Foot Locker (NYSE:FL) had two disappointing quarters and the stock is down more than 60%. Investors fear that it is the next one which is going to follow the destiny of Sears (NASDAQ:SHLD) and J.C. Penney (NYSE:JCP) and suffer from a shift in consumer behavior. While some of the concerns may be valid, I think the current price is rather the result of investors' psychology that is overblown and sent the shares to very depressed levels. If people believe that the majority of consumer purchases for goods such as apparel will be done through the Amazon (NASDAQ:AMZN) platform, then they should stay away from Foot Locker. Because Foot Locker is and will be in brick-and-mortar business. If the whole consumer purchases are going to move online, then there is no need for a Foot Locker as Amazon completely replaces Foot Locker digitally.
If you are on the other side of the debate as I am and think that the future of retail would be more balanced between online and brick-and-mortar stores, then Foot Locker may offer a good value at the current price. It is trading at a very depressed valuation, which is comparable to companies such as J.C. Penney, Bed, Bath & Beyond (NASDAQ:BBBY) and Macy’s (NYSE:M). However, those companies are in worse shape than Foot Locker. Foot Locker is a healthy company, sits on a net cash of $917m, offers 3.9% dividend yield, and it's cash flow positive even after dividend payments and share purchases, hence the company is in a very good shape. But the investment thesis is dependent on the notion that the last two quarters do not indicate that Foot Locker does not have space in future retail.
1Q 2017 Miss
The market priced Foot Locker as high as $77.71 in May this year.
And so, in May everything was nice and shiny until the company reported Q1 results. They were not that bad on the bottom and top line. The results only missed $0.02 on EPS and $20 million on revenue. Comparable sales rose by 0.5%. But what was disappointing was the lower gross margin and higher SG&A which is a double hit on the operating margin.
Yet, the management expected a mid-single-digit increase in EPS.
Source: Foot Locker 1Q 2017 Earnings Release
Last year's EPS was $4.82; therefore, perhaps $5.0 was the expectation for the full year. Next day, the shares declined to $58.13, which was almost an 18% decrease from $70.45, previous day's close (visible on the above chart). As a result, shares were repriced to an 11.6 price to 2017 expected earnings following the earnings results. The shares continued to decline further and closed at $47.7 on a day before the 2Q earnings release.
2Q 2017 Miss
2Q 2017 was really a huge miss. The EPS came down $0.28 lower than analysts expected, and revenue missed by $100 million. Same-store sales declined 6% while the total sales declined 4.4%.
The gross margin declined to 29.6%, and SG&A increased to 19.9%. These were terrible results on all fronts. The management also updated its guidance for the remainder of the year. Further weakness in gross margin and sales is expected in the second half which should result in a drop in EPS by 20-30%.
If we consider $1.97 EPS for the first half this year, and 20% to 30% lower EPS for the second half of the year, then the EPS for the remainder of the year is expected to be between $1.74 and $1.99 (Calculated as a 20-30% decline from the previous year's $2.41 for 2H 2016). That would be between $3.71 and $3.96 for the full year. Analysts expect $3.97 for this year and $4.01 for the next year. This is a price to earnings of 8.0 to this year's forecasted earnings and 7.9 to next year's forecasted earnings.
After the 2Q release, shares declined by 28% to $34.38 compared to the previous close of $47.70 (visible on the above picture). Currently, the shares are trading at $31.65 and so they declined by 60% over the course of six months. During the same period, we could observe the multiple of price to 2017 expected earnings as high as 15.5 and as low as 8.0. While some of the declines in the repricing are attributable to a weakness in business, most of the declines are attributable to a shift in investors' expectations. Now, the market put the company in the same basket as all brick-and-mortar companies. Recent moves by Nike (NYSE:NKE) to open a pilot program on the Amazon platform only confirms its position. I will discuss Nike's movement later in the article, but before that, I would like to compare Foot Locker to other companies suffering from the same declining trend in footfall in their stores.
Comparisons to Other Brick-and-Mortar Companies
The market currently prices Foot Locker the same way as it prices Bed, Bath & Beyond, Macy’s, J.C. Penney and other similar companies. Should Foot Locker really have the same value as J.C. Penney?
Comparison to J.C. Penney
J.C. Penney is expected to have an EPS of $0.43 this year and $0.38 the year after, according to analysts.
This translates into 7.9 price to expected earnings with further earnings decline. J.C. Penney also sits on a net debt of $3 754 million as of last reported quarter. The company has not earned money over the course of last seven years. It only had two years of positive free cash flow; $120 million in 2015 and $93 million in 2010.
Source: J.C. Penney 10-K
On the other hand, Foot Locker has been earning money every year since at least 2011 with sales and operating margin expansion.
