S&P Global Ratings downgraded the debt ratings of Foot Locker, Inc. following the sneaker giant’s report of weaker-than-expected second-quarter earnings amid elevated promotional activity and weak consumer demand.

On September 11, Moody’s downgraded (read SGB Media‘s coverage here) Foot Locker’s debt ratings. S&P said it now expects a free operating cash flow (FOCF) deficit of approximately $120 million this year and increased S&P Global Ratings-adjusted leverage to 2.9x for fiscal 2023. As a result, S&P lowered its issuer credit rating on Foot Locker, Inc. to ‘BB’ from ‘BB+’.

S&P also lowered its issue-level rating on the company’s senior unsecured notes to ‘BB’ from ‘BB+’. The recovery rating remains capped at ‘3’, reflecting its expectation for meaningful (50 percent to 70 percent; rounded estimate: 60 percent) recovery in the event of default.

The negative outlook reflects the risk that operating performance could remain challenged amid a soft operating environment and execution risks related to Foot Locker’s operating initiatives.

S&P said in its analysis, “For the second quarter ended July 29, 2023, Foot Locker’s total revenues decreased roughly 10 percent, with comparable same-store sales down about 9.4 percent as discretionary spending within the footwear and apparel sector continued to weaken. We project total sales to be down roughly 9 percent in fiscal 2023 as Foot Locker continues to navigate through its Nike reset and repositioning of its Champs banner, combined with lower-than-expected return-to-school sales volume. We expect sales to increase in the low-single-digit percent in fiscal 2024 as weak consumer discretionary spending trends and the resumption of student loan repayments strain Foot Locker’s customer base. Our negative comparable rating analysis modifier incorporates a holistic view of the stand-alone credit profile, factoring in Foot Locker’s outsized exposure to Nike, potential for long-term market share erosion beyond its Nike reset, and its mall-based store composition.

“We forecast S&P Global Ratings-adjusted leverage in the high-2x area this year, moderating to the mid-2x area in fiscal 2024. We expect leverage to increase roughly half a turn in 2023 to 2.9x, compared to our previous leverage projection in the mid-2x area, because the company’s adjusted EBITDA margins contracted below our base case. Foot Locker’s S&P Global Ratings-adjusted EBITDA margins declined roughly 400 basis points in the second quarter of 2023 toward the mid-14 percent area, compared to the mid-18 percent area in the prior-year period. We attribute this primarily to aggressive markdowns as Foot Locker continued to reduce its excess inventory. We forecast adjusted EBITDA margins will contract further toward the high-12 percent area for fiscal 2023 as continued promotional activity, increased occupancy costs, and ongoing retail shrinkage pressure profitability.

“For the second quarter, Foot Locker’s inventory was 11 percent above the prior-year period, a material improvement from the first quarter, which was roughly 25 percent above the prior-year period. We anticipate the company will remain promotional, allowing it to further reduce elevated inventory and partially mitigate weaker customer traffic trends.

“We forecast a free operating cash flow deficit this year, with improvement in fiscal 2024. As of July 29, Foot Locker had $180 million of balance sheet cash and an undrawn balance on its $600 million asset-based lending (ABL) facility. We anticipate the recent pause in dividend payments and share repurchases will allow Foot Locker to build its balance sheet cash over the next 12 months and reduce reliance on its ABL facility under potentially worsened operating conditions. Foot Locker had a cash burn of roughly $112 million of reported FOCF in the second quarter, a modest improvement to the about $177 million deficit in the first quarter. We project Foot Locker will burn roughly $120 million of FOCF this year after accounting for capital spending of $290 million, improving to roughly $130 million of positive FOCF in fiscal 2024, driven by improved profitability prospects following its reset year.

“Foot Locker has no near-term maturities, with an ABL facility maturing in 2025 and $400 million of senior unsecured notes maturing in 2029. We anticipate debt balances will be largely unchanged over the next 12 months.

“The negative outlook reflects the heightened risk that Foot Locker will not stabilize operating performance and improve cash flow generation over the next 12 months, which could lead us to downgrade the company further over that timeframe.”

Photo courtesy Foot Locker