Foot Locker’s (FL) second quarter results came in better than expected. The company reported strong consolidated comparable sales growth of 18.6% compared to its prior-year period, driven completely by a 173% increase in its direct-to-consumer e-commerce channel. The company’s consolidated comparable sales metric includes its retail store sales and online sales.

The medium-term outlook for FL seems to be bullish given management’s actions during the quarter. For example, the company reinstated its quarterly dividend payment at $0.17 per share and lifted the suspension of their share buybacks, qualifying it as “an opportunistic program.” However, given the lack of formal guidance for the rest of the year due to continued uncertainties, investors shouldn’t expect any share repurchases at the moment. The company is also expecting to invest $156M in CAPEX for the full year, which is a slight increase from their prior outlook. All these actions signal more confidence by management and better visibility ahead.

That said, we believe FL is not out of the waters yet. The company is pointing to a heavily promotional environment for the second half of the year to clear out old inventory. There are also expenses in SG&A related to COVID-19, such as PPE costs that the company sees as recurring in nature. During their second quarter, FL spent 6M in PPE. There is also a high level of uncertainty regarding the correlation between rising cases of infections and store underperformance. At quarter-end, the company still had 260 stores closed, of which 174 were the result of mandated closures in California as cases spiked in that state.

Currently, analysts are expecting EPS of $3.93 for their financial year 2022 (FY ends in January). With shares trading at $27, the market is pricing FL at a forward earnings multiple of just 7x. For context, FL’s average 5-year PE multiple stands at 14x.

We believe FL is a strong candidate for a short-term hold (1-3 yrs) based only on how cheap the company is trading. If the company hits the EPS target, and the market re-rates them at a 10x P/E multiple, we are looking at a fair value estimate of $39 per share, or a potential upside of 44%. However, FL’s heavy exposure to malls does bring a high degree of risk to the table. Investors should position size their holds accordingly.

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Strong DTC channel making up for lost retail store sales

FL reported second quarter sales of $2.08B, up 17.5% on a year-over-year basis, and beating analysts’ sales expectations by 10M. The company’s reported GAAP EPS of $0.43, missed the consensus by $0.17.

The highlight of the quarter came from the strong performance in their e-commerce channel, which saw growth of 173%, offsetting the 7.6% comparable sales decline at their stores. As a result, the company reported consolidated comparable sales growth of 18.6% for the quarter compared to its prior-year period.

Due to the strong surge in online sales, FL’s direct-to-consumer channel accounted for 33.2% of total sales during their second quarter, compared to just 14.3% last year. However, as more stores reopen and foot traffic at malls starts to pick up, we expect their DTC channel as a percent of total sales to “normalize.” Foot traffic during the quarter saw a decline of double digits, impacted by store closures and social distancing measure, with weaker trends in their European markets, as management believes consumers in Europe are more conservative coming out of stay-at-home orders. FL’s weaker digital penetration in their European market also affected results, with Foot Locker Europe posting a high single-digit comp decline.

That said, growth in their DTC channel is not free. The company’s merchandise margins decreased by 700 basis points due to a combination of high markdowns to clear out old inventory and backed up deliveries from Q1; and higher fulfillment costs, mostly freight, from higher online sales penetration. Management expects continued pressure in gross margins as they work through their inventory levels in their second half:

With respect to gross margin, as we look forward, we anticipate a continued promotional environment in general, and as we work toward our goal of being in a clean inventory position by year-end and well positioned to bring in fresh, exciting product. – Q2 call

What lies ahead for FL

The company continues to build on the strong momentum they are seeing in their DTC channel. For example, they want to keep building up their loyalty program called FLX. The company stated that membership growth was strong during their second quarter and they are seeing positive momentum in markets where FLX was launched, including the U.K., the Netherlands, and France. Strong momentum in their loyalty program is good news as it opens another channel to keep customers engaged with the Foot Locker brand. As stated by management, FLX members also tend to spend more than non-members.

The investments the company has made to increase its online penetration has certainly paid off during their second quarter. For example, the company has invested in things like “buy online,” “ship from store,” “buy online pick up in-store” giving consumers many options to shop with them and access to their entire inventory:

We actually opened stores first to ship out buy online, ship from store orders even before we could entertain our guests back in the stores. We had our associates in the backroom shipping out orders for direct-to-consumer or digital orders. So again, a it’s a wonderful ecosystem. And even with down traffic, you’re able to drive comp sales because all consumers really have access to all inventory. – Q2 call

Having a strong fleet of stores is also part of that strategy, which is why FL still sees brick-and-mortar stores as an important piece. The company also knows they are a key player to many mall operators and are using that leverage to get better lease terms, something that is still a work-in-progress given the size of FL’s store fleet:

Well, as we described, we did see some benefit from the conversations, which have been very constructive with our landlord partners on our occupancy as it was impacted by the closedown period. , you can imagine the time required to complete those conversations and actually get the agreements papered and it’s at that point, once you actually have it papered that you’re able to record the financial impact of those agreements. Hence — or call out to stay tuned on that because it’s still a work in progress. What I would say is we are very much a desired tenant for our landlord partners. – Q2 call

There were also hints about the use of technology in their stores to navigate the tough social distancing guidelines, like for example the use of mobile POS for checkouts, making them take advantage of their square footage in an otherwise restricted space:

So thinking about how we service them, both at bringing them products to try on, but also managing through the process of checkout. So giving us more points in the square footage where we can actually complete the transaction and making use of technology to make that checkout very smooth and quick. – Q2 call

The implementation of new technologies could be a reason for the increased capex outlook for the rest of the year.

Finally, we like how the company has partnered with companies that are tech-driven. This helps them leverage their “know-how” in the space. For example, the partnership with Carbon38 has helped the company in finding new efficiencies in their digital marketing by analyzing the engagements from their online customers, which in turn, builds them new strategies in marketing and customer loyalty.

The bottom line

We see FL as a short-term hold. The company is selling at a very low forward P/E multiple of just 7x, which reflects a very pessimistic view by the market. With analysts expecting EPS of $3.93 in 2022 and applying a 10x multiple to earnings, we get a fair value estimate of $39 per share.

That said, we understand the market pessimism towards FL. The impact of COVID-19 has accelerated the adoption of e-commerce as a reliable sales channel moving forward. The case for more demand shifting online is strong given the current circumstances, where social distancing guidelines could affect the in-store shopping experience. The retail companies we have been following have seen impressive growth rates in their e-commerce channels, which could act as a great incentive for them to focus more on their DTC strategies than rely on wholesale partners. From a long-term perspective, that would put FL’s business model in jeopardy.

FL’s heavy exposure to malls is also a risk. While the company has the leverage to negotiate better lease terms, the uncertainty surrounding the long-term impact of the pandemic on consumer behaviour could offset any gains. It would all depend on how comfortable the consumer feels about crowded places.

FL just needs to show the market things are not as bad for value to close the gap. However, we wouldn’t feel comfortable holding FL for the long term. Investors should position size according to their risk tolerance.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.