Tripping Up: Unpacking Foot Locker's Rocky Quarter and the Investment Opportunity in the Company's Bonds
A Deep Dive into Foot Locker’s Underperforming Metrics, Management's Shaky Credibility, and Investment Opportunity Amidst the Chaos
Foot Locker Inc. (“FL”) a market leading footwear, apparel, and accessories retailer, that primarily operates in US malls. The company is currently facing several headwinds including weak consumer spending, higher discounting initiatives, and inflationary pressures, all of which have resulted in weaker revenues/profitability, elevated inventory levels, and rising leverage. FL is particularly exposed to lower and middle-income consumers who have been significantly impacted by the current economic environment. This unfortunately has come at a time when FL is looking to reposition its brand and invest in omnichannel capabilities, the combination of which has put pressure on margins and FCF.
Most recently, on August 23, 2023, FL reported another weak quarter with little signs of business improvement. Net sales declined by 9.9% y/y due to cautious customer spending, decreased store traffic/conversion, and a weak start to the back-to-school season. All categories saw declines with lifestyle running being the weakest spot in footwear. Regionally, North America saw a notable 12.4% decline (Europe -2.3%, APAC +0.4%). Gross margins declined by 460 bps y/y due to higher promotions and elevated theft-related shrink levels, offset by savings from the company's cost optimization program. To top it all off, 2Q’23 Adjusted EBITDA declined a whopping 68% y/y to $65 million.
Although these results were not too far from street expectations, they were accompanied with additional cuts to guidance. Management proceeded to reduce its FY’23 revenue outlook down 9.5% (mid-point) due to weaker-than-expected sales trends in July and August and the need for increased promotional activities to clear excess inventory. Specifically, the same-store-sales (“SSS”) outlook for the full year was revised to down 9% to 10% (prior outlook was down 7.5% to 9%), and full year gross margins were revised down to 27.8% to 28.0% (prior outlook was 28.6% to 28.8%), as management intended to take more aggressive markdowns to both drive demand and manage inventory. See below for more detail on the recent guidance changes.
This revised outlook now implies a 2H’23 SSS decrease in the high-single digits (previously was mid- to high-single digits) and a 2H’23 gross margin y/y decline of 380 bps (430bps decline vs. 1H’23), implying decelerating 2H GM stacks vs. 2019. Lastly, Footlocker decided to pause its quarterly cash dividend beyond its recently approved October 2022 payout to ensure flexibility in funding strategic investments.
Investors reacted very negatively to this news with the stock declining by over 30% the following day, bringing total YTD declines to nearly 50% and a stock price that is at its lowest level since 2010. All in all, the substantial fiscal year guidance cut (a ~35% reduction in EPS) marked the second consecutive 30%+ fiscal year guidance cut under the new management team, further undermining management's credibility and overshadowing a relatively in-line second quarter.
In sympathy, FL’s bonds also reacted negatively to the news despite some credit positive events (e.g., dividend pause). Currently, the company’s unsecured bonds are trading at ~75.8 / 9.3% / 505bps, near all-time lows.
In summary, FL's second consecutive significant fiscal year guidance cut, slowing 2Q exit rate compared to mostly flat or strengthening peers, ongoing bloated inventory levels, dividend pause, and further eroded management credibility, all contributed to the weak price performance of the company’s stock and bonds.
For many value investors, it may seem natural to gravitate towards a stock following a 50% decline in relatively short order, especially for a large company such as FL. After all, despite some of these near-term challenges, the company's longer-term outlook remains solid, benefiting from secular growth in demand for sneakers and strong demand for leading athletic brands such as Nike, adidas, Puma, and New Balance.
In this scenario however, I believe the bonds of the company are more interesting than its equity. At present levels, I think that one can generate attractive total returns with significantly lower risk/volatility. In the following text, I will evaluate Footlocker from the standpoint of a creditor, which includes an analysis of its existing capital structure, examination of credit positives/negatives, and an evaluation of the trading opportunity.