2023-09-03 23:29:14 ET
Summary
- Foot Locker is a global retailer specializing in athletic footwear and apparel, operating in 29 countries.
- The company has been reshaping its portfolio by closing underperforming lines and acquiring new brands.
- Foot Locker aims to reduce its dependency on Nike footwear and increase exclusive products, but its concentrated sales and relatively high valuation are concerning.
Foot Locker Inc. ( FL ) is a global retailer specializing in athletic footwear and apparel. Founded in 1974, it is headquartered in New York City and operates in 29 countries across the North America, Europe, Middle East, and Asia Pacific regions.
The firm has modified its portfolio over the past few years, shutting down underperforming lines (Eastbay, Footaction, Sidestep) and acquiring two distinct brands (WSS, atmos). Foot Locker has opened a new distribution center (their third in the US) allowing for 2-day coverage for 95% of the US, which is up from 40% three years ago. They continue to update the real estate portfolio, transitioning to more off-mall locations of larger size which seek to offer a unique customer experience. I view FL's concentrated sales, 80% footwear vs 20% apparel, as an issue ignored by management. Their goal to reduce Nike footwear dependency from 70% to below 60% is a move in the right direction, but this still means a business that is on the order of 50% a Nike shoe store. As for the narrative underlying their goal of 25% shareholder total return over three years, I view it as hopeful. Comparison of its financials to a well-performing competitor, DICK'S Sporting Goods ( DKS ), do not change the story. My rating is Sell.
Industry & Market
As a Consumer Discretionary company, Foot Locker's goods and services are considered non-essential. Its revenue is highly influenced by economic conditions, disposable income levels, and consumer sentiment. Within the footwear and apparel industry more specifically, key business factors include fashion trends, consumer preferences, and brand loyalty.
After some portfolio reshaping over the past several years, the firm comprises the following four business segments. Each is summarized per investor literature along with 2022 revenue share shown in parentheses.
Foot Locker & Kids Foot Locker (69%) - Offering sneakers and apparel to the broadest audience. Traditionally located in shopping malls, this is changing as part of their current strategy.
Champs Sports (19%) - Positioned to serve the "active athlete" who is inspired and motivated by professional sports and whose peer group prioritizes fitness.
WSS (7%) - Focuses on underserved Hispanic neighborhoods with exclusively off-mall stores. It is a recent acquisition and seeks to build customer loyalty with a fully bilingual retail experience and community involvement.
atmos (2%) - Meant to bring Japanese street style to an international audience, it is a recent acquisition and will serve as an innovation lab for the firm.
Foot Locker's competition includes every store selling sneakers and athletic apparel, ranging from manufacturers like Nike to retail behemoths like Amazon. As a company more similar to Foot Locker in terms of business segments, DICK'S Sporting Goods will be included for comparisons herein. Below is the 5-year total return for these firms alongside that of the Consumer Discretionary Select Sector SPDR Fund ETF ( XLY ). In addition to returns lagging those of a relatively direct competitor, Foot Locker stock returns significantly underperform the sector's average.
Financials
Whether viewed on an absolute or relative basis, Foot Locker's revenue growth has been low, its profit margin is low, and its valuation is high even after the recent drop in price. As part of their capital allocation strategy, the firm announced a dividend policy with a targeted payout ratio (30–35%) going forward.
Revenue
Worthy of remark is that in the past FL and DKS had similar revenue in absolute terms. Until 2017 and a level of approximately $7.5 billion, trailing twelve month revenue had been lower for DICK'S Sporting Goods than Foot Locker. FL's revenue has stagnated over the past 5 years.
As part of reshaping their portfolio, management has closed underperforming lines like Eastbay, Footaction, and Sidestep. They also acquired WSS and atmos, which they reported as being accretive to earnings though as recent acquisitions, full year-on-year comparisons were not available.
There seems to be a suboptimal balance among the sources of revenue. In Foot Locker's 2022 Annual Report , management reported 80% of sales came from footwear and 20% from apparel and accessories. Given that customers wearing sneakers also wear apparel, this 80/20 split is too high. The move towards larger stores may address this, but management did not communicate a strategy on the footwear/apparel mix.
