Cabot Turnaround Letter Issue: June 26, 2024

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Sneaker Seekers Swiftly Shift This Rockstar Retailer Toward Stability

Over the past couple of months, you’ve probably figured out how I like to approach structuring these issues. First, I’ll tell a personal origin story about the development of my professional career. Then, I like to introduce some key concepts I learned that dovetail nicely with the themes behind that month’s recommendation. A tried and true method, for sure, and one I’ll continue to use in the future.

But doing the work on this month’s issue took me on a much longer journey, all the way past my professional career back to my hometown of Fairmont, WV in the fall of 1987. Now, junior high school isn’t exactly an era of life most of us look back on fondly – myself included in many ways. But what I loved about this year is that it’s when I really learned how to play on a team.

Regarding teams, I’m an absolute junkie for them. I love the camaraderie. I love the trust that is built between each other. I love that if you do it right, the whole is greater than the sum of the parts. And most of all, I love that when everybody works hard and cares, you wind up with a positive shared experience that you’ll carry with you for the rest of your life.

Now, I was never the greatest basketball player – I was tall, and I could shoot a little in 1987, but that’s about it. Baseball was WAY more my thing – and given it wound up paying for a couple of years of college, I was correct to focus on it. But 7^th grade was the first year that we learned how to play real offenses, real defenses and get in real shape so we could execute them for a full game.

Though I hated the running at first – we would run “suicides” for the last half hour of practice – I learned that it gets easier. Moreover, I learned that it’s important to work through that initial discomfort just so you can get past it and experience for yourself what the benefits of perseverance are … my first formative Turnaround lesson.

For me, the benefit was that I could move on to learn the nuts and bolts of our offensive and defensive schemes – just a couple of many things (good and bad) our character of a coach, Frank “Babe” Stingo, had adapted from infamous Indiana University coaching legend Bobby Knight after attending several years of his seminars. Over the first week or so, we learned what our offensive roles were and the basic options each position had in both motion and zone offenses, as well as inbounds plays. Over the next week, we’d learn how to properly defend them, how to run (and break) our diamond trap press and how to run the fast break off misses and made free throws.

I’m not sure I’ve ever crammed more content into my head in such a short period of time, but I LOVED it. The process. The repetition. The simplification. Learning how to identify opportunities and reduce them all down to a single decision, ideally made automatically. I was hooked for life and so were a whole lot of my teammates.

Obviously, I made the team, played a fair amount and made some incredible memories, including winning the City Championship – the first time I’d been a part of anything like that. But I’m going to be honest here, the one memory that has stuck with me the most is my dad taking me to pick up our team shoes – the red, white and blue Nike Air Force 2 high-tops that to this day are my all-time favorite sneakers.

You can’t see them on my feet here, but they’re being skillfully modeled by my former teammates John Hammond and Trent Zundell in the above photo. The nostalgia is so real for me that I can still smell them new in the box just like I got them yesterday.

Heck, I can still smell the store I got them from just like it was yesterday. And I’m not alone here – millions of kids coming of age in the late 1980s became burgeoning sneakerheads thanks to similar experiences.

And as it just so happens, that chain of stores is in the process of getting back to its sneaker roots in true Cabot Turnaround Letter fashion.

Purchase Recommendation

Foot Locker (FL)

330 West 34th Street
New York, NY 10001
https://www.footlocker.com/corp

Symbol: FL
Market Cap: $2.41 billion
Category: Mid-Cap
Business: Consumer Discretionary
Revenues (2024e): $8.13 Billion
Earnings (2024e): $153.5 Million
6/22/24 Price: $25.43
52-Week Range: $14.84-35.60
Dividend Yield: 3.07%
Price Target: $55

Background: Some Less Recent History

Although my formative experience at Foot Locker came right at the dawn of the sneaker revolution –just a couple of years removed from the release of Nike’s first-edition Air Jordans – the company itself has a rich history that spans more than a century, tracing its origins all the way back to the F. W. Woolworth Company, founded in 1879.

