BUSINESS OVERVIEW

Foot Locker, Inc., through its subsidiaries, operates in two reportable segments
- Athletic Stores and Direct-to-Customers. The Athletic Stores segment is one of the largest athletic footwear and apparel retailers in the world, whose formats include Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction, and CCS. The Direct-to-Customers segment is multi-branded and multi-channeled. This segment sells, through its affiliates, directly to customers through its Internet websites, mobile devices, and catalogs. Eastbay, one of the affiliates, is among the largest direct marketers in the United States. The Direct-to-Customers segment operates the website for eastbay.com, final-score.com, and eastbayteamservices.com. Additionally, this segment operates websites aligned with the brand names of its store banners (footlocker.com, ladyfootlocker.com, kidsfootlocker.com, footaction.com, champssports.com, and ccs.com).

STORE COUNT

At October 27, 2012, the Company operated 3,367 stores as compared with 3,369 and 3,402 stores at January 28, 2012 and October 29, 2011, respectively. During the thirty-nine weeks ended October 27, 2012, the Company opened 70 stores, remodeled or relocated 159 stores, and closed 72 stores.

A total of 40 franchised stores were operating at October 27, 2012, as compared with 34 and 32 stores at January 28, 2012 and October 29, 2011, respectively. Revenue from the franchised stores was not significant for any of the periods presented. These stores are not included in the Company's operating store count above.

SALES AND OPERATING RESULTS

All references to comparable-store sales for a given period relate to sales of stores that are open at the period-end, that have been open for more than one year, and exclude the effect of foreign currency fluctuations. Accordingly, stores opened and closed during the period are not included. Sales from the Direct-to-Customers segment are included in the total Company calculation of comparable-store sales for all periods presented. Division profit reflects income before income taxes, corporate expense, net interest expense, and net non-operating income.

The following table summarizes results by segment:

                            Thirteen weeks ended               Thirty-nine weeks ended
Sales                 October 27,         October 29,      October 27,        October 29,
(in millions)             2012               2011              2012               2011
Athletic Stores       $      1,375       $       1,268     $      4,060       $      3,773
Direct-to-Customers            149                 126              409                348
Total sales           $      1,524       $       1,394     $      4,469       $      4,121




                                              Thirteen weeks ended                  Thirty-nine weeks ended
Operating Results                        October 27,         October 29,       October 27,           October 29,
(in millions)                               2012                2011              2012                  2011
Athletic Stores                         $         166       $         119     $         480         $         360
Direct-to-Customers                                18                  12                47                    32
Restructuring charge (1)                            -                   -                 -                    (1 )
Division profit                                   184                 131               527                   391
Less: Corporate expense, net                       28                  25                76                    76
Operating profit                                  156                 106               451                   315
Other income (2)                                    -                   -                 1                     1
Interest expense, net                               1                   1                 3                     4
Income before income taxes              $         155       $         105     $         449         $         312

(1) During the first quarter of 2011, the Company increased its 1993 Repositioning and 1991 Restructuring reserve by $1 million for repairs necessary to one of the locations comprising this reserve. This amount is included in selling, general and administrative expenses in the Condensed Consolidated Statement of Operations.
(2) Other income includes non-operating items, such as: gains from insurance recoveries; discounts/premiums paid on the repurchase and retirement of bonds; royalty income; and the changes in fair value, premiums paid, and realized gains associated with foreign currency option contracts. Other income for the thirty-nine weeks ended October 27, 2012 primarily represents royalty income, partially offset by a premium paid on the repurchase and retirement of bonds. Other income for the thirty-nine weeks ended October 29, 2011 primarily represents lease termination gains related to the sale of leasehold interests and royalty income.

Sales increased by $130 million, or 9.3 percent, to $1,524 million for the thirteen weeks ended October 27, 2012, from $1,394 million for the thirteen weeks ended October 29, 2011. For the thirty-nine weeks ended October 27, 2012, sales of $4,469 million increased 8.4 percent from sales of $4,121 million for the comparable prior-year period of 2011. Excluding the effect of foreign currency fluctuations, total sales for the thirteen-week and thirty-nine week periods increased 11.0 percent and 10.4 percent, respectively, as compared with the corresponding prior-year periods. Comparable-store sales increased by 10.2 percent and 9.9 percent for the thirteen and thirty-nine weeks ended October 27, 2012, respectively.

