Dick’s Sporting Goods has a Foot Locker Problem

0:02Tyler Crowe:Dick's Sporting Goods stock has a case of athlete's foot. Motley Fool Hidden Gems Investing starts now. Welcome to Motley Fool Hidden Gems Investing. I'm your host, Tyler Crowe, and today I'm joined by longtime Fool contributors Rachel Warren and Matt Frankel. Guys, the earnings season has been winding down a little bit. I was looking for stories earlier today, but the news was looking a little thin. And then Dick's Sporting Goods reported earnings. And based on the stock reaction, we had to talk about it. Shares of Dick's Sporting Goods stock is down about 27 % as we're taping right now after the company reported earnings and updated guidance.

0:39Tyler Crowe:Now, like most investors, I would assume this means the news was bad. But we've seen like a lot of companies post decent results this quarter. Only kind of see their shares take it on the chin in the ensuing market reaction. So, Rachel, is that the case here? Give us a rundown of what happened and what were your guys' thoughts and reactions to what Dick's Sporting Goods had to say here? Yeah, I mean, there was actually some concerning numbers that came in. And it's interesting to chat about. We don't spend a ton of time focusing on retail here on this show. So Dick's actually missed on both the top and bottom lines for the quarter.

1:15They had adjusted earnings per share come in at$3.53. Wall Street was looking for$3.76. cents. Revenue dragged a bit, just under$6 billion. Wall Street was looking for a little bit more than that. So a lot of this is going back to the Foot Locker business, which Dick's Sporting Goods acquired last year. That's the primary culprit behind this drag. And it's interesting because you have the core Dick's namesake stores. They posted a roughly 5 % comparable sales increase. Foot Locker stores actually saw comps slide 3.6%. And you had management saying that they had fewer high-profile shoe launches.

1:52It's an increasingly competitive, discounted market that's actually forcing them to cut prices to protect their market share. But the other thing that's interesting here is this is also tied to the broader, what's called the Nike ripple effect. So we saw management essentially call out a lack of high-profile sneaker launches. They're pointing upstream to major partners who are, you know, And Foot Locker has historically relied on these legacy silhouettes, retro launches. And so Dix is really feeling the pain first when consumer hype slows down. Another key number, total inventory surged 63 % year over year.

2:33Now, obviously, they're still absorbing the Foot Locker acquisition, but they're carrying a lot of inventory, probably looking for a lot of clearance sales and promotions, which great for consumers, not great for the business, not great for investors. and to top it all off, Dick slashed its full year earnings guidance considerably. So really not a great readout for this business. Yeah, I mean, the numbers weren't great, but I mean, you're right. To me, the sharp decline, it's almost as much as what management said and not just the numbers. I mean, the CEO called out the quote, increasingly promotional athletic footwear and apparel market, said that conditions deteriorated as the quarter progressed, which is something you really don't like hearing from management.

3:13uh also said footlocker has a lot of exposure directly to the categories getting discounted the most um so just a couple things to point out here so i mean dick stock was down 10 year to date going into this so now it's really underperforming uh it's clearly a cyclical problem in the footwear space i mean if you look at nike under armor even academy sports which is i would call their closest direct comparison and on holdings. They're all underperforming too. Dix has a large buyback authorization is one of the key things I read in the earnings report,$3 billion. I'm curious to see if they accelerate their repurchases to kind of send the market a signal here.

3:55Tyler Crowe:You know, one of my favorite things in like these conference calls every once in a while is the management word salad that we get of trying to explain why all this happened. One of the best best ones I think I saw in this conference call was they mentioned geopolitical troubles, which apparently is affecting shoe sales. Look, some things are believable, but I don't know if, you know, closure of the Strait of Hormuz is exactly affecting how many people are buying Nikes before and after the World Cup here. So maybe, but we'll see. The thing that really pointed, it stuck out to me, and Rachel, you mentioned it here too, was Foot Locker specifically.