Below is a graph of DKS sales by product category. DKS's breadth of products is supportive of one-stop shopping, which in turn is supportive of revenue growth and margins (see next section), but even within FL's categories there is an interesting comparison to be made. If the most recent levels for DKS (40% hardlines, 34% apparel, 24% footwear) are adapted to Foot Locker's business model, a much different balance shows up. Within the categories of footwear and apparel, only 41% of DKS sales, 24 / (24 + 34), are attributable to footwear. It may be that DKS's level is lower than optimal, and FL's level is higher than optimal. Either way, Foot Locker management should communicate a strategy going forward.
Margin
Before and during the pandemic, profit margin at Foot Locker was greater than or equal to DKS. More recently however, FL's margins have seen a more significant drop. Often the cause is increasing inventory forcing lower prices, and while FL's inventory has increased, there is evidence against this conclusion.
Just as Foot Locker's inventory has been increasing over the past few years, so has that of DKS. Their trajectories are similar, and if normalized by revenue, their current levels are also similar. The most recent value for the ratio of inventory/revenue is 22% for FL ($1.83 billion/$8.31 billion) and 23% for DKS ($2.85 billion/$12.6 billion).
Dividends
Foot Locker announced earlier this year a more disciplined capital allocation approach, including a 30–35% payout ratio target for dividends. This is a welcome change to their past dividend policy, which has been reactionary, increasing dividends as share price declines and vice versa.
Valuation
Despite both firms missing estimates in recent earnings announcements—FL with a revisions grade of F and DKS not genuinely any better with a D+ grade—DICK'S P/E ratio is a full 20% lower than Foot Locker's. Given Foot Locker's market performance and financials, its current P/E should be viewed as elevated relative to a competitor which has not only outperformed FL but their sector as a whole. On a relative basis, FL should not be trading at a sizable premium to DKS.
Strategy
Highlights of Foot Locker's strategy include shifting toward off-mall locations of larger size. Off-mall stores make up about 35% of locations, with mall locations to be reduced by about one-third over the next three years. These larger venues (10,000–15,000 sq. ft.) will support their cited sales drivers: sneakers and customer loyalty.
They plan to reduce Nike footwear dependency from more than 70% to less than 60% and increase exclusive footwear. Given that footwear accounts for 80% of sales, then Nike levels of 60–70% mean that 48–56% of Foot Locker revenue is Nike footwear. Reducing single-vendor dependency is a valid goal and should continue.
Regarding the firm's current goal of 25% total shareholder return over the next three years, the single biggest driver cited is a "mid-teens" percent increase in profit margin. A significant increase (up 67%) in sales of their exclusive products, from 15% of sales currently to 25% will contribute to this margin expansion. Growth in the exclusive business will be driven by "distinction and scarcity" which means popularity. Management currently attributes 25% of sales to customer loyalty, which they seek to increase to 50% in three years and then higher than 70%.
Exclusive products not only reduce single-vendor dependency, but if popular, would also drive brand loyalty. To this end, management's summary comprises "exclusive concepts," "key franchises," "athlete partnerships," and the exclusivity of the atmos brand. Given atmos's size at 2% of sales, it is my understanding that Foot Locker's management is looking to special-edition sneaker partnerships with teams and athletes to grow from 15% to 25% of sales and thus drive margin expansion up about 15%. Given that the success of these exclusives is trend-driven, and down 1% Q2 2023 YoY, I view an increase of 10% relative to firm sales over 3 years as hopeful.
Conclusion
Several parts of Foot Locker's strategy make perfect sense: shuttering underperforming lines, adding distinctive brands, better distribution, and a logical dividend policy. Regarding the newer store formats, management mentions building communities and celebrating the sneaker whereas a strategy on the product mix would be expected. The proposed roadmap to increased margins is not a predictable one, and at its current price, Foot Locker is still expensive relative to a relatively successful competitor. My rating is Sell.
For further details see:
Foot Locker Needs A Strategy With More Focus