Gross margin, as a percentage of sales, increased by 60 basis points to 33.1 percent for the thirteen weeks ended October 27, 2012, as compared with the corresponding prior-year period. For the thirty-nine weeks ended October 27, 2012, gross margin, as a percentage of sales, increased by 100 basis points to 32.9 percent, as compared with the corresponding prior-year period.

For the thirteen weeks ended October 27, 2012, the occupancy and buyers' salary expense rate decreased by 100 basis points, as a percentage of sales, as compared with the corresponding prior-year periods, reflecting improved occupancy leverage. Partially offsetting this improvement was a 30 basis point decrease in the merchandise margin rate due to higher markdowns, primarily in Europe, and the effect of lower initial markups. The additional markdowns in Europe were necessary to ensure that merchandise inventories remained current and in line with the sales trend. Additionally, 10 basis points of the decline is attributable to the effect of lower shipping and handling income as the Direct-to-Customers segment continued to provide free shipping offers to remain competitive with other Internet retailers. For the thirty-nine weeks ended October 27, 2012, the occupancy and buyers' salary expense rate decreased by 110 basis points, as a percentage of sales, as compared with the corresponding prior-year period, reflecting improved leverage. The merchandise margin rate for the thirty-nine weeks ended October 27, 2012 decreased by 10 basis points from the corresponding prior-year period.

The effect of vendor allowances was not significant for any of the periods presented.

Segment Analysis

Athletic Stores

Athletic Stores sales increased by 8.4 percent and 7.6 percent for the thirteen and thirty-nine weeks ended October 27, 2012, respectively, as compared with the corresponding prior-year periods. Excluding the effect of foreign currency fluctuations, sales from athletic stores increased 10.2 percent and 9.8 percent for the thirteen and thirty-nine weeks ended October 27, 2012, respectively, as compared with the corresponding prior-year periods. Comparable-store sales increased by 9.4 percent and 9.2 percent for the thirteen and thirty-nine weeks ended October 27, 2012, respectively.

For the thirteen weeks and thirty-nine weeks ended October 27, 2012, most divisions posted strong comparable-store sales gains. The strongest performers were Kids Foot Locker, Champs Sports and domestic Foot Locker. Foot Locker Europe's comparable-store sales were essentially flat for the quarter and reflected a modest decline in the year-to-date period, primarily reflecting the macroeconomic conditions in that region. Total sales for Foot Locker Europe were higher than the corresponding prior-year periods for both the quarter and year-to-date periods as a result of new store openings. The total store count increased by 39 as compared with the corresponding prior-year period.

Lady Foot Locker's total sales declined in the quarter partially due to lower store count, as management has continued to close underperforming locations. Comparable-store sales for Lady Foot Locker also decreased for the quarter; however, year-to-date comparable-store sales were essentially flat. Management has continued to review the women's business and is developing and implementing various initiatives, such as expanded apparel offerings and a new store design, which is currently being tested in 14 locations. In November, the Company announced the introduction of a new banner, SIX:02, an elevated retail concept featuring top brands in fitness apparel and athletic footwear for women. The Company will open three stores in the fourth quarter. Management believes that these initiatives will improve the performance of the women's category over time, as the tests are studied and the actions are refined across all stores.

The overall sales performance was very consistent for footwear, apparel, and accessories. Total footwear sales gains were led by the kids category, which had strong gains across all banners, and the basketball category which benefited from key marquee player shoes. Overall apparel sales increased in the low double-digits, reflecting strong domestic increases offset, in part, by a decline in Europe's apparel sales.

Athletic Stores division profit for the thirteen weeks ended October 27, 2012 increased to $166 million, or 12.1 percent, as a percentage of sales, as compared with division profit of $119 million, or 9.4 percent, as a percentage of sales, for the thirteen weeks ended October 29, 2011. For the thirty-nine weeks ended October 27, 2012, division profit increased to $480 million, or 11.8 percent, as a percentage of sales, as compared with division profit of $360 million, or 9.5 percent, as a percentage of sales, for the thirty-nine weeks ended October 29, 2011. These increases were mainly attributable to improved sales, as well as a slightly improved gross margin rate driven by improved leverage of the fixed expenses within gross margin. Also contributing to the improvement was continued expense control.

