After an Earnings-Related Pop, Does Foot Locker Have More Upside Ahead?

Athletic footwear retailing king Foot Locker continues to ride Nike's coattails, recently posting better-than-expected results for its latest quarter. After a good five-year run, does the company have more upside?

May 18, 2014 at 9:00AM

Footwear retailer Foot Locker (NYSE:FL) has enjoyed a solid selling environment over the past few years, as it has anecdotally taken advantage of people's rising interest in physical fitness while also benefiting from a close relationship with athletic product kingpin Nike (NYSE:NKE), the source of more than two-thirds of its total sales. Consistently higher per-store productivity has led to profit gains for Foot Locker, powering a more than 300% stock price increase over the past five years.

Fortunately, the good vibes continued in Foot Locker's latest quarterly report, evidenced by higher comparable-store sales and better-than-expected profitability, which led to a subsequent pop in its share price. So after a strong five-year run, is Foot Locker still a good bet?

What's the value?
Foot Locker is the largest domestic retailer of athletic shoes, offering a diversified assortment of brands through a network of almost 3,500 stores around the world. The company has benefited from rising average prices in the footwear category, as well as in-store, co-marketing partnerships with major manufacturers that include its Nike-branded House of Hoops and Puma-branded Performance Labs. The net result for Foot Locker has been consistent increases in comparable-store sales and generally higher operating profitability.

In its latest fiscal year, Foot Locker continued to build on its long-term growth story as it reported a 5.2% increase in total revenue that primarily resulted from strong comparable-store sales growth. During the period, the company was able to leverage prior investments in its support infrastructure, especially in the online area, to power its highest adjusted operating margin of the past five years. More important, the higher profitability fueled higher operating cash flow for Foot Locker that provided the company with funds to expand its footprint in related product areas and geographies, which was highlighted by its 2013 purchase of Germany-based Runners Point Group, a major European seller of performance running footwear.

Tied at the hip
Despite Foot Locker's diversification efforts, its success is heavily tied to the continued popularity and success of footwear giant Nike, which continues to account for the vast majority of Foot Locker's sales. Fortunately, the iconic shoemaker has been posting pretty solid numbers lately as it has benefited from higher sales of shoes around the world, as well as its broadening forays into the sports apparel and equipment areas.

In fiscal 2014, Nike posted solid top-line growth of 9.4% thanks to rising sales volumes across its major geographies.  More notably, the company continues to show impressive pricing power, likely due to insatiable demand created by its huge investments in marketing that include big endorsement deals with high-profile professional athletes. The positive feedback loop between marketing activities and product pricing allows Nike to generate a double-digit operating margin, which provides it with strong cash flow to invest in new product development -- which ultimately benefits key suppliers like Foot Locker.

A better way to go
While Foot Locker has been an undeniable success story, the company seems to be a bit risky given that shoe sales make up approximately 77% of its total sales, much of which are likely expensive branded products that consumers are probably buying as much for fashion statements as for utility. As such, investors might find a better risk-reward ratio with a more diversified operator in the space, like Dick's Sporting Goods (NYSE:DKS).

The former bait and tackle shop has come a long way since its early days, as it currently operates nearly 600 sporting goods superstores around the country. Like Foot Locker, Dick's has forged in-store marketing partnerships with major manufacturers, like its Nike Fieldhouse initiative. These have allowed Dick's to leverage the manufacturers' large marketing budgets to fuel an upward trajectory for its operating profitability over the past few years. More important, Dick's has a much more diversified supplier and product mix than Foot Locker, which includes a growing private-label business in the apparel and equipment product areas.

The bottom line
Foot Locker has been a great profit growth story over the past few years as its stores have been productivity machines, generating sales per square foot of $460 in its latest fiscal year compared to just $333 in 2009. However, with Foot Locker's organic store expansion grinding to a halt lately, future sales growth is likely to be much harder to come by, especially if customers start gravitating toward lower-priced products. As such, investors should wait for the company's shares to cool off a bit before considering positions.

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Robert Hanley owns shares of Foot Locker. The Motley Fool recommends and owns shares of Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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