JPMorgan: Foot Locker convertible cheap, stock attractive, credit improving

By Ronda Fears

Nashville, Tenn., July 18 - JPMorgan recommends Foot Locker Inc.'s 5.5% convertible subordinated notes to both outright investors seeking capital appreciation and attractive yield, and relative value investors seeking theoretical cheapness.

"In our view, Foot Locker, Inc. is a company that has what convertible investors are looking for: a cheap convertible as well as an undervalued common stock and an improving credit profile," said JPMorgan convertible analyst Alex Robinson in a report.

Foot Locker's recently completed restructuring has transformed it from an overextended general merchandise retailer to a retailer focused solely on athletic footwear, apparel and accessories, the analyst said. Foot Locker traces its history to F. W. Woolworth. In June 1998, the company changed its name to Venator Group Inc., and the $150 million convertible was issued under that name.

However, he added, the stock continues to trade at a discount to its peers on both a price/earnings and PEG (price to earnings growth) basis. Foot Locker shares are trading at an 11.7% discount to the average P/E ratio of its peers based on consensus estimates for fiscal 2002, while its PEG discount for estimated 2002 earnings is 17.1%, Robinson said.

Foot Locker's strategy of balance sheet improvement is showing results, as both Moody's and S&P have upgraded the company's credit ratings since March, Robinson pointed out. Foot Locker is also pursuing a strategy of balance sheet improvement and targets an issuer rating of Baa/BBB within the next few years compared with Ba3/BB+ currently. The convert is rated B1/BB-.

JPMorgan expects continued balance sheet improvement and strong cash flow generation. As of the end of fiscal first quarter, the analyst noted that Foot Locker has shown 11 consecutive quarters of sales and earnings improvements.

With total liquidity of $468 million, including $190 million from an undrawn revolving credit facility, and significant estimated free cash flow from continuing operations, Robinson expects Foot Locker's leverage and coverage ratios will show meaningful improvement over the next several quarters.

Based on First Call consensus diluted EPS estimates, Foot Locker's EBITDAR to net interest coverage is expected to improve to 36.3 times in fiscal 2002 from 32.1 times for the last 12 months, while leverage - measured by total debt, including the present value of operating leases - to EBITDAR is expected to decline to 1.9 times from 2.0 times.

All that serves to make the convertible cheap, in Robinson's view.

Using a 90-day volatility of Foot Locker stock of 40%, versus an actual 90-day volatility of over 37%, and a 550 basis point credit spread, the 5.5% convertible is trading about 2.7% cheap to a theoretical value of 106.03, the analyst said.

Also, he said that at their current price of 103, the convertible offers less than 20% downside participation and almost 60% upside participation in common stock movements using 20% intervals.

He said he believe the convertible trades on an actual market delta of 80% compared with the theoretical delta using his assumptions of 63%.

But, the analyst said he remains watchful for potential risks, including common stock valuation compression, fashion risk, or unexpected cash demands from discontinued or restructured operations despite the completion of Foot Locker's repositioning.

Foot Locker 5.5% due June 1, 2008

Convertible subordinated notes

Amount: $150 million

Credit Ratings: B1/BB-

Price: 103.13

Current Yield: 5.33%

Yield-to-Maturity: 4.88%

Spread: 119 basis points over Treasuries

Conversion Ratio: 63.267

Conversion Premium: 34.5%

Parity: 76.68

Call protection remaining: 1.88 years

Breakeven: 4.81 years

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