Direct-to-Customers

Direct-to-Customers sales increased by 18.3 percent to $149 million for the thirteen weeks ended October 27, 2012, as compared with the corresponding prior-year period of $126 million. For the thirty-nine weeks ended October 27, 2012, sales increased by 17.5 percent to $409 million, as compared with the corresponding prior-year period of $348 million. These increases were primarily a result of the continued strong sales performance of the Company's store banner websites and Eastbay, both of which benefited from improved and fresh product offerings. Additionally, we continue to invest in our websites, by providing entertaining, engaging content, as well as developing and optimizing the sites for smart phone and tablet use. The Company continues to experience the migration of catalog sales to internet sales; therefore, providing the breakdown between catalog and internet sales is no longer meaningful.

Direct-to-Customers division profit increased 50.0 percent to $18 million, and increased 46.9 percent to $47 million, for the thirteen and thirty-nine weeks ended October 27, 2012, respectively, as compared with the corresponding prior-year periods. Division profit, as a percentage of sales, increased to 12.1 percent and 11.5 percent for the thirteen and thirty-nine weeks ended October 27, 2012, respectively, as compared with 9.5 percent and 9.2 percent, respectively, in the corresponding prior-year periods. These increases primarily reflect the improvement in sales. The results of CCS have been primarily adversely affected by the overall downturn of the skate market. The Company has refined its merchandise offerings as well as modified its catalogs to provide more content and product images, in an effort to improve the future results of this business. Management will monitor the results of this business during the fourth quarter, which may include an analysis of the recoverability of its intangible assets.

Corporate Expense

Corporate expense consists of unallocated general and administrative expenses, as well as depreciation and amortization related to the Company's corporate headquarters, centrally managed departments, unallocated insurance and benefit programs, certain foreign exchange transaction gains and losses, and other items. Corporate expense for the thirteen weeks ended October 27, 2012 increased by $3 million to $28 million from the corresponding prior-year period, primarily reflecting increased incentive compensation and higher professional fees. Corporate expense for the thirty-nine weeks ended October 27, 2012 was unchanged as compared with the corresponding prior-year period.

Selling, General and Administrative

Selling, general and administrative expenses ("SG&A") of $319 million decreased by $1 million for the thirteen weeks ended October 27, 2012 as compared with the corresponding prior-year period. SG&A, as a percentage of sales, decreased to 20.9 percent for the thirteen weeks ended October 27, 2012, as compared with 23.0 percent in the corresponding prior-year period. For the thirty-nine weeks ended October 27, 2012, SG&A increased by $12 million, or 1.3 percent, as compared with the corresponding prior-year period. SG&A, as a percentage of sales, decreased to 20.8 percent for the thirty-nine weeks ended October 27, 2012, as compared with 22.3 percent in the corresponding prior-year period.

Excluding the effect of foreign currency fluctuations, SG&A increased by $5 million and $32 million for the thirteen and thirty-nine weeks ended October 27, 2012, respectively, as compared with the corresponding prior-year periods. These increases principally represented increased variable costs to support sales, such as store wages and banking expenses. Variable costs, while higher than the prior year, were managed efficiently resulting in the decline in the SG&A rate. The improved leverage was achieved while also making incremental investments in marketing programs.

Depreciation and Amortization

Depreciation and amortization increased by $3 million for the thirteen weeks ended October 27, 2012 to $30 million, as compared with the corresponding prior-year period. For the thirty-nine weeks ended October 27, 2012, depreciation and amortization increased by $6 million to $88 million as compared with the corresponding prior-year period. Excluding the effect of foreign currency fluctuations, primarily related to the euro, depreciation and amortization increased by $8 million for the thirty-nine weeks ended October 27, 2012, as compared with the corresponding prior-year period. The effect of foreign currency fluctuations was not significant for the thirteen weeks ended October 27, 2012. These changes reflect additional depreciation and amortization associated with increased capital spending on stores, information systems, digital technology enhancements, and other projects.

Interest Expense



                                                Thirteen weeks ended                    Thirty-nine weeks ended
                                         October 27,            October 29,        October 27,           October 29,
(in millions)                                2012                   2011              2012                  2011
Interest expense                        $            3         $            2     $           8         $           9
Interest income                                     (2 )                   (1 )              (5 )                  (5 )
Interest expense, net                   $            1         $            1     $           3         $           4

The decrease in net interest expense for the thirty-nine weeks ended October 27, 2012, as compared with the corresponding prior-year period, primarily reflects lower expenses associated with the Company's revolving credit facility, which was amended at the end of 2011 with lower annual fees.

