Description

This is not a truly great business but is an interesting special situation undergoing permanent structural change.

It has been four years since the last writeup of PSS on VIC. The company and cast of characters looks a lot different since then. The old Payless was a value trap for the better part of a decade, languishing under a tired brand in a competitive no-growth business. Add in poor management with aggressive accounting and PSS was a good short over multiple extended periods in 1998 and 2001-04.

How is PSS different from any other retailer where business dried up in 2007-08 only to look like it's bouncing back a bit now off easy comparisons? This writeup focuses on structural change within the company and industry. These changes will allow PSS to surpass the peak operating margins it achieved in 1999-2000. While it is a wide range, I believe the long-term earnings power of this business is between $2-3 per share. At a below market multiple, PSS should be a $30-40 stock. Despite a trampoline-like bounce from $5 to $20 off last November's lows, these structural changes can drive earnings revisions even in a tepid consumer spending environment. With consensus at $1.50 for 2010, there is a sizable delta between what the market is expecting and what PSS can actually do next year.

I address some of these structural changes below and will leave the macro questions on the consumer for the post-writeup Q&A.

1. WMT backing away from shoes

Our research suggests that Wal-Mart is making strategic moves to maximize each store's return on capital. Part of this process involves dedicating more square footage to highly profitable areas and taking away from others. It just so happens that in many WMT stores the footwear is located right next to the profitable and growing consumer electronics space. Footwear is a casualty of making room for more televisions and game systems.

WMT does about $5bn in footwear sales annually and carries an average price point around $10. This makes it a top competitor for Payless ShoeSource, which provides ~60% of PSS's overall revenue. We think that the footwear department could see a reduction in square footage of 20-40% with a shift towards lower price points (think more cheap rubber flip flops and less athletic sneakers or stylish women's dress shoes). If WMT cedes that share over a three-year period as it revamps and remodels stores, that is $1-2bn in revenue. With just under 4,000 domestic stores, a mapping analysis shows that over 80% of Wal-Mart stores have a Payless within 5 miles and 40% of Payless stores have a Wal-Mart within 5 miles. If PSS can capture an additional $200-500m in business at a high incremental margin on what is basically a gift of market share, this could be worth 40-70c/share in earnings power over time.

2. Shift to dual distribution

This part of the story is lower-hanging fruit. Payless used to have one DC in Topeka, Kansas. Since almost all product is sourced in Asia, this meant landing goods in LA/Long Beach, putting them on rail or truck to Topeka, and in many cases backhauling goods to those stores in the western part of the US. This gross inefficiency is being solved now as DC in Ohio opened earlier in 2009 to complement one in California. The Topeka DC was shut down this summer as well. 

Of the domestic store base, 26% are located in CA/TX/AZ and another 20% are basically neighbors of Ohio. This compares to ~5% of the stores within a decent striking distance of Topeka. In addition to the benefits on fuel and transportation (which seem to become more important again as crude prices rise), the new DCs are more efficient with newer systems. This structural change should result in 20c/share in earnings power as the company eliminates a redundant $12m/year in cost from the Topeka DC and realizes efficiencies as it ramps the new Ohio location.

3. Mix shift towards 'brands' drives higher margins and ASPs

Changing image for a retail concept is like turning around a battleship, particularly for a company as large as Payless with ~4,000 domestic stores. Still, there are a few initiatives worth highlighting that seem to be working. 

Over the past three years, Payless has stepped up the assortment of brands in its store from ~50% to ~70%. This has the effect of dragging ASPs higher even in a tough environment. For example, footwear ASPs rose 6.9% in 2Q09 on top of a 5.9% increase in 2Q08. While I am far from a fashion guru, names like alice + olivia and Project Runway's Christian Siriano are driving a younger woman to shop at Payless who might have never set foot in the store (e.g. http://www.youtube.com/watch?v=X-Ee0ZUh9ps). Retailing Christian Siriano boots for $50 and a branded handbag for $35 is a meaningful change compared to the average pair of shoes at Payless selling below ~$14. While PSS should remain a low-priced affordable stop for footwear, this could be worth another 10-30c/share in EPS over time.

