Foot Locker Shows Limited Risk with 40% Midterm Upside.

Investment Thesis:
In an environment with increasingly fewer undemanding valuations in the consumer space (though in itself not a reason), Foot Locker offers an interesting value proposition: A company with a relatively dominant market position in its industry (>20% market share and >3x as big as next biggest pure play comp Finish Line) that is growing EPS at 10+% annually and is trading at a 20+% discount to the S&P 500 and peers. Additionally, a strong balance sheet with 16% of the market value in cash and little debt provides both downside valuation support and upside growth potential in the form of cash deployment. Today, based on our estimates, FL is trading at 10.7x FY2013E EPS, net of cash, and 7.9x FY2015E EPS.

Year-to-date shares have significantly underperformed YTD (up 11% YTD vs. 24% for S&P 500 and 35% for S&P Retail sector). While FL's second quarter slightly missed estimates, results were stronger than those of many other retailers in what is currently a very challenging environment. With 1.8% same store sales growth, FL was able to avoid negative comps experienced by many other retailers, though fell short of management's general mid single-digit guidance, and expectations around 3.5%. While gross margins surprisingly fell 10bp, even at a modest 1.8% comp growth in Q2, operating leverage led to 80bps operating margin expansion year-over-year (consistent with guidance of being able to leverage low single-digit comp growth) and EPS increased by 20%. Management reiterated guidance of mid single-digit SSS and double-digit earnings growth. Notably, FL repurchased $100mm of shares in the quarter.

We see several catalysts that could drive shares higher over the medium term:
1) Deploying Foot Locker's sizeable cash balance towards share repurchases: In Q2, FL repurchased $100mm of shares, a pace almost twice the rate needed to reach its target of repurchasing $600mm of shares by January 2016 (~11% of the current market cap). We believe this could signal an increased willingness by management to deploy its sizeable cash balance, currently at ~$840mm.
2) In H1 2013, Foot Locker remodeled 153 stores, or 6% of U.S.-based stores, with Q2 picking up pace at 89 remodels. By the end of 2013, the company expects to have ~15% of Champs and 10% of Foot Locker stores remodeled, ~190 stores. Despite being closed for several weeks during renovation, remodeled stores are included in FL's overall SSS growth figures and have thus been a drag on reported numbers. With more remodels completed and benefiting sales (some estimates suggest remodels are driving an improvement in store sales and margin performance in excess of 15-20%), FL could see a significant boost to comps in 2014 given that ~10% of stores will be remodeled. Further, insight into completed remodels should allow management to be able to provide more transparency around the success of remodels that could lead to greater investor confidence in the program.
3) The recent acquisition in May 2013 of Runners Point Group - a German apparel retailer with 194 stores in Europe and $250mm of sales - could provide meaningful upside to Foot Locker's sales and square footage growth and should be accretive to EPS in 2014. We believe the acquisition is currently underappreciated and not fully modeled by Wall Street analysts.
4) Continued progress toward Foot Locker's FY2016 strategic plan of $7.5bn in sales and 11% EBIT margins. FL reached most of its previous five-year targets for FY2014 2-3 years early, leading it to revise those targets to current levels. Given this, our estimates assume the company reaches most its FY2016 targets in FY2015. Strong management and with a history of executing well provide comfort that targets can be achieved.
5) Success in other initiatives: Continued improvement and turnaround of its women's business Lady Foot Locker; a renewed focus on apparel, a new merchandise allocation system, and continued leveraging of fixed costs could improve margins.
6) Rumors of CEO Ken Hicks' departure potentially overblown.

Further, while Foot Locker's February 2013 authorization for $600mm of share repurchases through January 2016 established repurchases as an important part of capital allocation, we believe there is significant room for more. At a total of $600mm, FL's strong free cash flow generation ($200+ annually after paying $100mm of common dividends) should keep its cash balance in the range of $1bn. Historically, from 2000-2007, with a larger store base than today, FL operated its business with between $50-450mm in cash on hand, suggesting that $1bn far exceeds the operationally necessary amount. Assuming an increase in the size of repurchases to $1.1bn, EPS could reach $3.74 in FY2015. Based on these estimates, FL would be trading at 7.9x 2015E EPS, net of cash - a bargain for a company that could average EPS growth above 13% over the next four years.

A downside scenario in which operating margins revert back to 2011 levels of 8% (from 10% in 2012) and SSS declines to zero, Foot Locker would still have enough cash to repurchase $850mm of shares and generate FY2015 EPS of $2.44. At a 12x P/E and $3.40 of net cash, we view the downside as $33 per share. In an upside scenario of EPS reaching $3.74 in FY2015, a 14 P/E market multiple and $3.20 of net cash leads to our $55 price target.

Potential Risks:
-Unpredictability of athletic cycle could lead to declines in same store sales growth.
-Fixed cost leverage can go both way in scenario of sales declines.
-Margin expansion not as easy to achieve as it was when Foot Locker started turnaround (least productive stores have already been closed).
-Reliance on Nike merchandise (65% in 2012) for exclusive products coupled with growth in Nike's own retail channel could pose long-term threat.
-Execution risk of banner turnarounds and store remodels failing to improve comps.
-Continued weakness in European economy (~20% of sales).
-Loss of footwear retail market share by footwear retailers.
-CEO departure (suggested as J.C. Penney CEO replacement by Perry Capital).

Background:
Foot Locker Inc ("Foot Locker", "the Company", or "FL") is the largest retailer of athletic footwear and apparel in the U.S. It operates 2,482 primarily mall-based stores in the U.S. and 1,013 stores internationally, in addition to an e-commerce, direct-to-consumer business. The company grew rapidly in the 1990s and early 2000s, but starting in 2006, comparable sales began a four-year period of decline that lasted through the financial crisis up to 2009. In August 2009, current CEO Kenneth Hicks (who previously served as President and Chief Merchandising Officer at JC Penney) took over and the company has seen a strong turnaround since then. He focused on closing unproductive stores and improving productivity. Operations have significantly improved since then, as has the industry environment. But now the company is seemingly at an inflection point. Since 2004, the number of stores has fallen by >15% from almost 4,000 to 3,300, while operating margins have improved 3x. Same store sales have averaged above 8% over the last three years, but are expected to moderate toward mid single-digits. The U.S. industry landscape is largely mature, though given international expansion, FL could start to grow square footage and add stores again - something it hasn't done since 2004. To address these challenges, FL recently purchased German athletics retailer Runners Point Group ("RPG") for $94mm, or 0.4x sales (compared to FL's shares, which trade at 0.8x sales). RPG operates more than 200 stores and had sales of $254mm in 2012.