Athletic footwear and apparel retailer Finish Line (click ticker for report: ) reported highly disappointing third-quarter results Friday morning. Revenue grew 5.2% year-over-year to $296 million, in-line with consensus estimates. Earnings were incredibly weak, as the company was roughly break-even for the quarter, well below the consensus estimate of $0.10 per share and down from earnings of $0.11 per share in the same period a year ago.
We were not expecting such weak quarter, particularly given the company’s increased focus on basketball shoes, as well as the blockbuster lineup of basketball shoe releases from the likes of Nike (click ticker for report: ) and adidas in the third quarter. Basketball wasn’t the problem, as management noted that basketball shoe sales grew in the double digits (as a percentage). Running, which Nike previously mentioned was weak, was the main culprit of the company’s weak 3.6% same-store sales growth rate. Though the company blamed the brands for not delivering enough good running products, we were pleased to hear management take responsibility for not focusing enough on basketball products.
The firm also missed on the e-commerce front, though digital sales still managed to grow 25%. Finish Line introduced a new website on Cyber Monday, which, in our view, was horrible, and it quickly reverted to its previous design. It certainly cost the company some sales, but we think the issue will be resolved with a superior web product sometime in calendar 2013.
Gross margins were weaker than anticipated, falling 200 basis points year-over-year to 30.3%. Not surprisingly the company blamed higher markdowns on running products and clearing inventory. Gross margins now trail rival Foot Locker (click ticker for report: ) by nearly 300 basis points, so we don’t think inventory is the only problem. Given Finish Line’s smaller size, we’re fairly confident the firm isn’t able to capture as much initial mark-up (IMU) as Footlocker–as Nike and adidas likely negotiate more favorable pricing. However, we think this could improve as Finish Line takes over the management of Macy’s (click ticker for report: ) athletic footwear and negotiates superior buying scale. Additional weakness from running could also give Finish Line more purchasing leverage.
SG&A expenses were also horrendous, increasing to 30.8% of sales from 29.5% a year ago, though this quarter’s number includes the rollout of certain technology investments and the failure of the new FinishLine.com. We think management will focus on cutting costs going forward, so we aren’t too worried about this category just yet.
Speaking of the Macy’s relationship, management appears confident that the partnership can add $0.30-$0.35 per share in earnings after it fully ramps, as well as an additional $300 million in sales. We love the deal, and we think it will be a long-term catalyst for the stock. Unfortunately, that catalyst is still far away.
Going forward, the firm cut its earnings outlook for the full-year to $1.47-$1.51 per share from its previous forecast of a 6-9% increase over fiscal year 2012’s results. Fourth quarter same-store sales are expected to increase at a low double-digit pace, as the firm anniversaries an additional week in the previous year. We think Finish Line might be a little pessimistic with respect to guidance, as fourth and first quarters of the calendar year are traditionally great months for Nike and Jordan basketball releases (and Finish Line reported a mid-single digits same-store sales growth rate for December). Jordan in particular has new management focused on improving the authenticity of its retro product, which could rope in higher prices and sales volumes, in our view.
Overall, while we were thoroughly disappointing by third-quarter results, we appreciated management’s sense of urgency and candor handling the situation. We see fundamental performance improving in the fourth quarter, but the recent news is by no means positive for Finish Line. Foot Locker will continue to benefit from a better basketball offering, but we think Finish Line still has a shot to catch up.
The firm continues to hold no debt and authorized a 5 million share buyback which is a savvy move, in our view. We continue to believe that shares are undervalued and the company has a clear path to improving profitability. When fulfilled, the buyback could be highly accretive to earnings. Still, its score of 3 on the Valuentum Buying Index (our stock-selection methodology) is keeping us on the sidelines for now.