4. Management is excellent and things are finally clicking

They levered up at the peak to buy Stride-Rite (SRR) in 2007. But with four years at the helm, CEO Matt Rubel has built an extremely deep bench of talent and transformed the company into a data and process driven machine. It sounds mundane, but Payless has used POS systems to collect phone numbers, zip codes and other customer information ever since Rubel took over. Before, the company was left to guess at important factors like its core customer was, how often she shops and what she buys for herself versus her kids. Now that PSS has reams of data to analyze it is no longer a guessing game. This means more dollars targeted to direct marketing and couponing as opposed to blanketing different markets with BOGO promotions. Further, this data allows PSS to optimize its inventory mix and reduce working capital in a meaningful way over time. For example, the company has focused on making children's styles available in larger sizes as the company discovered there was a lot of lost demand there for moms with bigger kids who weren't quite ready to put their daughters in adult shoe styles.

The Stride-Rite acquisition is finally working, too. Systems integration aside, Rubel was very careful to preserve the best parts of the SRR culture. This meant a slow but methodical integration which is still happening over two years after the deal. Brands like Saucony in the running channel and Sperry in boating/lifestyle are gaining share (e.g. see Sperry featured in J Crew this fall). Cross-pollination with the Stride-Rite brands doesn't happen at the Payless store level, but there are softer synergies in design and management in addition to the harder benefits of shared purchasing.

This is admittedly a softer point in the company's transformation, but it is relevant and a well-managed, data-driven company can maximize its profitability better than the old version of Payless ever could. A focus on shareholder return and return on invested capital makes for a highly disciplined management team.

5. Margin relief in 2H09-2010 (product costs & rent roll)

This might not be permanent, but a number of factors had pressured gross margins over the past 1-2 years and are reversing course. These start hitting in a big way in 2H09 and might still be underappreciated by the market.

Rent: with relatively short 5-year leases, PSS is probably seeing rent reductions of 10-15% as leases roll over. Concessions on rent will reduce G&A dollars in 2010 and may be additive to margins

Sourcing: product costs rose in 2007-08 for a number of reasons. Scaled back tax rebates in China, slower factory capacity growth, infrastructure issues (blizzard + earthquake) and even a focus on Olympics preparation resulted in higher prices for those who wanted goods from China. Now, that inventory has cycled through and the market has witnessed lower export taxes (Chinese stimulus) and less competition/jockeying for factory capacity. Cheaper product costs out of China allows PSS to keep some of that margin and reinvest some in driving volumes (this back-to-school season was a prime example of that).

These changes in product costs might not be permanent, but should provide ~60c in EPS over the next year.

6. Risks

• The step change in earnings power is also a function of the volumes of footwear running through the system. I think PSS can reach these goals with a flat to slightly positive comp number over the next few years. Another downturn in the economy + sustainable high unemployment would hurt for the core PSS customer who makes ~$50,000 per year.
• International stores had been doing quite well prior to the recession but are suffering from one-off issues. While this is a source of opportunity should things turn around, there are issues that need to be solved. For example, Wal-Mart is quite good in the shoe department in Canada, where Payless is perceived to be a bit more upscale. Tariff problems in Ecuador have hurt along with high unemployment in Puerto Rico. 
• The gross margin relief from product costs may not be structural or permanent. Oil is a relevant input.

Catalyst

Step-change in earnings power as various company initiatives flow through and industry landscape changes:

• Gross margin expansion from lower product costs (flows to earnings in 2009-2010)
• Shift to dual distribution system (flows to earnings in 2009-10)
• WMT backs away from shoes (flows to earnings in 2009-11)
• Continued share gains and margin enhancement from store-level initiatives (flows to earnings in 2010-11)
• Call option on Sperry turning into a real lifestyle brand that does more than just footwear