While it may be more exciting to bet on industries of the future and spend money on stocks like Tesla (TSLA) and Nvidia (NVDA), outsized returns usually come from unloved industries with cheap cash flow. When it comes to sector selection, famed investor Peter Lynch had a few tips:
“I’m always on the lookout for big companies in lousy industries. A big, fast-growing industry, like computers or medical technology, gets too much attention and too many competitors.”
This brings us to the lousy industry of mall retailers. Amid the sell-off, we think the market is showing long-term returns of 15% and 16% pa on stocks like American Eagle Outfitters (NYSE: AEO) and Foot Locker (NYSE: FL).
Fears are exaggerated
Many fear that e-commerce will wipe out sales of Foot Locker and American Eagle. But, for us, this thesis makes no sense. No one likes ordering multiple pairs of shoes online and constantly having to ship them when they don’t fit well. The average person tries on a number of shoes when visiting Foot Locker, as well as clothing from American Eagle. And, in the case of American Eagle, consumers buy the company’s products online. The company’s online sales are skyrocketing. American Eagle’s 2021 Annual Report stated:
“Compared to the pre-pandemic fiscal 2019 base, store revenue increased 3% and digital revenue increased 46%.
As Nike (NKE) prepares to sell more online, the business is not economically viable unless Nike charges shipping. The company would charge an $8 shipping fee, and it may take 1 day to 6 weeks to receive your order.
We recently visited a Foot Locker mall and business was booming. The staff at Foot Locker were fantastic and we bought pairs of cheap Nike sandals. The company now sells a range of brands from adidas (OTCQX:ADDYY) to Converse to Nike, and has increased its apparel offering. The American Eagle and Foot Locker brands and consumer mindshare enable them to enjoy industry-leading profitability. They are also expected to gain market share in the event of industry consolidation.
Why dividends are sustainable
American Eagle and Foot Locker have negative free cash flow over a 12-month period. Meanwhile, they have huge net incomes. So what’s going on here? Well, let’s look at American Eagle’s cash flow statement:
Here are some boring accounting discussions, but the bottom line is that net income is a better representation of the true earning power of these companies. What happens is that American Eagle and Foot Locker have spent a lot of money buying inventory over the past year, which results in a “working capital change”. This reduces their cash flow in the short term, but these stocks are expected to disappear in the coming years. As this happens, the cash flow will return. If you add that change in working capital, you’ll see that American Eagle’s free cash flow is about the same as its net income, about $350 million. And, the company only pays out $121 million in dividends, giving you huge dividend coverage.
Meanwhile, American Eagle and Footlocker have strong balance sheets, with working capital representing about 25% of their market capitalization. They have plenty of excess cash to pay dividends and buy back stocks.
The price-to-book ratio of these companies has declined significantly over time, which significantly reduces investment risk. In fact, Foot Locker is trading at 0.88x book value and American Eagle is trading near all-time lows. With some reversion to the mean, you could easily double these actions:
The sales price tells a similar story:
If we compare these companies to the S&P 500, we see how cheap they are:
|S&P 500 (SPY)||american eagle||Foot locker|
|Prizes at winnings||21.2||7.0||3.8|
Price to book
This valuation gap borders on madness, in our humble opinion. If you want to sell us FL or AEO to buy the S&P 500, we’ll take that bet all day.
Long Term Returns
As these companies maintain revenue through strong brands, inflation, and consumer wage growth, we believe you will see returns of 16% and 15% per year for Footlocker and American Eagle. This is primarily the result of share buybacks that increase EPS over time. We expect virtually no growth in revenue and net income. We also forecast low terminal multiples of 9x and 11x earnings in 2032. For more on Foot Locker’s valuation, see my article: Foot Locker: A Deep Value Play.
While e-commerce has been around since the early days of the internet in 1999, there’s no doubt that companies like Amazon (AMZN) and Alibaba (BABA) have become more efficient and relevant over the years. Many believe this means a secular decline for mall retailers, and it could. But, so far, these companies continue to grow:
American Eagle and Foot Locker have significant capital lease liabilities. We would like them to fully pay down their long-term debt and continue to close their less profitable stores. Management teams must maintain a healthy balance sheet as the industry consolidates.
Net income for these companies is expected to decline over the next 12 months, which should come as no surprise to investors. S&P Global warned Foot Locker:
Secular changes in the footwear retail industry, including the entry of online players and the increased focus of existing vendors on building their own DTC channels, have put pressure on the performance of business, as customers can connect directly with the brand and bypass retailers. Finally, despite the company’s gradual migration out of the mall, it still remains primarily in malls (approximately 79% of its fleet as of fiscal 2021), which continues to face age-old challenges.
We think AEO and FL are an easy double over the next 5 years. We came to this conclusion by analyzing each company’s value propositions and reviews. If Peter Lynch invested today, he could buy Foot Locker and American Eagle stocks. These are strong brands in a lousy industry. As industries consolidate, strong companies gain market share. We encourage you to assess the risks for yourself and consider the potential for outsized returns from these unloved stocks. For us, this is a “strong buy”.