2023-10-03 17:16:52 ET
Summary
- Foot Locker has experienced a sharp valuation decline, losing over half its value this year, due to slowing consumer spending and rising inventory costs.
- The company's efforts to diversify its product line and create off-mall stores have not been successful so far, and its cash position is dwindling, putting it at risk if economic demand falters.
- Foot Locker's fundamental trends show declining real sales, falling gross margins, and increasing inventory levels, indicating a challenging situation for the company.
- While Foot Locker may successfully turn around, I suspect it may soon need to sell equity and dilute shareholders to retain a necessary cash position.
The second half of 2023 has seen increased volatility in the retail sector. Slowing consumer spending and student loan repayment concerns have led to sharp valuation declines in many retail companies. One notable example is Foot Locker ( FL ), which has lost over half its value this year. The equity plummeted 30% over the summer as its Q2 results disappointed with lower-than-expected sales guidance and total dividend suspension. Short interest on the stock has risen dramatically to 13.6%, not necessarily pointing to a short squeeze, but certainly implying significant short positions on it.
At Foot Locker's current valuation, many investors are likely wondering whether or not the company may lose more value or recover. The macroeconomic trend will also be critical for the company because it has generally operated in a decent consumer spending environment over most of the past two years. A recessionary decline in consumer spending could make its difficult situation much worse. The company's managers are looking to turn it around by diversifying its product line away from Nike, creating off-mall stores, and encouraging customer loyalty. Thus far, its efforts have borne little fruit, and with its cash position dwindling, the firm is at some risk, particularly if economic demand falters. Still, even an at-risk business model may be a deep-value opportunity at the right price.
A Look at Foot Locker's Fundamental Trends
For the most part, 2020-2021 was an excellent period for consumer sales due to the massive increase in household savings and income, supported by stimulus efforts. Of course, due to the lockdowns, Foot Locker only benefited from the tail-end of that trend. Further, as the government stimulus resulted in inflationary pressures on households, Foot Locker has faced some negative economic strains associated with falling real retail spending. See below:
Without adjusting for inflation, Foot Locker's revenue per share trend appears firmer, although it is still slightly negative in the past quarter. However, adjusting for inflation, we can see an evident long-term trend, with its real sales peaking in early 2022 following the massive spike in real retail spending. As total US real retail sales have begun to trend lower, so too have Foot Locker's inflation-adjusted sales.
Crucially, Foot Locker has not managed to push inflation onto customers. Its gross margins have trended lower over the past year as the company struggles to move rising shoe costs into its prices. Its inventory level has also increased dramatically, implying it should reduce prices even further to attract and retain customers. See below:
The producer price index for footwear manufacturing roughly measures the price paid by Foot Locker for its products, but not the price charged by Foot Locker. As manufacturer's shoe prices have soared, Foot Locker's gross margins have quickly declined while its Days Inventory Outstanding (a measure of inventory-to-sales) has increased. The company's Days Inventory Outstanding is extremely high today and has consistently risen since the end of 2021. This rising inventory trend is a significant issue because it implies continued gross margin declines. Foot Locker's inventory levels appear too high today, meaning the company will likely need to offer substantial discounts to reduce inventory levels.
Interestingly, this trend is likely not limited to Foot Locker. Since last year, the consumer price index of footwear has not risen nearly as quickly as the producer price index from footwear manufacturers. In other words, product costs for all footwear retailers have grown much more rapidly than the prices they can sell at. See below:
Since the market's minor peak at the end of 2021, footwear costs have risen nationally by about 8% more than footwear consumer prices. Foot Locker's gross margins have also fallen by around 8% over that period, indicating that the company is merely keeping up with the national standard. Of course, as a primarily in-store retailer (with just ~17% of sales from e-commerce), its operating overhead costs are likely a bit higher than its online peers. According to recent surveys, that is a massive issue for Foot Locker because ~74% of all footwear spending is now online.
Despite only a slight decline in sales, the portion of Foot Locker's sales going toward operating costs has risen dramatically since 2021. Its total operating expenses did decline very slightly YoY last quarter, but not nearly as much as its sales. See below:
Should this trend continue, Foot Locker's ability to generate a positive operating income will be questionable. The company had a marginally positive operating income last quarter but with a severe negative change matched by an increase in OpeX-to-sales and a sharp decline in gross margins. Furthermore, the company's comparable sales fell in all its US brands (Foot Locker, Champs, and Kids Foot Locker) and most of its international outlets. Considering this is a global negative trend, the firm will likely have difficulty recovering because it cannot rely on growth in any particular segment. In other words, the company does not necessarily have different growing segments to invest in to offset losses in its major brands.
