Why Foot Locker Is Getting Smashed
Summary
- Foot Locker shares are getting slammed due to the perceived weakness in operations.
- The valuation after this selloff is rather compelling particularly for dividend growth investors.
- Comparable sales were weaker than we anticipated, but it is the back half of 2018 that you need to watch for, based on our expectations.
- There are a number of risks to the company that could impact comparable sales.
Foot Locker (NYSE:NYSE:FL) is getting slammed after its recently reported earnings. We are compelled to respond today because we are of the opinion that the results are not as dire as the selling would imply, and expectations for a strong second half of 2018 are being ignored.
We will make comparisons relative to what we projected and were looking for in 2018. We will start by discussing valuation, which we feel is cheap, to be it plainly. We shall describe what we perceive as the impetus for the selling. Specifically, we are going to discuss sales, and hone in on what we feel was the weakest component of the report, comparable sales. Finally, we discuss what it is we believe investors should be looking for on this vital metric going forward, in conjunction with ongoing risks, and how that impacts our long thesis.
Valuation after this selloff
At the time of this writing, shares are down 16.5% to $38.30. Just one month ago, shares were comfortably back above $50:
Source: Yahoo Finance
The market is nervous, and that is the result of some of the items we will discuss momentarily. That said, it is hard to argue against the fact that the stock is still cheap. With very little debt, and trading at both a trailing-twelve month, and future-twelve month price-to-earnings ratio below 10 and an enterprise value-to-EBITDA ratio of 5, Foot Locker appears to offer value. The market is baking in risk that the company will fail to execute right now.
That said, investors are being paid to wait. The perceived risk that investors see has priced the stock at a discount which we now see as more attractive considering the company just raised its dividend again The stock is attractive to dividend growth investors as the company has consistently raised its dividend, and with an 11% hike to the payout to $0.345 quarterly, the forward yield at $38.30 a share is over 3.6%. We remain in the camp that sees value in the shares at present levels but let us discuss why shares are getting hit so hard.
Sales spook The Street
The reason that the stock is selling off with such force stems from sales results. To be clear, sales did in fact miss our expectations. Our expectations were for a 5% increase in sales over last year to $2.25 billion. We arrived at this projection for the quarter because we expected a negative impact of fewer stores open and our expectation for a same-store sales decline of 2.5%. Further, we were baking in an extra week in the quarter period to benefit sales. Sales came in slightly below our expectations at $2.21 billion, but were still up 4.7% year-over-year. However, comparable sales data is in our opinion the biggest disappointment, but it should not surprise investors in our opinion, at least not to the tune of a 16.5% haircut in the stock.
Comparable sales: What you need to know
Declining comparable sales are a key weakness for the company right now. That said, recall that for the year, we are projecting flat-to-slightly positive same-store sales. We anticipated a weak start to the year on this metric, but comparable sales were below our projections, coming in at -3.7%:
Source: SEC filings; chart made by author in Excel
We think it is worth noting here that comparable sales are expected to ramp up from their lows seen in Q2 2017 where they fell a devastating 6%. The present quarter’s miss versus our expectations of -2.5% is probably the greatest weakness for the company and this is why investors are dumping the stock right now. This is a key indicator, and it had been strong, and very positive, for many quarters up until mid-2017. Is there any way to put a positive on this?
Well, despite a negative 3.7% comparable sales figure in the most recent quarter, we were pleased with the result in one sense only because comps are still trending upward off the lows from Q2 2017, but there is much work to be done. Make no mistake, as we were projecting comparable sales of negative 2.5%, we were disappointed. Comps came in worse than we expected, and as evidenced by the selling today, worse than the Street would have liked. Looking ahead to Q1, we expect a continued drag on comparable sales, but this will be in large part due to heavy promotional activity to move merchandise as the company transitions into the latter half of 2018 and beyond. On a forward basis, we previously opined that the second half of the year would see a ramp up in comparable sales, and we stand by that call, but we fully believe the second half of the year is absolutely critical.
