Foot Locker: Pent-Up Demand Will Change The Paradigm Here

Summary

• Dividend and buybacks get suspended on the back of negative earnings in Q1.
• This too shall pass.
• Shares look overbought over a short-term basis. We may get long here on a pullback.
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Josh Arnold made a very good call on Foot Locker (NYSE:FL) back in March when many thought the world was going to end. Josh actually recommended the stock around the $21 level. Shares actually dropped to close to $18 a share at the height of the panic. Fast forward a couple of months and change and shares are now trading just above the $29 handle. Suffice it to say, that is an impressive return on investment over the past 10+ weeks.

Foot Locker this year has been an excellent trading stock for a few reasons. First, there is plenty of liquidity as we can see from the tight bid/ask spreads in its options' chains. Implied volatility spiked aggressively back in March when equity markets tanked. The combination of high implied volatility, liquidity, a retailer with significant financial strength and a keen valuation definitely brought traders to this stock in a big way in the first quarter of this year.

With equity markets continuing to shrug off what is happening on main street, volatility has ebbed quite a lot in recent months. The retailer has just come off the back of a negative earnings print of -$0.67 in the first quarter along with lower than expected sales numbers of $1.18 billion in the first quarter. After a sharp share-price drop post the announcement 12 days ago, shares have recovered well as the market seems to be pricing in the re-opening of stores coming down the track. Therefore, let's look at the investment case for Foot Locker going forward.

Although profitability dropped ever so slightly in Foot Locker's latest fiscal year, the fundamental story of the retailer was strong coming into the first quarter of this year. Gross profit hit $3.56 billion in 2019, the dividend and share-buybacks remained strong and the balance sheet was in pristine condition. Fast forward a few months and the dividend has been suspended, the buybacks have been halted and $330 million has been drawn down from the firm's credit facility.

What investors need to remember here is that all of the above measures are precautionary, meaning they have been implemented to essentially protect the firm against the unexpected. Many value investors for example tend to alienate stocks which do not pay a dividend, but we do not believe that is necessarily the right course of action here. Suspending the payout was the right decision for the company. Reducing the expected capex spend was also the right call. It is all about protecting cash at present while at the same time attempt to whittle down those inventory levels as much as possible.

Inventory levels is really where many retailers will get hurt in the near term. Foot Locker's inventory levels for example increased by over 20% in the first quarter, whereas sales contracted by close to 43%. This trend obviously is not sustainable but Foot Locker (more than most) should be able to withstand this short-term trend for the following reasons.

1. When we take the "capital leases" line-item out of the retailer's liabilities section of the balance sheet, we can see that the company still has close to twice as much equity as debts. This puts Foot Locker in a strong position entering 2020.
2. Foot Locker is also working off a very strong base with respect to its cash flows. Even if for example, the firm's cash flow multiple was to rise to 15 this year (4.4 at present), since dividends and buybacks have been suspended, we do not foresee an issue where significant amounts of cash would be drained from the balance sheet.
3. Sales of sneakers are booming as lockdowns come to an end worldwide. For many, running shoes still require a visit to your local retail store which puts Foot Locker in pole position. Digital channel sales at present are acting as a significant hedge until foot traffic returns.

From our perspective, if the retailer can beat its first quarter number in Q2, it would bode well for a solid uptrend in 2020. From an investor's point of view, we would like Foot Locker to take a little more risk by upping its capex budget this year. Its finances are in solid shape and now is the best time to capture market share away from its competitors.

To sum up, the investment case for Foot Locker remains solid. Management has been prudent by suspending the dividend, buybacks and drawing down credit from its revolver. A pent-up demand here should see increased numbers enter its stores over the next few quarters. Despite the recent up-move, shares are still trading at just 0.44 times sales. Let's see what the second quarter brings.

Analyst’s 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.