4:30Tyler Crowe:This was an acquisition that Dick's kind of took, I don't want to say took a flyer on, that would be a little too flippant. But this was slightly different than what they have normally been doing. Like you said, it's a little bit more fashion trend, you know, very dependent on releases of signature shoes and stuff like that. And it's still, I would call it like indigestion of the acquisition. was this acquisition a mistake in your guys' opinion, or maybe is it a little too soon to call it that? I mean, I'd say it's too soon to call it a mistake, but it's not too soon to say that it's definitely going poorly.

5:08You know, those aren't the same thing. You know, Dix cut their full year earnings guidance, as Rachel mentioned, by 18%, and it's almost entirely because of Foot Locker. It's in a deteriorating environment for the entire footwear industry, as I said. It's not just a Foot Locker problem. This was a turnaround acquisition. You can't judge that after just four quarters. The company's making the right moves. They closed 110 stores in year one after the acquisition. So they bought a cyclical turnaround play and the cycle immediately went against them. So it's too soon to tell if it's ultimately going to be a good move long term, but it's not going well.

5:46Yeah, that's definitely the case. I mean, to put some numbers to that as well, the slashing of their full year guidance, They were originally looking for full year earnings per share between$13.27 and$14.27. Now they're looking for$10.94 to$11.94 on the high end. So significant downgrade there. I agree with Matt. I don't necessarily think that we can see the final story from where we're at now. But it's interesting to see. I mean, I think that Dick's acquired Foot Locker with the idea of kind of tapping into that younger consumer demographic looking to sort of revitalize the core business. And what's interesting as well is Dixas historically had been a bit more of a retail darling that managed economic headwinds better than its peers.

6:29And I think what we're seeing today, it isn't a reaction to a single bad quarter. I think there seems to be this broader concern, maybe realization that integrating this footlocker acquisition, it's going to be a much costlier, slower, and maybe more margin degrading endeavor than initially promised. And I know we've talked a bit about the K-shaped consumer reality on the show before, but it's something that's interesting to look at with this business. I don't want to read into the tea leaves too much, but you saw that Core Dix business grow 5%. We're seeing that mid to high end suburban consumers still walking in and buying that premium gear.

7:04But a lot of the younger demographic that traditionally would shop at Foot Locker is really getting tapped out by inflation. And I do think that we have to also look at that as a factor here.

7:15Tyler Crowe:Well, certainly a much more logical conclusion than saying that geopolitical concerns is keeping people from buying their premium athletic wear. So I kind of buy your case a little bit more than what management was saying there. Coming up after the break, it's still earnings season. So we're going to dip into a couple of earnings that may have slipped through the crack this past quarter.

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10:02Tyler Crowe:They were talking, kind of taking the opposite approach of Dick's Sporting Goods, where it's like, we're going to hold back some of our production and clear some inventory. Yeah, we're going to take it on the chin now. But it's a strategy that worked out pretty well, and the stock is benefiting a lot from it. And that kind of, hey, this is a company we haven't discussed in a while. It was a kind of an interesting story. I want to take that a little bit step further. We're coming to the end of earnings season here. We've got NVIDIA tomorrow, which we're definitely going to cover. But there's certainly not as many coming to the fore right now.

10:35Tyler Crowe:So with this quarter coming to the close, I wanted to give you guys an opportunity to maybe highlight a company that may have fallen through the cracks when we were trying to cover stuff with earnings that we didn't get to, but you're like, I really liked, or maybe didn't like what you saw. Matt, I want to start with you. You said you wanted to talk about Walker and Dunlop. I feel like I hear Crocs more than you do because that's all my son will wear. So they're not like yesterday's shoe by any means. But yeah, I wanted to call out Walker and Dunlop. It's a stock I've owned in my portfolio for a while, and I feel like it didn't get enough attention or at least the right kind of attention after its earnings report.

11:12I mean, the headline numbers were ugly. And understandably, that's what the market fixated on. Earnings were down sharply year over year. The company had$23 million in charges tied to loan repurchases from a fraud investigation. There was a$21 million credit loss provision. But below the surface, there was a lot to like. So, I mean, you and I have repeated the same thing about not just Walker Dunlop, but a lot of these real estate companies, they just need the real estate market to turn around and then everything's going to be fine. We've repeated that line how many times, Tyler? But their market share is growing.