Foot Locker was conceived in the early seventies, when Woolworth’s subsidiary Kinney Shoe Corporation was beginning to diversify into specialty stores. The first Foot Locker opened at the Puente Hills Mall in Industry, California in 1974 – a venture that proved highly successful and became a cornerstone for future expansions.

The brand grew quite steadily throughout the 70s and 80s before exploding during the Michael Jordan-fueled sneaker boom in the mid-1980s. That rapid pace of development encouraged Woolworth’s to spin off its footwear and sportswear divisions into a separate company named Woolworth Corporation, which later became known as Venator Group, Inc. This strategic move was part of an aggressive expansion into the athletic retail sector, marked by the acquisition of Champs Sports and, later, regional retailers such as Eastbay and Sporting Goods, which helped diversify Foot Locker’s offerings and expand its reach.

The transition from Woolworth, a name synonymous with retail innovation, to Foot Locker marked a significant pivot towards focusing exclusively on sportswear and footwear. By 1997, when the flagship Woolworth department store chain was closing its last stores, the Foot Locker brand was generating over 70 percent of Kinney Shoe Corp.'s sales, reflecting its rising prominence. The transformation was sealed in 2001 when Venator Group, Inc. renamed itself Foot Locker, Inc., thereby solidifying its commitment to the athletic retail market.

Background: Some More Recent History

Foot Locker’s growth continued into the 2000s with strategic acquisitions aimed at reinforcing its market presence. In 2004, it acquired approximately 350 stores from the bankrupt Footstar Inc., significantly enhancing its footprint in urban areas and resulting in a notable 19% rise in quarterly profits.

But Foot Locker’s history is not just about retail management and expansion. The company maintains a distinctive identity with its flagship stores’ employees donning referee uniforms, earning them the affectionate nickname “Stripers.” Those employees have served as the company’s “boots on the ground” over the years, helping management understand how to adapt to shifts in consumer preferences and the retail environment. And Foot Locker’s strategic store placements in malls, combined with an ability to quickly shift retail formats, underscores a flexible business model that has allowed Foot Locker to thrive despite a decline in overall mall foot traffic.

But if there’s one aspect of the company that stands out, it’s that approximately 70% of Foot Locker’s revenue over the years has come from OG Premium Sneaker Stalwart Nike. And while this highlights the significant partnership that contributed to Foot Locker’s market strength over the years, it also shows that the company had a whole lot of eggs in that particular basket.

And, obviously, that can cut both ways.

Analysis: Outlining the Opportunity

This particular story starts where a whole lot of recent turnarounds started – in the wake of the COVID-19 pandemic’s massive disruption of supply chains.

In 2021, Nike was grappling with shortages from shipping containers to labor and, as a result, wound up being incredibly short inventory that year. Given the dearth of inventory that resulted, and the fact that over the decade prior, the company had grown direct-to-consumer (DTC) sales from 16% of brand revenues to 35% – a development that allowed them to step away from Amazon – Nike made a strategic decision.

In 2022, the company announced it would move product out of wholesale markets to focus on growing higher margin DTC business, leaving smaller retailers like Foot Locker grasping for replacement revenue. As a result, Foot Locker’s stock price immediately tanked 31%, falling from 43 to 29 the week of the announcement before bottoming out at ~25 in July 2022.

This prompted some soul-searching for the nearly 50-year-old company, which culminated in the decision of longtime CEO Dick Johnson to retire from the post in order to bring on turnaround specialist and former Ulta Beauty CEO Mary Dillon.

If you’ve been following executives for as long as I have, then no doubt Mrs. Dillon has commanded your attention at some point. The brand management rockstar served as Chief Marketing Officer for McDonald’s from 2005-10 before shifting over into the CEO slot at U.S. Cellular from 2010-13. At that point, she was tapped to turn around strip mall stalwart Ulta Beauty’s fortunes, where she expanded the retailer’s e-commerce business and nearly tripled the cosmetics, hair care and skin care chain’s sales and store footprint in one of the most successful runs in modern retail history.