The second half of 2018 is critical
It is make or break time. The second half of 2018 is not only critical to our call, but will be a strong determinant for the future of the company and its stock. To be clear, we believed that second half of the year would do better thanks to strategic partnerships put into place, an ongoing transition of the company’s management structure, as well as the product cycle. This is one issue that is being overlooked. 2017 was a year that was far below average for popular sneaker products. It is a concern that has been shared by other retailers, as well as sneaker manufacturers. We will keep this in mind as this issue is expected to dissipate in the second half of the year. We are also pleased that the CEO gave some confirmation to our prior expectations when announcing earnings:
However, we are confident that we will inflect back to positive comparable-store sales by the middle of 2018, with the pace of sales continuing to gradually strengthen in the second half of the year based on the improving depth and variety of premium products we see coming from our key vendors.
Both the product cycle issue and comparable sales issue that we have harped on were addressed in this commentary. As such, we continue to maintain our previous forecast for flat to slightly positive comps for the year, driven by a strong second half of 2018.
With an understanding of why the Street is nervous, and why we are standing by our 2018 projections, we think investors need to be aware a few general risk factors that could lead to the company failing to deliver.
Risks to keep in mind
There is no doubt that the last two years have been tough on retail in general. Although the competitive pressures did not really hit Foot Locker until spring 2017, the company has taken aggressive steps to counter the negativity it has experienced. Still, there is risk here, which needs to be considered despite our thoughts on the valuation and the outlook.
Like many other retailers, especially those that rely on a heavy physical store presence, many of which are anchored to malls, traffic is a concern. This is one reason comps have taken a beating, however we are pleased with the company’s aggressive property management as part of the strategic plan in place. The company is no longer wasting time relocating and shuttering losing operations (in Q4 alone the company closed 67 stores, relocated 45, and only opened 28 new ones), but we would like to see the company go on even more offense in this regard to get the comparable sales number up through more traffic.
For existing stores, we still believe a true effort and comprehensive plan to bring people back into the stores is necessary. While the product cycle will benefit sales in the second half of 2018, and new partnerships are being made with key suppliers (e.g. Nike), negative foot traffic in the Foot Locker U.S. stores, Foot Locker Europe stores, as well as in Foot Locker Kid shop will lead to continues to pressure comparable sales if something is not done. We would like to see an aggressive plan to increase traffic.
That said, we should acknowledge the company really stepped up its promotion and advertising, even knowing it would hurt margins, in an effort to push out old inventory and clear space for the next product cycle. Of course, even with a new product cycle, there is no guarantee that Foot Locker will get the business.
There is concern over other competitors selling the same product. There are also even larger concerns over online/ direct-to-consumer selling. Very few retailer stocks have done well in recent years given the fears over Amazon (AMZN) taking over the world, but let's be clear they aren’t selling the newest footwear (yet). Foot Locker has been especially vulnerable as fears of its top selling products being sold directly to consumers from the manufacturer have weighed. Namely, this applies to Nike (NKE) products.
Still, while direct-to-consumer is a threat, sneakers in general remain something people like to try on before buying. This is not always the case, but certainly offsets some of the online pressure. But even with online pressure, Foot Locker is doing well with direct-to-consumer, as comparable sales here were up 4.3% in the period. In addition, margins are strong in this area, and sales continue to rise. While direct sales are an ongoing threat, we think Foot Locker is doing well in keeping its business, and would go so far as to suggest it should focus even more on improving these sales as they continue to grow.
Take home
While we believe the stock is cheap on a valuation basis, the multiple compression we have seen on the stock is a result of weakness in sales, driven almost entirely by weaker than expected comparable sales. There is uncertainty for the future and investors are pricing this into the stock. With expectations for a strong second half, we are of the opinion that this selloff may be overdone, but from an investment standpoint, the risk-reward is attractive here given the high-yield from the company and established dividend growth, as well as the aggressive corrective action being put into place by the company. We believe investors should focus on direct-to-consumer sales, comparable sales, strategic partnerships, and efforts made by the company to close losing operations and invest in winning ones. The second half of the year is critical for the company and investors need to be alert. We remain long, but are cautious.
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