11:47They're a leading originator of multifamily loans guaranteed by HUD, by Fannie, by all the government agencies. Their market share in that went from about 11 % at the start of this year to over 14 % now. So that's the kind of thing that sets itself up nicely for when the market recovers. So it's not just, you know, the rising tide lifts all ships. Companies that are growing their market share in the tough times are better set up to capture that rebound. The servicing portfolio, which is part of the business a lot of people overlook, not only it grew 6 % year over year, it's predictable revenue.

12:21These are just loans. They get a little fee every time someone pays their loan. But over 50 % of that servicing portfolio, which is about$146 billion worth of loans, over 50 % matures within five years. That creates kind of a built-in pipeline of refinancing where they actually make a lot of money from. The stock trades for less than 10 times adjusted earnings right now. It trades there for a reason, but there's more to like in this earnings report than the market gave it credit for.

12:47Tyler Crowe:We do agree when it's like for a lot is when the commercial real estate market comes back. But I think one thing we have gone back and forth about a lot is with Walker and Dunlop specifically, it was late 2010s, early 2020s, they went on a bit of a buying spree, not necessarily in their wheelhouse either, some kind of like ancillary and tangential businesses. When I hear things like, oh, well, they had to buy back some loans because of fraud and increasing credit provisions, it started to make me go back to that maybe some of these acquisitions weren't as good as they had said, and that maybe they're, I don't want to say asleep at the wheel, but still not quite figured out how to integrate all of these into their company.

13:32Tyler Crowe:Is that a fair assessment? Yeah. Not only did they go on a buying spree like a lot of real estate companies did at that time, they overpaid for certain acquisitions. They weren't all bad. Their appraisal business, which is called Apprise, is actually a pretty solid business. I just think they overpaid for a lot of the parts. There was the real estate investment banking business that specialized in selling the tax credits that were going on at the time. They overpaid for a lot of this, and that's a big problem. It's not necessarily that the integrated businesses are no good. They went on an acquisition spree and they paid a lot of money for some of these components.

14:07Tyler Crowe:Well, like you said, we'll just have to see maybe when the commercial real estate market turns around, some of these maybe not so great investments or acquisitions can fall into place, I guess, if it will. And it seems like the theme is turnaround stories or maybe companies that aren't doing as hot because, Rachel, the one you brought to the table here was CVS Healthcare. Yeah, I thought it'd be interesting to talk about a healthcare business and CVS, you know, I think a lot of people obviously think of the neighborhood store aisles, pharmacy counters, but CVS is actually one of the larger healthcare insurers in America through their Aetna division.

14:41And so they beat expectations this quarter. It was a particularly really good quarter for the business after a series of difficult quarters, which we'll talk about in a bit. Adjusted earnings per share came in at$2.58 against Wall Street estimates of$1.87. Total revenue rose over 7 % to about$106 billion. And management actually raised their full-year profit guidance. One of the dynamics that CVS Health is benefiting from right now is just broader trends in the healthcare space. We've seen a lot of major hospital chains note that consumers are putting off doctor visits. They're scheduling fewer elective surgeries due to tight household budgets, which is a really, really unfortunate trend.

15:21The flip side of that trend, of course, is when people skip surgeries. It lowers expenses for an insurance company because they're paying out fewer medical claims. So for CVS and their Aetna network, fewer procedures means their medical costs decreased. And so essentially, this trickled over to their healthcare benefits division. If you're looking at their report, they saw their operating income rise by more than a billion dollars above what analysts had originally predicted, all going back to these industry dynamics that I mentioned.

15:49Tyler Crowe:Yeah, a good quarter. And the thing is, with CVS, going back to the integration of Walker and Dunlop, here we have a retail pharmacy combining with a major insurer. It hasn't exactly been a perfect marriage here. And the stock has reflected that over the past couple of years. So between the lowering of the earnings forecasts, it's closed hundreds of stores. The CEO has been a kind of a revolving door as of late. It hasn't been easy for this company. But having said that, the stock trades for like 11 times forward earnings estimates. So clearly the market is pricing this then is not doing great.

