I apologize for not posting lately. Our kids are in full throttle school and activity mode, which has limited my time to post. I should be back to my old schedule in June once the kids are out of school and their baseball and softball seasons end (unemployment has really helped my kids’ swings!). Until then, I plan to spend most of my work-related time keeping up with my 300 name possible buy list. My backlog of topics to discuss is growing and I’m looking forward to posting more soon.

Today I wanted to briefly write about earnings season. Although it’s very early, results appear to be coming in as I expected. I don’t believe this earnings season will be a catalyst for the bulls or bears. In my opinion, it appears to be more of the same and similar to the past couple of quarters. As I touched on in a previous post, after several consecutive quarterly declines in 2005-2006, the current profit cycle has stabilized. In my opinion, the profit cycle was revived after the drag from the energy credit bust and strong dollar ran its course. Relentless asset inflation – resulting from reassurances from central bankers that global QE will be forever a part of our lives – most likely played a role as well.

While I’m not expecting major changes in operating results this quarter, this doesn’t mean I believe it’s safe to invest in overvalued equities. Price, of course, is the main determinant of future returns and at today’s prices, expected future returns remain well below my absolute return hurdle rates. Therefore, I continue to wait and watch and then wait some more. It’s a very boring part of my absolute return investment process, but essential.

Although earnings shouldn’t be too surprising in aggregate, I continue to expect dispersions between industries. Energy, industrials, and other cyclicals should continue to see some signs of improvement (1-2 more quarters of easy comparisons). Meanwhile, I’m expecting operating results of consumer companies (outside of those closely tied to asset inflation) to remain uninspiring. For example, yesterday Foot Locker (FL) preannounced its first quarter earnings will be equal to slightly below last year’s earnings. Management blamed the delay in tax refunds. Instead of declining, Foot Locker’s stock actually increased sharply, as management stated its sales rebounded from February (they also acknowledged the rebound did not fully offset the slow start to the quarter). Regardless of the actual impact tax refunds had on the purchase of sneakers (???), based on the sharp rise in Foot Locker’s stock, the market is apparently in a very forgiving mood. I suppose it is a refreshing change from blaming the weather!

As I’ve stated in past posts, I consider most retailers to be cyclical businesses. And some, such as Foot Locker, can be very cyclical. Below is a ten-year chart of Foot Locker’s operating margins. I actually owned Foot Locker in the past. Can you guess when? If you guessed when operating margins were 1-3%, you’d be correct. At that time (during the last recession), I did not believe depressed operating margins would stay depressed indefinitely. Similarly, I’m currently not assuming Foot Locker’s 13% operating margins are perpetual.

Foot Locker

Foot Locker

As is the case with most cyclical businesses, I believe normalizing profit margins for consumer discretionary businesses is very important and provides investors with a more accurate and stable valuation calculation. In my opinion, investors currently finding comfort in “only” paying 15x earnings for Foot Locker’s shares should consider performing a full cycle scenario and margin analysis. Assuming a full-cycle operating margin of 7%, investors are actually paying closer to 30x normalized earnings for a cyclical retailer, not 15x.

Foot Locker investors aren’t the only ones incurring significant extrapolation risk these days. Many operating businesses have similar profit margin charts this cycle. In my opinion, one of the many aggressive assumptions investors are making this cycle is that record profits and margins will remain elevated indefinitely. I’ve refused to make the same assumption. In fact, my unwillingness to extrapolate current profit margins has contributed to my decision to go all-in on patience. I continue to believe in the business cycle and the factors that have historically influenced profit margins have not been abolished.

Out of curiosity, I pulled up Foot Locker’s “Risk Factors” listed in its 10-K near the last profit cycle peak (2007) and compared it to the list in its current 10-K (2017). According to Foot Locker, the number of risks to its business has actually increased from 9 near the peak of its last profit cycle to 28 currently. In other words, the risks to future cash flows (or at least the disclosed risk) has increased, not decreased as its equity valuation suggests. See below. Have a great weekend!

2007 Foot Locker Risk Factors (P/S Valuation: 0.6x sales)

  1. The industry in which we operate is dependent upon fashion trends, customer preferences and other fashion-related factors.
  2. The businesses in which we operate are highly competitive.
  3. We depend on mall traffic and our ability to identify suitable store locations.
  4. The effects of natural disasters, terrorism, acts of war and retail industry conditions may adversely affect our business.
  5. A change in the relationship with any of our key vendors or the unavailability of our key products at competitive prices could affect our financial health.
  6. We may experience fluctuations in and cyclicality of our comparable store sales results.
  7. Our operations may be adversely affected by economic or political conditions in other countries.
  8. Complications in our distribution centers and other factors affecting the distribution of merchandise may affect our business.
  9. A major failure of our information systems could harm our business.

2017 Foot Locker 10-K Risk Factors (P/S Valuation: 1.3x sales)

  1. Our inability to implement our long-range strategic plan may adversely affect our future results.
  2. The retail athletic footwear and apparel business is highly competitive.
  3. The industry in which we operate is dependent upon fashion trends, customer preferences, product innovations, and other fashion-related factors.
  4. If we do not successfully manage our inventory levels, our operating results will be adversely affected.
  5. A change in the relationship with any of our key suppliers or the unavailability of key products at competitive prices could affect our financial health.
  6. We are affected by mall traffic and our ability to secure suitable store locations.
  7. We may experience fluctuations in, and cyclicality of, our comparable-store sales results.
  8. Economic or political conditions in other countries, including fluctuations in foreign currency exchange rates and tax rates may adversely affect our operations.
  9. The United Kingdom electorate voted to exit the European Union in a referendum, which could adversely affect our business, results of operations and financial condition.
  10. Macroeconomic developments may adversely affect our business.
  11. Instability in the financial markets may adversely affect our business.
  12. Material changes in the market value of the securities we hold may adversely affect our results of operations and financial condition.
  13. If our long-lived assets, goodwill or other intangible assets become impaired, we may need to record significant non-cash impairment charges.
  14. Our financial results may be adversely affected by tax rates or exposure to additional tax liabilities.
  15. Changes in tax laws could materially affect our financial position and results of
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