Let's just jump right in. Finish Line (NASDAQ:FINL) is falling behind. That's because a traditionally weak third quarter was even weaker this year. And here's my data to back it up.

3Q 2006

3Q 2005

3Q 2004

Gross Margins

27.7%

28.3%

28.0%

Op. Margins

-1.7%

0.4%

1.2%

Net Margins

-1.1%

0.3%

0.9%

Return on Capital

-2.7%

0.6%

2.0%
Data from Capital IQ, a division of Standard & Poor's

What happened this quarter to cause margins and return on capital to fall again? First of all, management commented on the continued shift in the merchandise mix. In the second quarter, that meant selling fewer men's running and basketball shoes from Nike (NYSE:NKE) and more Heelys (NASDAQ:HLYS). This quarter, Heelys sold well again as the shift continued from performance to athletic casual products.

Despite an increase in the average selling price of footwear, gross margin fell 60 basis points. Finish Line mentioned continued heavy use of promotions and poor sales of soft goods (e.g., hats) and accessories. To make matters worse, the lack of sales growth caused operating deleverage -- the company's selling, general, and administrative costs (which act like fixed costs) rose 8.1% for the quarter, causing operating income to turn negative. That's not good at all because that means that all the cash that Finish Line invested in new stores and working capital destroyed lots of value this quarter. Again, Finish Line is falling behind.

Inventory was up 15% on an absolute basis and up 5% on a per-store basis. There are 12% more stores in the base (792 at the end of the period versus 707 last year), so it appears that products are not piling up to the ceilings. Again, the problem is with thinning gross margins and rising SG&A as a percentage of sales.

Curiously, a $20 million loan popped up on the balance sheet. A quick scan shows that the company needed this to fund working capital. Perhaps a little less cash should be spent on opening new stores and repurchases of stock, given the low return on invested capital, so that the company could focus on improving operations to stop the slide in margins.

On that point, I agree with an activist shareholder that the results do not necessarily show the company is being managed effectively. Foot Locker (NYSE:FL) is also experiencing a slowdown but continues to maintain its margins despite the lack of growth. So once again, Finish Line is playing catch-up with merchandise trends, returns on capital, and the competition. That's not an inspiring performance by any stretch of the imagination.

To my surprise, Finish Line has a four-star rating in our Motley Fool CAPS community intelligence service. I believe most investors believe a turnaround story is in the making or that the company may be bought out. And to those investors' credit, the stock is up about 50% from its 52-week low. But I've said it before and I'll say it again: I'll pass on Finish Line and I wouldn't rely on a buyout to lift my returns.

For more on the athletic shoe business, check out:

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Retail editor David Meier is ranked 328 out of 18,048 players in CAPS, owns shares of Nike, and does not own shares in any of the other companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.