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Foot Locker Crushes Earnings, but Is Caution Warranted?

By Jamal Carnette, CFA - May 30, 2018 at 9:16AM

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Shares of Foot Locker jumped post-earnings. Have you missed the rally or should you stay clear of the name?

Foot Locker (FL -6.17%) stock is finally showing signs of life. Shares jumped 20% in response to first-quarter earnings. The company outperformed analyst expectations on both the top and bottom lines by reporting revenue of $2 billion and adjusted earnings per share of $1.45 ($1.38 GAAP compliant) versus consensus estimates of $1.96 billion and $1.25, respectively.

Although investors reacted positively to the news, shares are still lower on a one-year basis including post-earnings gains. Concerns about the death of retail, particularly lower traffic at malls, continue to weigh on the company. And although Foot Locker outperformed this quarter, caution is warranted when you look deeper into the company's results.

A scale with blocks labeled Risk on one side and Reward on the other.

Image source: Getty Images.

A better-than-expected quarter

In response to a poor fourth quarter, Foot Locker was lucky to have had low expectations. Analysts expected comparable sales would fall 3.6% from the prior-year's quarter. Therefore, Foot Locker's comparable sales decrease of 2.8% was considered strong by investors. Foot Locker did report total sales growth of 1.2%, but this figure is somewhat misleading because it includes foreign sales -- after accounting for foreign exchange fluctuations, sales decreased 1.5%.

Although EPS registered a significant beat, that was due to lower share counts, as total profit decreased from the prior year. Looking further up the income statement gives reason to pause. Foot Locker's gross margin decreased to 32.9%, down more than a percentage point from the year-ago quarter. The company blamed investments in its digital channel for the compression.

Interestingly enough, it does not appear the sales mix is to blame for lower margins, like many retailers are claiming, as CEO Richard Johnson notes, "The flow of premium product continues to improve, with increasing breadth and depth in the most sought after styles from our key vendors."

Foot Locker remains cheap

The best argument for Foot Locker is valuation-based. Shares currently trade at 10 times consensus earnings, much lower than the S&P 500's 17 times valuation, and the $0.20 adjusted EPS beat portends analysts' further earnings estimates may be low. And at 3.2%, Foot Locker's dividend is nearly double the yield of the greater S&P 500. Barring a significant development, the dividend appears safe as the last five years the dividend hasn't exceeded 30% of free cash flow.

However, it's likely the company's total cash return is unsustainable as it exceeds 100% of free cash flow -- although the net cash position of $900 million provides significant cushion in the intermediate time frame.

Furthermore, the Tax Cuts and Jobs Act will be positive for Foot Locker. While many analysts have commented about the one-time repatriation charges that big tech giants will have to pay, the legislation is likely to have a more positive effect on smaller, less-profitable companies like Foot Locker. The company's income tax rate (federal and state) dropped from 33% to 29%. It's likely the firm will use its tax savings to continue to buy back shares, which it did to the tune of $112 million during the quarter.  

Like many mall-based retailers, Foot Locker is becoming a Rorschach test for investors. On one hand the overall industry is contracting under pressure from e-commerce giant, which recently inked a deal to sell Nike products and has been selling adidas products since 2014, two of Foot Lockers strongest brands, and will continue to struggle. On the other side are value-oriented investors who realize many of these companies appear undervalued amid an irrational fear of a total retail apocalypse that may never come. Although far from the all-clear for low-risk investors, the Foot Locker's earnings did present a company showing steady signs of improvement.

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