Value Investors Club / Finish Line (FINL)

Description

The market has assumed that Finish Line is all but dead thanks to a proposed deal gone bad. We believe that at 0.3x Tangible Book, 1.5x TTM EBITDA and 0.1x Revenue, FINL is ragingly cheap. As a court case to determine the fate of the deal concludes, we believe the likelihood of an adverse decision is more than baked into today’s stock price.

Catalysts:

1. Resolution of the FINL/GCO trial(s)

2. FINL’s underlying business returns to an industry average valuation

Current Operational Headwinds:

Sandman898 did a nice write-up of FINL in September 2006, which I encourage readers to browse. Subsequent to Sandman’s report, FINL has combated a tough retail environment, some fashion headwinds and some trouble with its growth concepts.

In the last few quarters, same store sales have declined markedly:

Same Store Sales
	Q3 '06	Q4 '06	Q1 '07	Q2 '07	Q3 '07	Q4 '07	Q1 '08	Q2 '08
FINL Concept	n.a.	n.a.	-7.3%	-6.6%	-3.5%	-5.8%	-4.1%	-4.8%
Man Alive	n.a.	n.a.	0.6%	-4.8%	3.1%	4.4%	0.6%	-2.4%
Paiva	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.
Overall	4.0%	0.0%	-7.2%	-6.6%	-3.3%	0.4%	-3.9%	-4.7%

This has resulted in negative operating leverage over the past several quarters:

Operating Margins
	Q3 '06	Q4 '06	Q1 '07	Q2 '07	Q3 '07	Q4 '07	Q1 '08	Q2 '08
Op. Margin	0.4%	11.4%	2.2%	4.7%	-1.7%	9.6%	-2.0%	2.7%

Part of the decline has been due to the fashion cycle. The trend for the last few years has been toward “sport lifestyle” (think: low profile Puma’s). While high performance athletic shoes have still performed well, the more classic athletic shoes have been lackluster. These trends typically cycle after 3-5 years. This trend is approaching that time frame now, suggesting it may soon begin its fade. On the most recent earnings call, management hinted at signs of a pick-up in the [non-premium] basketball market.

Typically in the 20+% of total sales range, apparel sales have been a real comp.-killer. The most recent quarter showed apparel comps down 15.5%, despite strength in licensed apparel and Under Armor product. Management has said that they have simply had the wrong product.

Man Alive’s underlying Urban market has been sluggish and the profitability of the chain has been disappointing.

The Paiva concept has not met expectations for sales or profitability.

Up to now, the balance sheet has been very clean, with no long term debt and $34m of cash as of the FQ2 ’08 10-Q for the period ended September 1, 2007.

Addressing the Problems

In April 2007, FINL made an offer to purchase Genesco (GCO). GCO sells lifestyle shoes through its Journeys family of concepts and men’s dress shoes through its Johnston and Murphy concept. GCO’s lifestyle/brown shoe products are countercyclical to FINL’s athletic product, thus smoothing the sales and operating volatility of the separate companies. GCO also has several hat concepts, such as Lids, Hat World, Hat Shack and Head Quarters. More on this “solution” later.

Looking inward, FINL has made some portfolio decisions. In March, FINL hired a new Chief Merchandising Officer, Sam Sato. Mr. Sato hails from Nordstrom, long known for its expertise in shoes. He picks up the CMO duties from Glenn Lyon, who remains President of Finish Line.

Management has also announced that they will be taking a closer look at the Finish Line division’s stores and will address some of the underperforming locations. However, FINL continues to open new stores as well.

For its Man Alive division (Urban & Hip Hop clothing), FINL appointed a new President, Lou Spagna, on November 12^th. Mr. Spagna has experience in both the “Street” apparel category and in retail turnarounds.

With regard to its small and struggling Paiva division, FINL has decided to shutter the concept.