Income Taxes

The Company recorded income tax provisions of $49 million and $156 million, which represent an effective tax rate of 31.7 percent and 34.8 percent, for the thirteen weeks and thirty-nine weeks ended October 27, 2012, respectively. For the thirteen weeks and thirty-nine weeks ended October 29, 2011, the Company recorded income tax provisions of $39 million and $115 million, which represent an effective tax rate of 37.3 percent and 36.9 percent, respectively. The Company's interim provision for income taxes is measured using an annual effective tax rate, adjusted for discrete items that occur within the periods presented.

The Company regularly assesses the adequacy of the Company's provisions for income tax contingencies in accordance with the applicable authoritative guidance on accounting for income taxes. As a result, the Company may adjust the reserves for unrecognized tax benefits considering new facts and developments, such as changes to interpretations of relevant tax law, assessments from taxing authorities, settlements with taxing authorities, and lapses of statutes of limitation. The effective tax rate for the thirteen weeks ended October 27, 2012 included a tax reserve release of $9 million due to a foreign tax audit settlement. The effective tax rate for the thirty-nine weeks ended October 27, 2012 included tax benefits of $12 million related to tax reserve releases due to the settlements of federal, state, and foreign tax audit settlements. The effective tax rates for the thirteen weeks and thirty-nine weeks ended October 29, 2011 included tax reserve releases of $1 million due to the lapse of a foreign statute of limitations.

Changes in tax laws or tax rates are reflected on deferred tax assets and liabilities when enacted. The thirty-nine weeks ended October 27, 2012 included a tax benefit related to a Canadian provincial tax rate change that resulted in a $1 million increase in the value of the Company's net deferred tax assets. The Company does not expect this change to have a significant effect on future periods.

Excluding the reserve releases and the Canadian provincial rate change, the effective tax rate for the thirteen weeks and thirty-nine weeks ended October 27, 2012 increased as compared with the corresponding prior-year periods, due primarily to a higher proportion of income earned in the United States, which bears a higher tax rate.

The Company currently expects the fourth quarter tax rate to be in the range of 37 to 38 percent and its full year tax rate to approximate 36 percent, excluding the effect of any additional nonrecurring items that may occur. The actual tax rates will primarily depend on the level and mix of income earned in the United States as compared with its international operations.

Reconciliation of Non-GAAP Measures

The Company provides non-GAAP information to assist investors with the comparison of the Company's results period over period. In 2009, the Company excluded from its non-GAAP results the effect of a Canadian provincial tax rate change that resulted in a $4 million reduction in the value of the Company's deferred tax assets. In the second quarter of 2012, the Company recorded a benefit of $1 million, or $0.01 per diluted share, to reflect the repeal of the last two stages of the Canadian provincial tax rate changes. In the third quarter of 2012, the Company also recorded a benefit of $9 million, or $0.06 per diluted share, to reflect the settlement of a foreign tax audit, which resulted in a reduction in tax reserves established in prior periods. Accordingly, consistent with prior periods, the Company has excluded these benefits to arrive at its non-GAAP results. The non-GAAP financial measure is provided in addition to, and not as an alternative to, the Company's reported results prepared in accordance with GAAP.

Net Income

For the thirteen weeks and thirty-nine weeks ended October 27, 2012, net income increased by $40 million or 60.6 percent and $96 million or 48.7 percent, respectively, as compared with the corresponding prior-year periods. Presented below are GAAP and non-GAAP results, as more fully described above.

                                              Thirteen weeks ended                Thirty-nine weeks ended
                                         October 27,         October 29,      October 27,        October 29,
(in millions)                               2012                2011              2012               2011
Net income                              $         106       $          66     $        293       $        197
Diluted EPS                             $        0.69       $        0.43     $       1.90       $       1.27

Net income (non-GAAP)                   $          97       $          66     $        283       $        197
Diluted EPS (non-GAAP)                  $        0.63       $        0.43     $       1.83       $       1.27

The improved performance represented a 38.5 percent and 39.4 percent flow-through of increased sales to pre-tax income for the third quarter and year-to-date periods of 2012, respectively, reflecting leveraging of fixed costs and effectively controlling operating expenses.

LIQUIDITY AND CAPITAL RESOURCES

The Company's primary source of liquidity has been cash flow from operations, while the principal uses of cash have been to: fund inventory and other working capital requirements; finance capital expenditures related to store openings, store remodelings, Internet and mobile sites, information systems, and other support facilities; make retirement plan contributions, quarterly dividend payments, and interest payments; and fund other cash requirements to support the development of its short-term and long-term operating strategies. The Company generally finances real estate with operating leases. Management believes its cash, cash equivalents, short-term investments, future cash flow from operations, and the Company's current revolving credit facility will be adequate to fund these requirements.

