and about the same number now. So the increase is not due to FL having to service a greater number of leases. According to the annual reports, the increase in operating lease obligations reflects new leases related to flagship locations and landlords raising the rent during lease renewals.

The final graph in this panel shows the debt to capital ratio (data pulled from annual reports), where debt includes the present value of operating leases. So while FL's debt load has increased in absolute terms, FL's debt to capital ratio has remained steady relative to the rest of the balance sheet.

Overall, FL's debt situation is encouraging.

Note: Trendlines are shown in red. Data were pulled from Morningstar. I made the graph myself.

Are Foot Locker's per share earnings and cash flow growing?

Looking at companywide measures of profitability can tell us a lot. But as shareholders, we only own a fraction of the company, so it behooves us to examine a few items on a per share basis as well.

The first graph in the below panel shows the number of shares outstanding. We can see from the graph that FL has been committed to buying back shares. According to the annual report, the company is planning to continue share buybacks for at least another three years.

The next two graphs show earnings per share (EPS) and free cash flow (FCF) per share. Both of these show consistent increases over the last ten years. Assuming that the Amazon threat is overblown, there is every reason to expect these trends to continue into the future.

Note: Trendlines are shown in red. Data were pulled from Morningstar. I made the graph myself.

How is Foot Locker's dividend health?

As we complete our survey of FL's fundamentals, it's finally time to talk about dividends. I prefer to discuss dividends last, because if the fundamentals don't excite you, the dividend history is irrelevant - you shouldn't be buying the stock.

When it comes to dividends I look at two things, first sustainability and second growth. As a proxy for sustainability, I look at the dividend payout ratio as calculated using EPS, and then using FCF.

FL's payout ratios are 25% using EPS, and 32% using FCF. Both payout ratios have been consistent over the last five years. These low payout ratios suggest that there is plenty of room for FL to grow the dividend, and that the dividend should remain safe if sales slow down.

Although FL did not grow its dividend for a couple years (2008 and 2009) following the great recession, it did not cut or suspend the dividend either. The dividend remained constant at $0.60 per share. While over the last 7 years, FL has been steadily growing its dividend at approximately 10% per year.

Note: Trendlines are shown in red. Data were pulled from Morningstar. I made the graph myself.

Foot Locker valuation panel

Now that we've covered the fundamentals, it's time for exercises in valuation. But first a few caveats. Much like dividends, if the fundamentals of a stock don't excite you, the valuation is pointless - you shouldn't be buying the stock.

I approach stock valuation by employing several different methods, each with its own strengths and weaknesses. The more agreement between the results, the more confidence I have that my valuation reflects reality.

The first approach is a relative valuation of Foot Locker vs its historical valuation. Five valuation ratios will be examined: the price/earnings (P/E) ratio, the price/book (P/B) ratio, the price/sales (P/S) ratio, the price/free cash flow (P/FCF), and the dividend yield (if present). In the graph below, we assume that FL is a mature company with a relatively stable range of valuation ratios, then we compare the current value to the historical range to get a feel for FL's current valuation relative to its past performance.

To explain how the graphs are constructed and interpreted, we'll walk through the P/E graph. I began by determining the high and low PE value for each of the last 10 years. This was done by dividing the lowest and highest stock prices during a given year by the stock's reported earnings for that year. Then I took the median of the past 10 years for the annual low P/Es (the green horizontal line) and the annual high P/Es (the red horizontal line). The x-axis of the graph is drawn at the midpoint between the two medians. If the current P/E (the blue diamond) is closer to the red line, the more overvalued the stock may be based on its historical highs. If the current P/E is closer to the green line, the more undervalued the stock may be relative to previous lows.

The same process applies to P/B, P/S, and P/FCF. For dividend yield, higher dividends are associated with lower stock prices (remember dividend yield = annual dividend / stock price), so the graph appears flipped, with higher numbers representing undervaluation and lower numbers representing overvaluation.

When we look at FL's valuation across these different metrics, we don't see a clear trend. Compared to its historical performance, FL may be undervalued based on P/E and P/FCF, while it may be overvalued based on P/B, P/S, or dividend yield.

Note: Data were pulled from Morningstar and Yahoo Finance. I made the graph myself.

The second approach is a relative valuation of Foot Locker's current valuation multiples to those of its competitors in the same sector. In these graphs we can see not only how FL stacks up against similar companies, but also how all of these companies compare to both the S&P 500 average (solid black line), which approximates the market as a whole and serves as the reference. The green shaded area is undervalued vs the S&P 500 and the red shaded area is overvalued. The orange dashed line indicates the industry average. Competitor companies are shown as black dots and FL is the blue diamond.

Four metrics will be examined: the P/E ratio, the P/B ratio, the P/S ratio, and the dividend yield. For competitor companies, I selected Finish Line (FINL), Genesco (GCO), Shoe Carnival (SCVL), Hibbett Sporting Goods (HIBB), and Dick's Sporting Goods (NYSE:DKS).

