Blog

Jan 07, 2024

3 Reasons I Avoided Foot Locker Stock (NYSE:FL)

Zhanna Hapanovich I have written a lot of words over the years warning investors about the risks surrounding different stocks. After Foot Locker's (NYSE:FL) recent earnings disappointment, the stock

Zhanna Hapanovich

I have written a lot of words over the years warning investors about the risks surrounding different stocks. After Foot Locker's (NYSE:FL) recent earnings disappointment, the stock fell an incredible -30% in the blink of an eye. When I can, I try to warn investors about specific stocks ahead of time so investors can potentially avoid this sort of carnage. But the truth is, there isn't enough time in the day to cover every stock with a public article. In place of that, I occasionally write articles where I share the principles and techniques individual investors can use to identify some of these dangers themselves and apply them widely, far beyond the particular stock in question. An example of such an article was one I wrote on 5/19/22 titled "Why Target Stock Fell. And How To Scan Your Portfolio For Similarly Dangerous Stocks". In that article, I highlighted what I termed the boom/bust risk of stimulus money. As I will show in this article, Foot Locker certainly met that boom/bust criteria, but there were also two additional factors that caused me to avoid Foot Locker. I'll share those in the article as well, and hopefully, investors can use these as a guideline to increase the quality of their portfolios.

I've written about this dynamic a lot since early 2022, and it's fairly simple. The US consumer received trillions of dollars in stimulus money during the pandemic. This caused a boom in many parts of the economy. The boom shifted from goods in 2020 and 2021 increasingly to services around 2022. This consumer spending caused a huge boom in corporate earnings for many companies during this time. But starting in early 2022, stimulus money began to slow down, and when student loans begin to be repaid next month, the stimulus will be in full reverse. It has also taken some time for consumers to spend down any extra money saved from the earlier stimulus, but as time goes on, that savings is diminishing. After that money runs out, consumers become more budget-conscious and price-sensitive and don't spend as much money on goods and services and that hurts corporate earnings. This dynamic is very simple to understand at its core.

All investors needed to do was to look at businesses that had a huge boom in earnings in 2020, 2021, or 2022 and identify cases in which earnings growth broke dramatically higher from the pre-pandemic trend, and assume that at some point those earnings would fall back down to trend, perhaps also taking into account some inflation that happened along the way.

We see this very clearly with Foot Locker's earnings history.

FAST Graphs

As I show in the FAST Graph above, investors should have suspected that +177% earnings growth in the calendar year 2021 for Foot Locker probably wasn't sustainable. Even if we compare it to pre-pandemic 2019 EPS instead of from the pandemic bottom, earnings grew more than +50% in calendar year 2021. So, investors really should have known that EPS growth would eventually reverse and that probably wouldn't be good for the stock price.

I do have to say that with both Target (TGT) and Foot Locker, the declines in EPS were deeper than simply going back to trend, so the depth of the earnings downcycle wasn't necessarily easy to predict even if the overall danger and negative direction of travel was. When I published my Target article, analysts were predicting $14.39 per share last year, and I pointed out that if we carried the pre-pandemic trend forward, we would expect Target to earn about half that, at $8.08 per share. Target's EPS ended up being $6.02 per share. With Foot Locker, last year's earnings brought the EPS back pretty close to the historical trend at $4.95 per share, so to have that trend go even deeper wasn't totally predictable, and, it may potentially be an early sign of a US recession, but one additional explanation is that these retailers had to pay up for labor in a way they didn't have to pre-pandemic in order to have the staff necessary to handle the boom. And when the boom turned to bust, their staffing and other overhead costs didn't fall as quickly as sales. This is pretty normal for the cyclical businesses I specialize in covering in my Investing Group even if the pandemic and stimulus were unusual mechanisms to cause it in this case.

While I think the stimulus boom/bust was relatively easy to identify, there were some other metrics with Foot Locker that would have likely caused me to avoid even without the boom/bust risk.

These factors are always a little tricky to discuss because if an investor is the type that looks to invest in turnaround businesses, then we should probably assume virtually all turnaround investments are going to have weak earnings or revenue growth since that is pretty much the definition of what needs "turned around" with a turnaround investment. I don't purposefully invest in turnaround businesses if it looks like the business might be in secular decline and not just in a normal economically driven downcycle or experiencing a one-time blip in earnings growth. (Sometimes I accidentally buy a stock that ultimately does become in need of a business turnaround, but I don't buy these types of stocks on purpose.) So, if you are a turnaround specialist, feel free to ignore this section of the article.

Additionally, if a person specializes in investing in what Warren Buffett called "cigar butts", businesses that are clearly fading away, but still earning money, these metrics might not bother these types of investors either. And it can be a viable strategy if a person is good at finding things like net-nets, or potentially really high-yielders that can pay investors back their investment in a short period of time plus some before fading away. These are not the types of investments I am interested in buying.

For what it's worth, I don't think Foot Locker realistically fell into any of these categories during the past couple of years anyway, but they are worth pointing out since this article is about widely applicable investing principles and techniques.

My view is that the key virtue of owning stocks is that the underlying businesses have the ability to pass inflation costs on to customers and therefore future long-term returns are inflation-protected even if we don't know exactly what the inflation rate will be. This means that I usually only buy businesses that have a history of being able to grow earnings at a rate faster than long-term inflation. Historically, in the US, long-term inflation has run about 3%, so I want the stock of businesses I buy that have a long earnings history and to have demonstrated they can grow earnings at about a 4% rate or higher (including downcycles). If a business has a history of being able to do that, then it meets this pretty basic requirement of what makes a "quality business". If it doesn't, then I don't consider buying it.

