When looking at earnings quality, we at The Motley Fool have two databases -- EQ Scan and EQ Score -- that we use to uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important for investors to understand before they lose their hard-earned money.

The EQ Score database assigns an index rank to the company from 1, for the lowest quality, to 5, for the highest. As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward.

In this series of articles looking at specialty retailers on the S&P 400 mid-cap index, we've examined names that have some income-statement and revenue issues. We've already looked at ANN (NYSE: ANN), American Eagle Outfitters (NYSE: AEO), and Aeropostale (NYSE: ARO). Today, let's wrap up our series by tackling Foot Locker's (NYSE: FL) earnings quality.

EQ trends for specialty retailers with revenue recognition issues


EQ Score, January 2012

EQ Score, February 2012

EQ Score, March 2012


Likely Issue

ANN 3 4 2 Down Revenue
American Eagle Outfitters 2 2 1 Down Revenue
Aeropostale Not Ranked Not Ranked Not Ranked Flat Revenue
Foot Locker Not Ranked Not Ranked Not Ranked Flat Revenue

Source: Fool EQ Score for the week ended 3/16/2012.

ANN's and American Eagle's EQ scores have trended down, and Aeropostale and Foot Locker aren't rated. Let's quickly review the companies we've looked at so far and then dig in to Foot Locker:

  • ANN's revenues have increased year over year (YoY) almost 10%, but the company's cost of goods sold (COGS) has increased 16% and the gross margin has decreased 5% YoY. Inventory levels have increased from $169.14 million in FY 2010 to $213.45 million, or 26%. Revenue hasn't kept pace with increases in the cost of goods sold (COGS), and inventory remains on hand longer.
  • American Eagle shows increasing revenue YoY, up 14%, but its gross margin is down 14% and its COGS is up 24%. This translates to decreasing gross profit levels, which have been negative for six of the past eight quarters, and net income is down 41% YoY.
  • Aeropostale's revenue was down 4% YoY, while its COGS was up 51% and its gross margin down 51% YoY. Gross profit was down 53% from the same period a year earlier, and net income and earnings per share were down 69% and 66%, respectively.

Foot Locker could be off to the races
Foot Locker is a retailer of athletic footwear and apparel. Its Athletic Stores segment operates under the Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction, and CCS brands. As of Jan. 28, it operated 3,369 stores in 23 countries in North America, Europe, Australia, and New Zealand, along with 34 franchised stores in the Middle East and South Korea.

Foot Locker Revenues Chart

Foot Locker Revenues Chart by YCharts

Foot Locker's revenues rose 8% YoY to $1.502 billion, and gross margin increased to 31.96%. While the low gross margin reflects a high COGS of 68%, revenue and gross margin trends are positive. Foot Locker's revenue and gross margin also don't reflect the traditional holiday seasonal patterns -- in fact, just the opposite. Revenue indicates that new athletic footwear is purchased in time for enjoyment of outdoor activities like road racing, track and field, and organized sports. This should have implications for inventory levels.

Foot Locker Revenues Chart

Foot Locker Revenues Chart by YCharts

And sure enough, inventory patterns appear to be fairly consistent, while revenue is rising. It's unnecessary to use much discounting, because the proper footwear is mandatory to play sports, but some discounting probably still occurs. Revenue growth may be due to higher unit sales or higher price points per unit, or perhaps both reasons. Let's face it -- some retailers, such as Nike (NYSE: NKE), have been able to transcend the distinction between athletic and fashion footwear, and the newest styles have been spotted selling at places like eBay for well above retail price.

As with the other specialty retailers we've reviewed, Foot Locker has repurchased stock to reduce shares outstanding. This tactic boosts net income and earnings per share, and the $37 million spent on stock repurchases in 2011 has had the desired effect: The net income trend has been positive, with reported net income of $48 million in 2010, $169 million in 2011, and $278 million in 2012. Foot Locker's cash position has increased $269 million since January 2010 to a very healthy $851 million on hand.

Since Aug. 8, shares have nearly doubled from $16.77 to a recent close of $31.53. The only negative is that Foot Locker experiences lower margins than many other specialty retailers, but heck, the rest of the story is very positive. Analysts anticipate next year's EPS to increase by 23.6% to $2.25 per share, but the trailing P/E is only 17.52, and the forward P/E is 12.51. This could be one race worth running.

Looking from a wider perspective, though, there is a monumental shift in the retail space that no company will be able to avoid. The changes are so dramatic that it could mean The Death of Wal-Mart. You can learn more about this in our special free report.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.