For P/E, P/B, and P/S, almost all of the companies are undervalued compared to both the S&P 500 and the industry overall. This is consistent with the market's recent sell-off of many retailer's stocks out of fear that online retailers (e.g., Amazon) are going to put them out of business.

Looking at FL vs its competitors, for P/E, P/B, and P/S, Foot Locker appears to be on the high end of valuation compared to its competitors. For dividend yield, FL appears to be undervalued relative to its competitors.

The bottom line is that while FL may be a bit overvalued compared to similar retailers, it is severely undervalued vs. the S&P 500 as a whole.

Note: Blue diamond = FL; Black dots = competitor companies; Black line = S&P500; Orange dashed line = Industry average. Green shaded area is undervalued vs the S&P500. Red shaded area is overvalued vs the S&P500. If data are not available for a particular company, it will not appear on the graph. Data were pulled from Yahoo Finance and Morningstar. I made the graph myself.

Having examined two different flavors of relative valuation, it's time to take a crack at a discounted cash flow valuation.

For my DCF model, I used these key assumptions:

  • Discount rate of 10%.
  • EPS growth of 7% for 3 years. This is a conservative estimate, chosen for the following reasons: 1) FL will eventually hit a limit of how much it can increase per store profitability, 2) Amazon or other online retailers will begin eating away at FL's business and within a few years the competition will be noticeable, and 3) let's just throw in the possibility of an economic slowdown in the near future, where people where people no longer have money for fancy sneakers.
  • Terminal growth rate of 2%, chosen to match the approximate annual growth of the U.S. economy.

Based on these very conservative estimates, FL has an intrinsic value of $71.12, which implies approximately a 31% margin of safety.

Review and conclusions

Now that we've finished our analysis of Foot Locker, let's see how FL stacks up against my six principles of investing.

1. A clear and understandable business model and corporate objectives?

Yes. They sell sneakers and athletic wear - can't get much more straightforward than that in a company. The main concern related to their business model is that they are dependent on their suppliers. If Nike or Adidas decides to shift away from FL towards their own branded stores or an online platform such as Amazon, FL will take a hit. On the positive side, FL is not aggressively expanding its store count, but rather focused on increasing the profitability of the existing stores. I am also encouraged by the fact that their executive compensation is tied to ROIC, which helps align executive pay with the creation of shareholder value.

2. Strong fundamentals?

Yes. Overall, FL's balance sheet and finances look good and have been steadily improving over time. This is a trend investors like to see. Based on the company's history there is no reason to think that the current trend will cease. Of course, the wildcard is Amazon, and only time will tell how much of FL's lunch it will be able to devour.

3. Wide or growing economic moat?

Yes. Several of the metrics above can be used as rules of thumb to estimate the presence of a competitive advantage. All of them (SG&A, gross margin, ROA, ROE, and ROIC) are in agreement suggesting that FL has been able to carve out an economic moat and widen it over time. Whether FL is able to use this moat to defend against Amazon and other online retailers remains to be seen.

The big question is how long FL can stay competitive. While I doubt that Amazon will crush FL in the near term, the entire retail sector is slowly shifting toward e-commerce. My hunch is that this shift will push many of the smaller players out of the field. The larger players will be able to survive if management stays on point, relationships with supplies and customers are maintained, and the companies do not over-leverage themselves. FL is a big player in the sneaker business, and based on my review of the financials and my research during the course of this analysis, I suspect that FL will be around for a while.

4. Low debt burden and prudent use of debt?

Yes. FL's only major financial obligations are related to its operating leases. While the cost of these leases has increased over time as landlords raise the rent, FL's debt to capital ratio has remained constant. Given management's current focus on increasing the profitability of existing stores, it is unlikely that they will pick up substantial new debt in the future.

5. Sustainable and growing dividend?

Yes. FL has an EPS-based payout ratio of around 25% and an FCF-based payout ratio of around 32%, leaving plenty of room for the dividend to grow. Speaking of growth, FL has been increasing its dividend at about 10% per year. Even if sales slow down, FL has room for several more years of dividend growth at this pace.

6. Appropriate valuation?

Yes. Three different valuation models were examined, and two of the three models (relative valuation against the market and discounted cash flow) suggest that FL is undervalued. When FL's valuation was compared to historical data the results were mixed.

Buy, sell, or hold FL?

Based on the above analysis, FL is a buy. By almost every metric, FL is currently a great company and severely undervalued. If you think that the retail apocalypse is overblown, then FL should be on your watch list. If you're not convinced that FL is going to hold up in the face of Amazon, don't rule out a short-term play. Amazon can't crush FL overnight, leaving plenty of time for investors to profit from an upward mean reversion.

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Disclaimer: My analysis and strategies are aligned with my values, and meet my investing goals. This may not be true for you. You must do your own research before investing. Your wallet will thank you.

Disclosure: I am/we are long FL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.