Her hiring was greeted with a 25% run in Foot Locker’s stock price over the next few weeks, ultimately topping out at around 45 in January of 2023. Soon after that peak, Dillon presented the company’s “Lace Up” plan, which included a complete overhaul of the company’s real estate footprint, shifting off-mall and shutting over 400 underperforming locations, coupled (naturally) with a Dillion-led relaunch of the brand itself.

The relaunch has some genuinely good ideas. First, they want to capitalize on the “mass casualization” trend largely caused by the rapid acceptance and proliferation of work-from-home environments. But perhaps more importantly, they recognize that sneakers are incredibly important in terms of self-expression – a point that my 12-year-old self certainly took to heart back in 1987, and which shows in the company’s segment sales.

Now, I love all these angles. And, frankly, how they’ve redesigned store footprints is really cool, from the upfront section which highlights new sneaker releases to the “sneaker hub” itself, where customers can get a consult on customization options with Stripers now sporting digital technology that provides them with all aspects of inventory availability and streamlines the in-store checkout journey.

But amidst several quarters of taking down guidance, it has been quite clear that there has been one glaring thing missing in that investment thesis … more Nike.

And fortunately, as it turns out, apparently Nike needs more Foot Locker.

Nike’s earnings have revealed stagnant revenue and a decrease in net income over the past few quarters, prompting CEO John Donahoe to announce a strategic pivot away from the purely direct-to-consumer (DTC) focus that had been emphasized since before the pandemic. Addressing the challenges with its DTC strategy, Donahoe emphasized a renewed commitment to wholesale channels and accelerating product innovation. The move includes focusing more on sports, enhancing product flows, engaging in bolder marketing and strengthening relationships with wholesale partners. This shift is part of a broader $2 billion cost-saving initiative aimed at reducing complexity and inefficiency in operations.

While that’s fantastic from a Nike shareholder perspective, it is doubly so – possibly triply! – for Foot Locker. Per Hedgeye’s fantastic Retail Analyst Brian McGough, FL is “the leveraged way to play the positive rate of change story in Nike’s profitability.” With a current margin around 1.9% and Nike ramping back up to around 75% of the product mix from sub-60% last year – not to mention helping to fund the marketing or raising both revenues and margins – Foot Locker now has the potential to double or even triple earnings per share from the current level of $1.58 all the way up to $4 or $5, as implied by the chart below.

Should that also result in multiple expansion from 7-8x up to 10-12x, we could really see this stock fly over a one- or two-year duration … and that would also serve as our cue to exit.

Entry and Exit Strategies:

The stock got up to as high as ~35 recently before not-great Q4 results and another guide lower pushed it back down around the 22 level. We do really like where it is currently trading at a price of around 26.35, but in an ideal world, we would get an opportunity to add some below 25 and perhaps all the way down as low as 20.

Ideally, we want to try and secure a full position at an average price somewhere between 20-28 per share, with an eye to sell somewhere around the 55-75 level we think FL will hit sometime over the next two years.

For the more trading-focused subscribers, my preferred technical indicators of Bollinger Bands and Relative Strength Index have been fantastic buy/sell guides over the past few months following the stock price bottoming last August. Trimming near the top band at RSIs over 65 and adding near the bottom band and RSIs of 35 is likely the best way to manage a position actively.

We recommend the purchase of Foot Locker (FL) shares with a 55 price target.

You can find more details by visiting our website at cabotwealth.com.

The chief analyst of the Cabot Turnaround Letter does not yet personally hold shares of every company on the Current Recommendations List, but that will change over time subject to the following guidelines. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may currently hold and may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations.

Large Cap¹ (over $10 billion) Current Recommendations

Mid Cap¹ ($1 billion - $10 billion) Current Recommendations

Small Cap¹ (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:

1. Based on market capitalization on the Recommendation date.
2. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNRE return includes spin-off value of BAM shares.
*** GE total return includes spin-off value of GEHC shares at January 6, 2023 closing price to reflect our sale.

The next Cabot Turnaround Letter will be published on July 31, 2024.

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