Additionally, 3-year cumulative revenue growth is a good number to watch in order to see if a business's growth may have started a secular decline or stagnation. I like to see this number above 10% before buying a stock (about 3% per year), and if it turns negative when we aren't in a recession, I typically will sell a stock. (It's worth noting that big M&A can make this metric useless and often companies desperate for growth will buy other companies to boost revenue growth, so I also avoid the stocks of businesses that have had recent big M&A.)

Above is a graph of Foot Locker's 3-year revenue growth from the end of 2016 to January 2020 before the pandemic. While this isn't negative, it is very weak, and below my 10% threshold for long-run inflation expectations and at just over a 1% CAGR, below the rate of inflation during this time period. This was not during a recession, so this was genuinely a sign of a no-growth business before the pandemic started. For no-growth, or borderline businesses, I like to see them returning most of their earnings to shareholders via a dividend, so it's possible if the shareholder yield was high enough, and it had perhaps a 7% or 8% dividend yield, a person might be able to make their money back, plus some, in time before the business fades away.

At the time, in January 2020, the dividend yield was about half of what I would have liked to see in order to perhaps be tempted to take a chance on the stock at that time. In fact, a person could roughly use the dividend to see the stock price needed to fall around -50% at that time to even be remotely attractively valued because that is what it would have taken to get a reasonable 7% to 8% dividend yield.

Interestingly, -50% is about how far the stock has fallen since then.

Only now the dividend has been cut. If Footlocker had been yielding about 7.5% in January 2020 until now, the dividend could have mitigated about 30 percentage points worth of the -50% loss. So, demanding at least a reasonable valuation before buying a no-growth business can serve to limit the potential damage if the business quality deteriorates faster than expected. It's not a strategy I use very often at all anymore, but I held Altria (MO) for a few years starting in early 2019, and that was enough to eke out an 8% to 9% CAGR for a few years, which was almost exactly the dividend yield.

As I noted in the FAST Graph earlier, earnings growth leading into the pandemic was essentially flat and very similar to revenue growth. Over the past year or two, I have been more aggressive in avoiding and selling the stocks of businesses with mid-cycle average annual earnings growth of less than 4%. The reason for this is that often if earnings growth tips from positive to negative, the stock market significantly punishes the stock price. I think it has to do with extrapolating future returns. If you extrapolate positive earnings growth far in the future, you can potentially see decent returns, but if you extrapolate negative earnings growth far into the future, you are in danger of going bankrupt. The switch from one to the other can be jarring and that is partially what we see with these -20% and -30% overnight declines in prices when business earnings look like they are tipping negative.

For these reasons, and because I don't invest in turnarounds or cigar butts, I avoid and sell stocks that have slow or negative revenue and earnings growth when we aren't in a recession or explainable situation like a pandemic.

Debt is a factor I have mostly ignored for less-cyclical stocks until this summer because debt had been very cheap for so long. I am no longer ignoring debt when considering buying a stock. While most businesses don't have a lot of immediate debt obligations investors should be worried about, my investing strategy focuses a lot on the medium-term of 3-5 years. Over that time period, if interest rates remain high, then businesses with higher debt loads will have a drag on earnings.

There are lots of ways a person can examine and think about debt. Since I have an unconcentrated portfolio and monitor hundreds of stocks, I like quick, easy, simple metrics that work most of the time, at least during an initial screening. For deep cyclical businesses, I like to look at debt-to-equity changes over time because my strategy for deep cyclicals is based on historical cycles repeating, so I check for things that might be different than they have been historically. Things that might impede a recovery (like higher debt-to-equity than previous cycles).

Lately for, less cyclical business, I take a quick look at the difference between market cap and enterprise value found on the FAST Graph. For Foot Locker, it shows a Market Cap of $1.616 Billion and a Total Enterprise Value of $4.470 Billion. So, if you were going to buy the company, it would cost more than twice the value of the market cap due to other obligations like debt, preferred stock, etc. This shows how if a person looked at just Foot Locker's mid-single-digit P/E ratio the past couple of years, Foot Locker might have looked cheap when it wasn't. It is really about 2.75x more expensive than the P/E suggests. This is a metric I check with every stock now, and you'll find that a lot of stocks that look cheap on the surface no longer look cheap when considering the total enterprise value.

It's nice when I'm able to warn investors about the dangers of a stock before it has a big price drop. But it's also useful to review stocks that have already experienced a big decline in order to understand how to avoid making that same mistake with similar stocks in the market. I hope readers find some of my processes useful and it will save them some money in the future.

If you have found my strategies interesting, useful, or profitable, consider supporting my continued research by joining the Cyclical Investor's Club. It's only $30/month, and it's where I share my latest research and exclusive small-and-midcap ideas. Two-week trials are free.

This article was written by

My analysis focuses on the cyclical nature of individual companies and of markets in general. I've developed a unique approach to estimating the fair value of cyclical stocks, and that approach allows me to more accurately buy near the bottom of the cycle.

My academic background is in political science and I hold a Bachelor's Degree and a Master's Degree in political theory from Iowa State University. I was awarded a Graduate Research Excellence Award in 2015 for my research on conservatism.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.