16:31Tyler Crowe:You as the investor, are you buying this as like a value stock now with like a turnaround in play here? Or are you still seeing this as, yeah, this is still a work in progress. I'm going to check back later kind of stock. This is what I'm watching from the sidelines for sure. And there's a few reasons for that. I mean, this is a company that's faced serious operational issues over the last few years. You know, it's not just a matter of the difficulties of integrating the Edna acquisition from a number of years ago. Of course, they're one of the largest pharmacy benefit managers in the U.S. They were dealing with costs from higher Medicare utilization rates that also eight into the growth story.

17:09And then 2024, 2025, they continuously were adjusting expectations downward. They had to cut earnings forecasts in multiple quarters because of rising insurance costs and a slow retail pharmacy market. So there's been a lot of factors at play that have posed challenges for the business. Now, they did launch a$2 billion cost-cutting initiative. There were layoffs, management closed underperforming stores. You've got a new CEO, David Joyner. David Joyner, you've got their CFO, Brian Newman, overhauled their insurance underwriting, really kind of moved away from the unprofitable business lines. And they also put in stricter cost controls over their medical benefit ratio.

17:46So I think we are starting to see the signs that their vertical integration strategy, which is, you know, you've got the drugstore side, the pharmacy benefit manager side, the insurance provider side. I think we're seeing the results starting to show there. I'd say it's too soon to declare that the turnaround is complete. This is a long-time dividend payer, but I think if you're looking for income stocks, there are probably other compelling opportunities to find.

18:10Tyler Crowe:One of the things with turnaround stocks is the turnaround always takes way longer than anyone ever expected. Coming up after the break, we're going to jump into the mailbag.

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20:44Tyler Crowe:As always, keep it short enough. We can read on air. keep it foolish, and we can't give personalized advice so we don't get in trouble with the SEC. So today's question comes from Sterling Clark. And Matt, he actually named you personally. So we wanted to make sure that you were on the show when we did this. Question is, hi, fools. What does Matt Frankel think of UPS stock as a value stock or value trap? A little bit of a theme here today. Sterling says he works at UPS and he can see that they're working on remodeling their buildings in order to improve sorting efficiencies. It still has an attractive dividend yield, but the other hand, and Amazon keeps indicating it wants to take UPS's lunch.

21:21Tyler Crowe:Do you buy the turnaround story? Matt, we'll start with you since it was directed to you. And Rachel, if you have any thoughts, you can share them as well. Yeah, I'm not surprised that was directed to me. I love a good value stock. Everybody knows that. But what the listener is referring to is what UPS calls its network reconfiguration program. And it is showing up in the numbers. UPS expects almost$3 billion of program benefits for this full year. Unfortunately, part of it's of cutting about 30 ,000 jobs, operational positions specifically as the network becomes both physically smaller and a lot more automated, which is what he was referring to there.

21:55So I'm not terribly worried about the Amazon part. UPS, they've already removed a ton of what they call low quality Amazon volume. That's not where they make their money. You don't make your money by free two-day shipping. You make your money from the medical equipment and more specialized forms of moving things from one place to another. So the way I would put it is Amazon didn't really steal UPS's lunch. UPS just gave back the part that it didn't really want to eat. So in Q2, UPS raised its guidance. They posted double-digit growth in operating profit. Their dividend yield is 6.4%, which might sound attractive.

22:36It represents about 98 % of the company's free cash flow. So that's a pretty high payout ratio. they haven't raised their dividend every year, but they haven't cut it for 27 consecutive years. So that's a pretty big kind of history they want to maintain. They're going to need some serious free cash flow growth over the next few years to justify keeping it where it is. So I wouldn't go so far as to call this a dividend trap. There are plenty of dividend traps in the market, and I wouldn't say this is one of them. If they can grow their premium shipping volume, meaning like the non-Amazon parts of the business, while making the network more efficient, which they're clearly doing.