Timeline and Court Case

Date		Event
04/23/07		Genesco receives (and declines) a bid of $46 from Foot Locker (FL)
05/31/07		FL raises bid to $51; GCO rejects; FL bows out
06/18/07		FINL says it will buy GCO for $54.50; financed almost entirely w/debt from UBS
08/30/07		GCO announces drop in earnings; FINL disappointed and "evaluating options"
09/14/07		FINL announces UBS letter seeking info on potential MAC; GCO denies MAC
09/17/07		GCO shareholders approve deal
09/19/07		GCO says UBS is looking to back out
09/21/07		GCO files lawsuit seeking "Specific Performance"
09/28/07		FINL and UBS accuse GCO of MAC
11/16/07		UBS countersues, claiming MAC and fraud at GCO
11/26/07		US Atty. begins fraud investigation
12/10/07		Trial begins in Tennessee
12/18/07		Arguments conclude; Chancellor takes case under advisement

After a hotly contested bidding process, FINL (financed by UBS) agreed to acquire GCO in a highly-levered transaction at $54.50/shr. (~$1.5B). Before the deal could close, GCO’s results deteriorated and credit markets froze. With UBS unable to resell the debt, what had appeared to be a risky deal at the start now appears to be a disaster in the making.

GCO sued to force FINL and UBS to honor the agreement. The main issues in the court case are

1) Whether GCO’s declining performance constitutes a “Material Adverse Effect” (MAE), also commonly known as a “Material Adverse Change” (MAC).

2) Whether GCO inappropriately withheld information about its performance prior to the signing of the deal.

If the court rules that either of these events occurred, FINL and UBS will not be required to complete the acquisition. If the court finds in favor of GCO, then it may order “Specific Performance” (execution of the acquisition as per the contract) or monetary damages. If FINL/UBS lose in Tennessee, a New York court will determine whether or not the combined companies would be solvent, as per a UBS lawsuit to block the deal. Separately, if the US Attorney escalates its fraud investigation, FINL/UBS would have yet another chance to escape.

Our read of the testimony that concluded 12/18/07 leads us to believe FINL and UBS stand a decent shot of walking away from the deal. GCO’s CFO instructed its bankers to withhold some disappointing May results from FINL’s bankers. Specifically, we found emails from GCO’s CFO and testimony from FINL’s banker to be convincing. We estimate a value for FINL based on our judgment of the probabilities of various trial outcomes.

Valuation:

Stand Alone

To determine what FINL is worth now, we constructed a model of the stand alone business, and then discounted that by the possibility of an adverse outcome at trial. We use conservative estimates for the business going forward.

The stand-alone FINL business has generated ~$1.3B of Revenue for each of the last two fiscal years (ending late February/early March). The TTM revenue is also ~$1.3B. My base valuation assumes no growth from these levels. Upside could come in the form of further store openings, effective efforts from the new CMO & the new President of Man Alive or the eventual turning of the fashion cycle to a more favorable trend. Downside could come in the form of significant store closures (though I would expect this to be accompanied by an offsetting increase in operating margin performance).

Over FINL’s history, operating margins have fluctuated. They have typically been in the mid to high single digit range, with a 15 year average of 6.8%. In the early 2000’s, margins dipped to between 3.6% and 4%. This time period covered a company restructuring coinciding with the general economic slowdown of the early ‘00s. The TTM Operating Margins have come in at just about 3.0%, a 15 year low. Note that this includes the operational drag of just-opened Finish Line and Man Alive stores, inventory-clearing markdowns and the margin drag from the underperforming Paiva concept.

For our basic valuation we use a 4% EBIT margin and assume it in perpetuity. We note that in the most recent conference call, management indicated that the Finish Line concept (698 out of 793 stores) had 60 bps of YoY operating margin improvement.

To determine the equity value of the stand-alone business, we will triangulate with three valuation methods: a simplified No-Growth DCF, a conservative EBITDA multiple and a Price/Tangible Book comparison.

No Growth DCF.