Finally, Foot Locker's liquidity position is fragile today. Its quick ratio is just 0.12X, meaning it has 12% of the liquid assets necessary to meet obligations over the next year. Most retailers naturally have low quick ratios because they rely on inventories (not counted in this metric). Still, Foot Locker's quick ratio was historically over 1X before 2019 and has deteriorated dramatically with its cash position since 2021:
Foot Locker had just $180M in cash at the end of the last quarter, far below its average level of nearly $1B before 2020. This massive deterioration in liquidity should be a significant concern for investors because it may fail to meet its obligations should its income fail to rebound over Q3-Q4. If its net margin falls to -2%, in line with its current trend, Foot Locker has around a year of cash to cover losses. Its working capital was ~$920M at the end of Q2, indicating a decent barrier, assuming its inventory prices do not slide (which I believe they will do to inventory buildup).
Foot Locker's debt-to-EBITDA is not significant because the company has very little financial debt. Most of its liabilities are rental obligations, but they can still become a massive issue if Foot Locker's profit-making ability falters. Given a conservative continued decline in its margins, the company has sufficient working capital to survive for at least a year. However, if its profitability declines sharply due to a recessionary shock, I do not believe Foot Locker's liquidity profile is strong enough to support it long-term. The decision to cut its dividend was undoubtedly necessary, given its operating cash flow may be chronically negative for a sustained period.
Beware the Macroeconomic Trends
Foot Locker's path forward depends greatly on changes in macroeconomic circumstances and its managers' decisions. The company recently announced a plan to close hundreds of stores over the next three years while opening nearly three hundred new stores. Most closed stores will be in underperforming malls, while new ones will be away from traditional malls. Like many struggling retailers, it aims to focus on smaller local stores as more shoppers gravitate away from traditional malls.
In my view, the success of this plan is questionable, given the associated costs of closing and reopening stores and other factors beyond Foot Locker's control. It may cost a great deal to open and close so many stores, and Foot Locker does not appear to have sufficient liquidity to make that possible without selling additional equity. Further, Foot Locker is struggling with rising theft levels , particularly as shoe prices rise disproportionately compared to inflation (making them a theft target).
The most significant risk to Foot Locker is a decline in consumer spending. Consumer spending has been resilient during the past three years due to stimulus efforts and a decent job market. However, household savings levels are lower than normal due to rising living costs and fell over the past three months. Consumer debt increased dramatically as savings fell in 2021 and 2022 but are now slowing dramatically. See below:
Since both savings and consumer debt are declining, there is a decent indication that many households have maximized their debt capacity. Consumer spending was resilient despite inflation, mainly due to increased borrowing. Thus, because we're seeing borrowing slow despite the recovery in savings, it is very likely that people are reducing discretionary spending due to a lack of available spending capacity. Of course, Foot Locker is a primary target for the " student loan repayment " trend that will begin this month as Federal loans come due again, forcing many younger working people in the US to reduce excess spending. While everybody needs shoes, most people can choose to replace shoes at a lower rate, utilize cheaper online options, or purchase non-name brand shoes - all of which would be negative for Foot Locker.
The Bottom Line
Overall, I expect Foot Locker to need to utilize equity sales over the next twelve months to offset negative cash flows. Its weak liquidity position and excessive inventory level could easily exacerbate its need for external financing. The company's turnaround efforts could eventually prove fruitful, but I doubt its current liquidity position is sufficient, particularly given its declining operating margin trend.
To me, the macroeconomic outlook for Foot Locker is also problematic. The data shows consumption habits are becoming more conservative after relatively strong spending years in 2020-2022. The substantial increase in footwear prices is likely a major driving factor. It should continue to be one as consumer pressures rise on lower credit card capacity and student loan repayments. By many measures, the odds of a recession in 2024 are very elevated today, creating the potential for an unemployment shock that could drive Foot Locker's sales much lower.
I am bearish on FL and believe it will likely lose value as its EPS estimates decline due to its competitive margin pressures and deteriorating macroeconomic consumer conditions. Further, due to its store opening and closing plans and its weak balance sheet, I believe Foot Locker may need to sell substantial equity to restore its cash position. While FL is a bit difficult to value due to my negative EPS outlook, its downside risk appears to me to be greater than its recovery potential - mainly due to changes in economic circumstances.
Additionally, my view differs from the analyst consensus. Most FL analysts expect its 2024 EPS to decline to $1.34 and then rise back to $3.84 by 2027. Its immediate "P/E" valuation based on this target is 13.7X (a high figure given its risks), but its 2027 forward "P/E" would be a more attractive 4.77X. Thus, investors who firmly believe FL will successfully execute a turnaround plan without diluting equity may find value in the stock today. This is enough of a reason that I am not so bearish on FL that I would short-sell it at its current price. However, I personally doubt its EPS will recover so quickly due to recession risks and immediate declines in consumer spending, particularly on higher-cost footwear. Further, while it appears possible for Foot Locker to revamp its stores in a more profitable direction, given its cash and cash-flow positions, I strongly suspect that can only occur with relatively significant equity dilution.
For further details see:
Foot Locker: Student Loans May Be 'The Straw That Broke The Camel's Back'