- Shares of Foot Locker fell nearly 13% after the company reported lackluster earnings in Q4.
- This was completely expected, but I think the market was spooked by a lack of high conviction growth guidance.
- Nevertheless, capital allocation is excellent.
- I think the stock looks cheap, but return timing will be hard to predict.
Foot Locker (NYSE:FL) posted Q4 results late last week that went about as expected, though both revenue and top-line results fell slightly short of expectations. Though the market somewhat panicked, sending shares down nearly 13%. I am not sure what exactly the market was thinking, but the quarterly results and guidance were not really unexpected. In fact, I believe shares remain undervalued, and I would consider adding shares after the dust settles in the high-$30 range, as I believe shares have upside to $55-63. Let’s take a look at quarterly performance in addition to what Foot Locker and I are seeing in the footwear marketplace, respectively.
Full-Year Earnings Remain Historically Strong
For full-year 2017, Foot Locker earned about $3.99 per share, down from last year’s $4.82 per share, but still quite strong relative to historical standards. In fact, $3.99, which includes a $0.12 hit for the extra week in the retail calendar year, is above every year in company history and still higher than FY16. Put into perspective, unless this decline materially accelerates, Foot Locker’s earnings are in pretty good shape.
From a revenue perspective, comps were pretty poor in Q4, with same-store sales down 3.7% y/y. In-store comps were down 5.1% y/y, which was partially offset by a 5.1% gain from online sales. For the quarter, sales were up 4.6% y/y to $2.2 billion thanks to the extra week. In total, sales were about flat for the year, down about $79 million on a base of $7.76 billion, when adjusted for the extra week. Full-year comps were down about 3.1% y/y.
With comps falling, gross margin declined 230 basis points y/y to 31.4% of sales. This isn’t bad considering the other poor quarters we saw in 2017, including a Q2 that saw gross margin decline below 30%. For the full-year, gross margin was 31.6% of sales. Again, this isn’t a great number, but it’s acceptable in light of the big decline in comps. I think Foot Locker does an excellent job of marking down slow moving product while capitalizing on whatever is turning quickly. The margin management at Foot Locker is without question the envy of the industry.
Consistent with margin management initiatives, Foot Locker did a strong job of managing inventory. Adjusted for Fx, inventory was down 5.2% y/y, which was consistent with the comp decline. This tight inventory control will be crucial in mitigating further gross margin deterioration.
Guidance – Hopefully Hedging
Guidance for FY18 was definitely not particularly encouraging. Comps were expected to be flattish, while gross margin could slightly recover during the year. I think both of these are modest comments meant to sandbag expectations after the company missed the mark in forecasting what would happen in footwear in FY17.
I’m seeing several positive developments over the past few weeks in the footwear marketplace, starting with much better product management allocation from Nike’s (NKE) Jordan Brand. The uber-popular Jordan 3 “Black Cement” sold out instantly through all channels, and a more obscure Jordan 13 retro model sold out completely yesterday. This is the sort of progress I am looking for. Once Jordan becomes scarce, customers become excited once again, and the excess demand from missing out on one release translates into exceptional demand for the next release. Nike knows this playbook works, but Nike couldn’t resist the temptation of higher revenue from blowing every retro model out in 2016 and 2017. Though sales might be negatively impacted by this decision in the near-term, I think it will be very positive for gross margin and long-term health of the brand.
In addition to some positive signs of revival from Jordan, I am seeing some solid excitement around Nike’s retro Air Max models as well strong interest in the fashion-centric VaporMax and Air Max 270. Designing for lifestyle is a reaction to adidas (OTCQX:ADDYY) and their rise to prominence over the past few years. Again, this will be positive for Foot Locker, which remains Nike’s most important vendor partner.
Lastly, Nike running has finally answered the Ultra Boost with the Epic React launch. I was at a launch event this weekend, and customers are definitely excited about the technology. Unfortunately, from my test run, it is not quite as game changing as Boost.
Capital allocation remains wise
Foot Locker is lowering its capital expenditures in FY18 and opening just 40 new stores while it closes 110. Foot Locker has been a net store closer in the United States for a decade, and much of the $230 million earmarked for capex will go to supporting the direct-to-consumer business.
With the acknowledgment of a lack of need to open a large amount of new stores, I expect Foot Locker to continue to repurchase stock and return more capital to shareholders in FY18. The firm already announced an 11% increase to the quarterly dividend to $0.345 per share. Unfortunately, Foot Locker’s stock rose rapidly during Q4, thus allowing the company to repurchase 2.8 million shares for a total expenditure of $105 million, for an average price of $37.50. Full-year repurchases totaled a whopping $467 million to buy back 12.4 million shares for an average price of $37.66. This equates to 10% of the company. I love management’s confidence and ability to flex buybacks up when the stock is underpriced. This is great for shareholders over the long-term.
Shares continue to look undervalued
As I have noted for months, shares of Foot Locker look cheap, trading at less than 10x next year’s earnings with a DCF value of $55-63. Foot Locker does an excellent job managing inventory and expenses while also knowing when to buy back their stock in a material way. Frankly, this is one of the best management teams in retail.
However, Foot Locker remains a market taker, and the likes of adidas, Nike, and even Under Armour (UA) need to improve time to market as well as producing products that consumers really want. I see this improving, but it is not where it needs to be. That said, I think we could see a strong recovery in H2’18. Therefore, I remain bullish, though as anyone who has followed the company can attest, it has been a bumpy ride.
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Analyst’s Disclosure: I am/we are long FL, UA. 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.
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