No-Growth DCF
Revenue ($m)	1,300
EBIT	52	4.0%
Tax	20	37.5%
NOPAT	33
D&A	42
Capex	(42)
? WC	0
FCF	33

Discount Rate	10.0%
Ops. Value	325
Net Cash	34
Equity Value	359

Shares O/S (m)	47.7
PPS	$7.52

EV/EBITDA

Industry EV/EBITDA
Company	Ticker	EV/EBITDA
Foot Locker	FL	5.2x
Shoe Carnival	SCVL	3.7x
Collective Brands	PSS	7.1x
DSW	DSW	5.2x
Brown Shoe	BWS	4.8x
Average		5.2x

Finish Line	FINL	1.5x

FINL EV/EBITDA
Revenue ($m)	1,300
EBIT	52	4.0%
D&A	42
EBITDA	94
Multiple	5.0x
EV of Ops.	470
Net Cash	34
Equity Value	504

Shares O/S(m)	47.7
PPS	$10.56

We use a 5.0x EBITDA multiple. This is slightly lower than current multiples for others in the industry, although most of the industry is currently out of favor.

Price/Tangible Book

Price/Tang. Book
Company	Ticker	P/TB	P/S
Foot Locker	FL	1.2x	0.4x
Shoe Carnival	SCVL	0.7x	0.2x
Collective Brands	PSS	n.a.	0.6x
DSW	DSW	2.0x	0.5x
Brown Shoe	BWS	2.0x	0.3x
Average		1.48x	0.40x

Finish Line	FINL	0.33x	0.11x

PPS	$13.35

We use the industry average P/TB multiple of 1.48x.

Combining the methodologies:

Triangulated Stand Alone
No-Growth DCF	$7.52
EV/EBITDA	$10.56
P/TB	$13.35
Blended PPS	$10.48

Weighing each of our three methodologies equally gives us a very conservative estimate of FINL’s standalone PPS of $10.48. These numbers assume no growth, historically low margins and multiples derived from an out-of-favor industry.

Damages

If FINL wins the lawsuit, we see a quick return to our stand-alone valuation.

If FINL loses the case, several things can happen. First, the Chancellor in the Tennessee case has suggested that she may need to determine damages (if any) at a later date. This is partially dependent on events outside her jurisdiction.

Attention would then turn to New York, where a court would decide if UBS must complete the financing. The Tennessee trial has limited the scope of the fraud determination due to the expedited nature of the trial. It is unclear how New York would differ. However, if the US Attorney were to escalate its fraud investigation, that could constitute a MAC and render the whole affair moot. New York also would need to determine the solvency of a combined FINL/GCO. If New York found the companies to be insolvent, this would relieve UBS of its obligations and potentially get FINL off the hook.

Implied Damages

We approach damages from two directions. First, we determine what the market imputes potential damages to be. This is our present value estimate of the market’s probability weighted damage award.

Damages Baked In
Estimated PPS	$10.48
Current PPS	$3.00
Difference	$7.48
Shares O/S (m)	47.7
Impl. Damages ($m)	356.9

Probabilistic Damages

Second, we look at specific scenarios for damages.

Specific Performance: For the “Specific Performance” outcome, we value the combined businesses at $0. Though FINL/GCO would likely limp along for a while, the massive leverage would leave very little cushion. At 1.8x Interest Coverage, bankruptcy is likely with any poor short-term operating performance. Given the handcuffs this capital structure would put on the combined businesses, a court would be very unlikely to order a combination. Therefore, we assign a small probability to this outcome.

