Three months ago, I argued that Foot Locker (FL) was a better pick than Dick's Sporting Goods (DKS). Foot Locker is up 21% since that date, and Dick's 11%. The comments section was quite harsh on my article then. On paper Dick's is more diversified over its suppliers, an important factor in today's environment when brands are increasingly trying to sell directly to consumers. It also has more than a 15 year record of higher revenue growth rate relative to Foot Locker. But these aspects should not be looked at in isolation. Valuation requires a more holistic view and that's the view I took when I said Foot Locker seemed more beaten down than it deserved. Now that the stocks have diverged, does this warrant a change in the way I rate these stocks? Yes, it does.
Sales to Free cash flow conversion
A look at the graph below, and it's fair to have a doubt on whether Foot Locker as a stock will do well compared to Dick's. Over the years, Foot Locker squandered away a hefty lead and now trails Dick's Sporting Goods on the amount of revenue earned.
Now to sow the seed of doubt in your minds look at the above graph in conjunction with the one below. Foot Locker has a better rate of converting its revenues into free cash flows. Simply because, one, the company earns operating margins that are 600 basis point higher than that of Dick's. This ensures that more of its revenues get converted to net income. Two, Foot Locker is more efficient than Dick's on the capital expenditures side. A major portion of the gap you see in the graph below is because of the 200 basis point differential in the capex as a percent of sales figure of the two companies.
How big a difference does this make?
Now consider the impact of growth on the above equation. Between the two companies there is a 3% differential in the conversion of sales to free cash flows.
Assume that this differential were to persist. Even if the revenues of Dick's were to grow at a rate five percent higher than that of Foot Locker, it would take Dick's 8 years to exceed FL's free cash flows. To calculate the number of years I have converted everything into percentage terms for the sake of simplification. If you still don't get it, drop me a comment below and I will be happy to help you out.
|Foot Locker Revenues||90||90||90||90||90||90||90||90||90|
|Revenue Growth Rate||0||0||0||0||0||0||0||0|
|Free Cash flow/ Sales||7.10%||7.10%||7.10%||7.10%||7.10%||7.10%||7.10%||7.10%||7.10%|
|Free Cash flow||6.39||6.39||6.39||6.39||6.39||6.39||6.39||6.39||6.39|
|Revenue Growth Rate||5%||5%||5%||5%||5%||5%||5%||5%|
|Free Cash flow/ Sales||4.30%||4.30%||4.30%||4.30%||4.30%||4.30%||4.30%||4.30%||4.30%|
|Free Cash flow||4.3||4.5||4.7||5.0||5.2||5.5||5.8||6.1||6.4|
(Note: Foot Locker's Revenues this year are expected to be 90% of that of Dick's. That is why the figure of 90 as the starting figure for Foot Locker, and 100 for Dick's)
Therefore, for a bullish case to strengthen, DKS should either up its free cash flow conversion rate or grow at a rate much better than that of FL.
The Counterpoint about Depreciation
The counterpoint one can pitch is that the operating margin of Dick's Sporting Goods is suppressed artificially by the higher accounting of depreciation, a non-cash expense. Lower depreciation ensures that the company pays less in taxes. So that's a fair argument.
But the tax code is changing isn't? A lower tax rate ensures that the entities that were paying lower taxes by the higher accounting of depreciation have less to gain compared to those who weren't. Therefore, the counterpoint plays a role in defeating the case for Dick's rather than strengthening it.
A comeuppance that reverses all the above arguments
The thing that reverses all of the arguments is something called the number of diluted shares outstanding. With 21% lower shares, the free cash flow per share gets tilted in favor of Dick's. The company would require just two years to exceed the free cash flow per share generated by Foot Locker based on the assumptions in the table above. If DKS grew revenues at a rate only 3% higher, then it would require four years. While the argument that Foot Locker will do better than Dick's worked well for my previous article, recent price corrections ensure that I reverse my stance. Therefore, I, now prefer Dick's Sporting Goods over Foot Locker.
Note: Company related data sourced from Morningstar and respective company filings.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.