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What happened

Shares of footwear and apparel retail chain Foot Locker (NYSE: FL) plunged 27% in August, according to data provided by S&P Global Market Intelligence. After the company reported financial results for the fiscal second quarter of 2023, the stock was down as much as 38% for the month before modestly rebounding.

FL data by YCharts.

Foot Locker reported Q2 results on Aug. 23, showing that sales dropped nearly 10% year over year — worse than anticipated. And lower sales resulted in dramatically lower profitability. The company had net income of $94 million in the prior-year quarter, but it swung to a net loss of $5 million in Q2.

As a result of its poor showing in Q2, Foot Locker lowered its full-year guidance for a second time this year, which sparked a really negative market reaction.

The market capitalization of Foot Locker has dropped enough that S&P Dow Jones Indices needed to make a change. Foot Locker stock is part of the S&P MidCap 400 index. But on Sept. 18, it’ll be removed from that index and added to the S&P SmallCap 600 index. The impact on Foot Locker stock from this news was far less than the impact from its lackluster Q2 financial results.

So what

For Foot Locker, it’s more than just slumping sales and plummeting profits. The situation is more concerning when zooming in.

Consider that Foot Locker’s inventory is currently sitting at its highest level in more than a decade. In the apparel business, inventory can quickly become outdated. So it’s paramount to keep it moving.

To move inventory, Foot Locker’s management is marking down merchandise. And in its updated guidance, it said it’s planning for “more aggressive markdowns.” This might move merchandise, but it’s coming at the expense of profits.

In short, Foot Locker’s inventory is rising because sales are stalling. This is making management give up profits by lowering prices to stimulate sales.

FL Inventories (Quarterly) data by YCharts.

Now what

Trading at a price-to-sales (P/S) ratio of just 0.2, Foot Locker stock hasn’t been this cheap in 15 years. But as already mentioned, inventory is still up. Therefore, management will keep lowering prices at least until that problem is fixed. And that means it’s likely that sales will keep struggling and losses will be ongoing.

Once Foot Locker moves past its current problem, I think it’s fair to wonder what the upside is for this business. In its Q2 report, management repeatedly emphasized its commitment to its long-term “Lace Up Plan.” But the growth targets in the Lace Up Plan are quite modest, suggesting investors should expect low growth even when things are going well.

The stock may be cheaper now. But given the dynamics of this business, I’m not sure Foot Locker will generate enough sales growth or profits to be a market-beating investment.

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Jon Quast has no position in any of the stocks mentioned. The Motley Fool recommends Foot Locker. The Motley Fool has a disclosure policy.

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