Interest Coverage
GCO TTM EBITDA	127
FINL Est. EBITDA	94
Synergies	28
FINL/GCO EBITDA	249

Combined Debt (est.)	1,700
Interest Rate (est.)	8.1%
Interest	137

Interest Coverage	1.8x

Assumptions:

1. Synergies are the low end of FINL/GCO’s projected $28m to $46m.

2. Combined debt is our estimate of the combined indebtedness at the conclusion of the transaction.

3. Interest Rate is a weighted average of floating rates detailed in the commitment letter.

Monetary Damages: GCO’s declining business performance and the fraud allegations have both had depressing effects on the stock. A few possible damage awards the court could consider include:

Potential Damages
FINL Bid	$54.50
Current GCO PPS	$35.30
GCO Shrs. O/S (m)	22.8

Scenario	Prior Day Close	? from FINL Bid	Damages ($m)
GCO Termination Fee			46.0
Current GCO Price	$35.30	$19.20	437.6
Initial FL Bid	$43.41	$11.09	252.8
3 mos. Undist. Price	$39.58	$14.92	340.1

Scenario Analysis:

1. The GCO Termination Fee refers to a situation in which GCO would terminate the deal. There was no indicated termination fee if FINL were to terminate (“Specific Performance” being the only agreed upon remedy). We assume this to be a floor on monetary damages.

2. The current GCO price includes so much additional noise, we find this number to be unrealistic. Additionally, such a high damage award might kill FINL. It would be illogical for the court to award GCO an amount that it would not be able to effectively collect.

3. The price just prior to the FL bid includes market rumors which had driven up GCO in anticipation of an offer, so this is not a clean number. We therefore discard it.

4. The Three-Month Undisturbed Price is a price quoted in the FINL/GCO deal announcement. This price refers to GCO’s average closing price over the three months before GCO was rumored to be in-play. This is the cleanest number of these possibilities.

We assigned probabilities to weight the outcomes. Despite our positive read on the evidence at trial, we assumed FINL has only a 20% chance of a positive outcome (i.e. it gets to walk away, either after the Tennessee or New York trials). Stepping back, every $47.7m of damages reduces our base case FINL target price by $1.

Target PPS: Scenarios
	FINL wins		FINL Loses
Damage Scenario	n.a.		3-mo. Undist.	Spec. Perf.
Base Target PPS	$10.48		$10.48	$10.48

Damages ($m)	0.0		340.1	n.a.
Damages per Shr.	$0.00		$7.12	$10.48
Target PPS	$10.48		$3.35	$0.00

Probability
Scenario	FINL wins		FINL Loses
Probability	20%		80%
Scenario			if Lose, Prob.	if Lose, Prob.
Probability			95%	5%

Total Probability	20.0%		76.0%	4.0%

Target PPS	$10.48		$3.35	$0.00
Prob. Wtd. Tgt PPS	$2.10		$2.55	$0.00


Expected Value	$4.64	= sum of Prob. Weighted Target PPS
Current PPS	$3.00
Expected G/(L)	54.8%

Sensitivity

Based on our stand alone valuation and our damages scenarios, even if FINL had a 0% chance of walking away from the deal unscathed, the damages are more than priced in.

		Expected FINL. PPS
		Expected FINL. PPS
		$ 4.64
Prob. of FINL Win	40%	$6.10
	30%	$5.37
	20%	$4.64
	10%	$3.91
	0%	$3.18

Summary

This is high risk situation. We have used draconian assumptions for the underlying business (no revenue growth, historically low margins, out-of-favor comparable multiples) and for damages (assigning zero value to a combined business, assuming only 20% probability of FINL getting out of the deal). If FINL wins, the stock should rocket up. If FINL loses, we see damages as mostly priced in.

Combining options positions with the basic long FINL idea mitigates some risk. One possibility would be to purchase naked calls on both FINL and GCO. A FINL win would produce a nice profit, whereas a GCO win would likely only cover the losses on the FINL calls. The tradeoff in reduction of price risk is that this strategy introduces a time horizon to the idea.

Alternatively, one could go long FINL stock and add GCO calls as a hedge against a FINL loss.

Risks

1. A ruling for Specific Performance

2. Our assumptions for damages are too low

3. Severe LT operational deterioration at FINL

4. The usual macroeconomic caveats

Catalyst

1) Resolution of the FINL/GCO trial(s)
2) FINL’s underlying business returns to an industry average valuation

show sort by

			2007	2008
Price:	3.00	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	143	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT