Foot Locker Appears Fairly Valued

| About: Foot Locker, (FL)
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As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Foot Locker's (NYSE:FL) case, we think the firm is fairly valued at $30 per share, about in line to where it is currently trading.

For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Footlocker posts a VBI score of 5 on our scale, reflecting our "fairly valued" DCF assessment of the company, its attractive relative valuation versus peers, and neutral techinicals. Though imperfect, we use DSW (NYSE:DSW), Finish Line (NASDAQ:FINL), Collective Brands (NYSE:PSS) and Shoe Carnival (NASDAQ:SCVL) for our peer group analysis.

Our Report on Foot Locker

Investment Considerations

Investment Highlights

• Foot Locker scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 12.3% during the past three years.

• The firm is trading at attractive valuation multiples relative to peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the firm's shares.

• Foot Locker has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 4.7% in coming years. Total debt-to-EBITDA was 0.2 last year, while debt-to-book capitalization stood at 6%.

• Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.

• The firm sports a very nice dividend yield of 2.3%. We expect the firm to pay out about 32% of next year's earnings to shareholders as dividends. We are strongly considering adding Foot Locker to our watch list in our Dividend Growth Newsletter (please view the links on our left sidebar for more information).

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Foot Locker's 3-year historical return on invested capital (without goodwill) is 12.3%, which is above the estimate of its cost of capital of 10.6%. As such, we assign the firm a ValueCreation rating of GOOD. In the chart to the right, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Foot Locker's free cash flow margin has averaged about 5.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Foot Locker, cash flow from operations increased about 44% from levels registered two years ago, while capital expenditures expanded about 71% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Foot Locker's shares are worth between $24.00 - $36.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $30 per share represents a price-to-earnings (P/E) ratio of about 16.7 times last year's earnings and an implied EV/EBITDA multiple of about 7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.4%. Our model reflects a 5-year projected average operating margin of 8.9%, which is above Foot Locker's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.2% for the next 15 years and 3% in perpetuity. For Foot Locker, we use a 10.6% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Future Path of Fair Value

We estimate Foot Locker's fair value at this point in time to be about $30 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart compares the firm's current share price with the path of Foot Locker's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $38 per share in Year 3 represents our existing fair value per share of $30 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.