Foot Locker (FL) is an American athletic shoes and apparel retailer that is positioned well to ride the “athleisure” wave. It is one of the few retailers that is growing revenue and earnings but has been thrown out with the retail bathwater. It is trading at 14x PE while growing EPS at a double-digit rate. At a more reasonable 16x multiple, the stock is worth $76 for 15% upside from the current level including a 1.6% dividend yield.

Business and financial overview

Foot Locker operates 3400 stores, under the Foot Locker, Lady Foot Locker, Kids Foot Locker, Pacific, SIX:02, Footaction, Champs Sports, Runners Point and Sidestep brands. It also operates e-commerce websites under these brand names. Its stores are located in the US, Canada, Europe, Australia and New Zealand. The stores are generally small, averaging 3800 square feet on a gross basis, with approximately 60% of the space devoted to sales.

The company generated $7.4 billion of revenue last year @ 34% gross margin. Operating expenses were 21% of revenue, giving the company an operating margin of close to 13%, resulting in $940 million of operating income (excluding a litigation provision of $100 million). The company had no debt expense. It paid taxes at a 35% rate, leaving $600 million in net income. On 140 million diluted shares, this amounted to EPS of $4.29. Any reduction in the US corporate tax rate would be positive for the company as it generates 80% of its profits (and 70% of its revenue) in the US.

Good financial results and reasonable valuation

The company is expected to grow its revenue by 5% this year on 1% store growth and 4% comparable store sales growth. It is estimated to have stable to slightly increasing operating margin and grow its EPS by 11% to $4.76 in 2016. The company does not give detailed guidance but has said that it expects double-digit EPS growth this year. At a recent price of $67, the stock sells for 14x EPS. Free cash flow has slightly lagged net income as the company’s CapEx in remodeling and opening stores has exceeded depreciation. The company uses approximately one-third of its free cash flow to pay its dividend and two-thirds to buy back stock. Inventory is usually well-contained, growing in the low single digits year over year. The company carries about three months worth of inventory, and this is the largest asset on the balance sheet.

Subtracting net cash of $0.9 billion from the company’s market cap of $8.9 billion gives an Enterprise Value (EV) of $8 billion. The stock trades at a trailing EV/EBIT multiple of 8.6x, EV/EBITDA of 7x and Price/Book Value of 3.6x. The company has a pre-tax Return on Capital Employed of more than 50% and post-tax Return on Equity exceeding 20%.

Valuation: Fair value of $76 per share

Putting a 16x multiple on current year EPS of $4.76 results in a fair value per share of $76. Add in a 1.6% dividend yield, and that is 15% upside from the current level of $67. The company has more than $900 million (close to $7 per share) of net cash and I am not including this in the valuation. It could easily take on $2 billion of debt and retire a quarter of the outstanding shares. This would entail a $100 million interest expense (at a 5% annual rate) against $850-900 million of operating income.

FL does not have any close comparable. Among other footwear retailers, Skechers (SKX​) trades at 13x PE, DSW at 15x, and Finish Line (FINL) at 15x. I would regard all of these as lower quality companies than FL with more volatile financial results in the face of uneven execution. Footwear and athleisure manufacturers admittedly are a better business, with rich multiples to match. Nike (NKE) trades at 23x PE, Lululemon (LULU) at 30x and Under Armour (UA) at 65x. Other high-quality retailers like Home Depot (HD) and Lowe’s (LOW) trade at 18-20x EPS, but they are growing a bit faster than FL. I do not use EBITDA multiples in my valuation analysis, regarding it as a flawed metric, but an EBITDA comparison will reveal similar results.

While there is no known catalyst on the horizon for the company’s shares to reach fair value, continued share repurchases coupled with the company continuing to grow earnings should lead to a rising stock price. Also, the upside potential may not seem very high, but given the company’s strong balance sheet with net cash, this is a low-risk opportunity with limited downside.

Reasons for recent underperformance and low valuation are unfounded

Until recently, the stock had underperformed this year as retail stocks have been hammered. However, unlike most companies in this sector that have declining revenue and earnings coupled with high debt, FL has growing revenue and earnings and $0.9 billion of net cash (60% of cash is held abroad). Although the company faces threats from Amazon and manufacturers selling direct, these trends are not affecting the company’s growth. It has a growing e-commerce operation and sells a “high-touch” product that consumers prefer to buy in stores. According to the company’s disclosure, e-commerce accounts for 13% of revenue, growing 10% a year, at similar margins to store sales.

Risks are manageable

The company faces the risk that consumer preferences change such that the products it sells are no longer in demand. While it is conceivable that the athleisure trend may fade, it is a reasonable supposition that people will be buying athletic footwear for decades to come.

The company could lose share to other online retailers like Amazon. This is the biggest risk in investors’ minds. However, footwear is a personal purchase that people like to look, feel and fit. The return rate for online footwear purchases is high.

Manufacturers like Nike are trying to increase selling their product directly to consumers. However, Foot Locker enjoys a good relationship with its vendors and has been able to get an adequate supply of “hot” products.

Supplier concentration is an issue as Nike accounts for 72% of merchandise. 90% is from top 5 suppliers. However, FL is an important channel for these vendors, accounting for close to 10% of Nike’s revenue.

While there is always a risk that a cheap stock gets cheaper, I do not regard this as a huge risk as the company can then buy back even more of its stock, leading to an even larger increase in EPS. This of course, assumes that the business results hold up.