The Company may also from time to time repurchase its common stock or seek to retire or purchase outstanding debt through open market purchases, privately negotiated transactions, or otherwise. Such repurchases, if any, will depend on prevailing market conditions, liquidity requirements, contractual restrictions, and other factors. The amounts involved may be material.

Any material adverse change in customer demand, fashion trends, competitive market forces, or customer acceptance of the Company's merchandise mix and retail locations, uncertainties related to the effect of competitive products and pricing, the Company's reliance on a few key vendors for a significant portion of its merchandise purchases and risks associated with global product sourcing, economic conditions worldwide, the effects of currency fluctuations, as well as other factors listed under the heading "Disclosure Regarding Forward-Looking Statements," could affect the ability of the Company to continue to fund its needs from business operations.

On May 16, 2012, the Company's Board of Directors approved an overall increase of $10 million to the 2012 capital expenditure and lease acquisition plan to $170 million, representing capital expenditures of $163 million and lease acquisition costs related to the Company's operations in Europe of $7 million. Separately, in May 2012 the Company purchased from its U.S. pension trust an investment in real estate for $8 million.

Operating Activities

Net cash provided by operating activities was $259 million and $265 million for the thirty-nine weeks ended October 27, 2012 and October 29, 2011, respectively. These amounts reflect net income adjusted for non-cash items and seasonal working capital changes. Net cash provided by operating cash flows for the thirty-nine weeks ended October 27, 2012 reflects higher net income, offset by higher income tax payments as compared with the prior year. The corresponding prior-year period reflected the receipt of a $46 million IRS income tax refund resulting from a loss carryback.

Investing Activities

Net cash used in investing activities was $170 million and $111 million for the thirty-nine weeks ended October 27, 2012 and October 29, 2011, respectively, reflecting the Company's net purchases of $50 million of short-term investments as well as capital expenditures. The Company's current full year forecast for capital expenditures is $163 million, of which $126 million relates to the modernizations of existing stores and new store openings and $37 million for the development of information systems and infrastructure. For the full year of 2012, the Company expects to open 84 new stores and to modernize 198 stores. Capital expenditures for the thirty-nine weeks ended October 27, 2012 also includes $8 million to purchase land and buildings from the Company's U.S. pension trust.

Financing Activities

Net cash used in financing activities was $129 million and $157 million for the thirty-nine weeks ended October 27, 2012 and October 29, 2011, respectively. During the thirty-nine weeks ended October 27, 2012, the Company repurchased and retired $2 million of its 8.5 percent debentures payable in 2022. Additionally in 2012, the Company repurchased 2,961,161 shares of its common stock for $94 million, as compared with $97 million purchased during the corresponding prior-year period. The Company declared and paid dividends during the first three quarters of 2012 and 2011 of $82 million and $76 million, respectively. This represents a quarterly rate of $0.18 and $0.165 per share for 2012 and 2011, respectively. The Company received proceeds from the issuance of common stock in connection with employee stock programs of $40 million and $13 million for the thirty-nine weeks ended October 27, 2012 and October 29, 2011, respectively. In connection with stock option exercises and share-based compensation programs, the Company recorded excess tax benefits of $9 million as a financing activity during the thirty-nine week period ended October 27, 2012 as compared with $3 million in the corresponding prior-year period, primarily reflecting higher stock option exercises in the current year.

Credit Rating

On October 17, 2012, Standard and Poor's raised the Company's corporate credit rating to BB+ from BB.

Recent Accounting Pronouncements

During the first quarter of 2012, the Company adopted ASU No. 2011-08, Testing Goodwill for Impairment. The revised standard is intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a qualitative assessment to determine whether further impairment testing is necessary. The adoption of this ASU did not have a significant effect on our results of operations or financial position.

During the first quarter of 2012, the Company also adopted ASU No. 2011-05, Presentation of Comprehensive Income, which requires presentation of total comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The implementation of the amended reporting guidance had no effect on our disclosures.

During the second quarter of 2012, the FASB issued ASU 2012-02, Testing Indefinite-Lived Intangible Assets for Impairment, which allows an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset, other than goodwill, is impaired. If . . .