Source: Foot Locker 10-K and 10-Q for 2Q 2017
It has generated money in excess of capital expenditures, dividend payments, and even share buybacks.
Source: Foot Locker 10-K
Currently, it has a net cash on the balance sheet of $917m, or $6.95 per share. Perhaps it is just J.C. Penney still being overpriced and Foot Locker correctly priced. So the other company I would compare is Macy’s.
Comparison to Macy’s
Macy’s is in much better shape than J.C. Penney. It is a cash flow generating entity. Currently priced at 6.0 to 2017 expected earnings and 7.6 expected earnings for 2018 (Current price of $20.20 to below forecasted earnings of $3.39 this year and $2.67 next year).
At these metrics, it seems Macy’s is more undervalued than Foot Locker but it does not have that stellar balance sheet. As of last quarter, Macy’s had a net debt of $6,630 million compared to free cash flow of $886 million from 2016. In addition to that, Macy’s gross margin has been declining since 2010. Even though the operating margin started to decline later.
Source: Macy's 10-K
On the other hand, Foot Locker has been increasing its sales and expanding gross and operating margin every year until this year. And, as I wrote above, it does have a surplus amount of cash on the balance sheet as opposed to net debt compared to Macy’s.
Comparison to Bed, Bath & Beyond
Another company suffering from a decline in footfall has been Bed, Bath & Beyond. Bed, Bath & Beyond is currently priced at 7.0 price to 2017 forecasted earnings and 7.6 to 2018 forecasted earnings (Price of $21.2 to forecasted EPS of $3.01 for this year and $2.78 for next year visible in the below picture).
Its profitability has been declining every year since 2012. In 2012, it was 16%, and it is expected to be 6% this year.
Source: Bed, Bath & Beyond 10-K
The balance sheet carries a net debt of $1,028 million, which at the moment is healthy given the cash flow generation and maturities distant in the future). As I wrote above, Foot Locker's deterioration came only this year, and the balance sheet is the healthiest among all three companies.
J.C. Penney, Macy’s and Bed, Bath & Beyond trade at similar multiples to Foot Locker but have much worse dynamics than Foot Locker. This suggests that Foot Locker is either undervalued or all other companies overvalued. In my point of view, it is that Foot Locker is undervalued. Yet, all the comparisons may be irrelevant if we believe that this time is different and Amazon is a game changer.
Shift in consumer behavior
Nike announced that it started a pilot program with Amazon.
Source: Seeking Alpha
And so, the market perception is that Foot Locker is dead given the Nike-Amazon relationship.
Source: Foot Locker 2Q 2017 Transcript
The management believes that the key to the success is a differentiation strategy. It also believes that Amazon will take over the lower-end segment but higher-end segment will stay within the company if it can achieve the transformation on its part. It believes that selling $100 sneakers require storytelling and engaging digital and in-store experience.
Source: Foot Locker 2Q 2017 Earnings Call Transcript
The management also gave different examples how it will adapt to a new consumer taste and what is its perspective of the future for this business.
Source: Foot Locker 2Q 2017 Earnings Call Transcript
Source: Foot Locker 2Q 2017 Earnings Call Transcript
And so it really comes down to a question where do we stand on the future of retail debate. Most of the brick-and-mortar companies' response is to transform their stores to appeal to millennials who are digitally literate and prefer spending money on experience rather than physical goods. Perhaps it will save them; after all, they are left with no other choice. To build a similar platform as Amazon would require a significant amount of capital. If investors believe that Amazon will be the single platform where people will shop, then Foot Locker is not a place to be. On the other hand, if you are a believer that the future of retail will look more as a combination of Amazon and brick-and-mortar companies, then Foot Locker may be a good value opportunity at current prices.
I personally have not bought any clothes through a digital platform. The main reason is that I like to see the product and try it on. If I don’t like it, I will not buy the product and walk away from the store. I do not want to have the hassle of returning if I don’t like it once tried on. Also, I can see products shining and try them instantly. But perhaps I am an outlier in such behavior. Surely companies like Zappos made a good progress and quickly grabbed market share with a digital strategy. There are people who prefer buying online than from physical stores. But I also believe there are people who would still prefer purchases from brick-and-mortar stores. It remains to be seen which ones will be the majority though.
Foot Locker declined by 60% over the course of last six months. Currently, it trades at a very cheap valuation that suggests a good buying opportunity. If you are in the camp that Amazon will be the only digital platform for all products and all products will be sold through that channel, then Foot Locker should be avoided. On the other hand, if you are in a different camp who believes in a more balanced future of retail, then Foot Locker could be a good long-term play at these levels.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FL over the next 72 hours.
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.