Foot Locker (FL -0.18%) recently had some positive surprises for investors that spurred a quick bounce in the stock price. The footwear retailer announced modest second-quarter sales declines compared to soaring results a year ago. Management signaled a major strategic pivot ahead, too, with the appointment of a new CEO who has a great track record in the industry.
But investors might still want to stay cautious before buying into a broader rebound story. Let's look at a few reasons why.
Sales are weak
Management stressed the fact that Q2 sales rose 16% compared to 2019, despite falling 9% year over year. That big-picture trend is helpful since it removes some of the noise associated with last year when financial stimulus helped spur huge demand spikes.
But Foot Locker still faces big growth challenges. Its main supplier, Nike, is pivoting toward a direct-to-consumer selling approach that removes retailing partners like Foot Locker. And the chain is seeing pressure from weaker consumer spending in a few niches thanks to inflation. Executives said the industry was impacted by "an increasingly challenging macroeconomic backdrop."
Other warnings signs
There are other warnings signs that should make investors doubtful about a quick operating rebound ahead. Foot Locker's gross profit margin fell by three percentage points in Q2 after falling by less than one percentage point in the prior quarter. Management suggested that price cuts are finally stabilizing, but that's no guarantee that margins will return to the highs investors saw in earlier phases of the pandemic. Operating income in the first half of the year has shrunk to $356 million from $546 million, in fact.
FL Gross Profit Margin data by YCharts
The company is also awash in inventory. Merchandise holdings jumped 52% to $1.6 billion by late Q2, which is normally a red flag for any retailer. Sure, Foot Locker needed to bulk up its inventory to prepare for the back-to-school and holiday shopping seasons. But as peers like Target have demonstrated recently, those purchasing decisions come with major risks around declining earnings if demand doesn't match up to management's projections.
The new boss
There is warranted excitement around Foot Locker's appointment of a new CEO. Not only does the move imply major strategic shifts ahead, but the company will now be led by Mary Dillon, who helped build Ulta Beauty into a leader in the highly competitive beauty products industry. Dillon's stellar track record in multi-channel retailing will directly apply to Foot Locker's turnaround initiatives.
Yet, investors might still want to wait for more concrete signs of a rebound before buying the stock. Profitability is declining even as inventory levels rise heading into the second half of the fiscal year. Management lowered its 2022 outlook as well, saying sales should fall by at least 6% this year rather than about 4%. Profit margins will shrink, helping drag earnings lower.
It is possible that these declines will represent the worst of a tough selling situation for Foot Locker as it reduces its reliance on Nike and moves through the growth hangover from earlier phases of the pandemic. But it would be risky to assume that the retailer can easily recover this lost ground. That's why investors might want to watch this retail stock from the sidelines while they wait for more concrete evidence of a rebound.
