By year-end, Footstar should have ~$5/share of cash, ~$1/share of equity value (net of mortgage) in its owned HQ building, and no other debt.  Although discount footwear is decidedly not a sexy business, Footstar is trading at a negative EV yet is positioned to maintain its ~30% FCF yield to equity in ’07 and ’08 and, in the worst case, close shop and generate additional value from the liquidation of its $100mm of inventory at book value (as contractually arranged with Kmart).

Based on conservative assumptions described below, there is over $9/share of equity value and the stock is currently at $5.10.  With a primarily variable cost business that has de minimis capex and tax and no interest expense, it seems likely that an abundance of cash flow will accrue to the equity over the next two years and force the stock higher.  At least one liability on the balance sheet substantially over-states Footstar’s likely obligations, and thus obscures the fact that a generous sum of cash would be generated in a wind-down.  Upside may materialize over the next 12 months from the potential announcement of a contract with a new player or a contract extension with Kmart.

Background

Under different leadership, Footstar was once a collection of shoe companies which filed for Chapter 11 due to accounting issues, tightening credit terms and liquidity problems, largely stemming from some bad acquisitions.  That is largely irrelevant now, as the problem business (Just for Feet) with the accounting/inventory problems was liquidated, the Footaction business was sold to Foot Locker and the only operating company left is Meldisco, which operates the shoewear department in all ~1,400 Kmart stores and in ~850 Rite Aid stores, and sells shoes on a wholesale basis to 2,500 Rite Aids.  Kmart currently represents over 90% of the company’s revenue.

During the company’s Chapter 11 stay, I understand that Eddie Lampert (formerly a 9.9% holder) tried (more than once) to acquire the company at an unreasonably low price.  The Meldisco business used to be a 51/49 JV between Footstar and Kmart, and a legal battle between Kmart and Footstar in Chapter 11 (largely an attempt to force Footstar to sell the company to Sears for liquidation value) resulted in a settlement.  The details are in the 10-K but the most relevant terms are that Footstar now owns 100% of Meldisco, Meldisco’s contract with Kmart runs till 12/31/08 (was 2012 before) and Kmart is obligated to buy Meldisco’s inventory at book value at the end of the contract (or when stores are closed before 12/31/08).  Now that the Sears Essential format has proven unsuccessful, conversions of Kmarts to Sears Essentials stores have effectively stopped.

In February 2006, the company emerged from its two year spell in Chapter 11 with a large cash balance and no debt.  All of Footstar’s creditors received 100c/$ plus post-petition interest as part of the Plan and the equity rolled over without dilution.  The head of the equity committee during the Chapter 11 case, Jonathan Couchman, is now the chairman of Footstar and the other Board members are primarily accomplished retail executives.  Per the public filings, Couchman and his fund each own around 2% of the equity and although I have not spoken with the Board, my understanding is that they are aware of the need for a substantial dividend in ’07 absent an extremely compelling use of the cash to grow the company.

A lot of useful detail can be found in the Disclosure Statement (“DS”) filed in November 2005 as an 8-K.  Weeden Securities covers the stock but publishes infrequently.

Valuation

Sources of Cash

Let me go through each of the items in the table.  I have tried to cover all of the liabilities on the balance sheet and am assuming that Meldisco is closed at the end of 2008.

1)      and 2) Assumptions are discussed below.

2)       

3)      $10-25mm is a rough guess of the value here, because there are many possibilities.

First, Thom McAn and the other brands owned by Footstar can be sold or used in a licensing arrangement.  The Thom McAn brand has been around since 1922, having formerly had its own stores, and represents over $200mm of annual sales at Kmart.  Brand recognition for Thom McAn brand is high and it’s noteworthy that Eddie Lampert objected when Footstar began selling Thom McAn shoes in Wal-Mart because he wanted this to be a Kmart-only brand.

Based on discussions with industry contacts, I believe that if there is no contract extension for Meldisco at Kmart, Footstar might sell the Thom McAn and other brands (note: $10mm sales price for Thom McAn would be under 0.05x revenues) to Kmart, a competitor or someone like Iconix, Cherokee, etc.  Alternatively, Footstar will license the Thom McAn brand name to Kmart or sell shoes on a wholesale basis to Kmart for a few years. 

In terms of other venues, Footstar is exploring whether it can sign a contract as the footwear department operator or to sell shoes on a wholesale basis in Kohls, Target, Shoe Pavillion, etc. which would create additional value.  Meldisco’s Rite Aid business is currently a $1-2mm EBIT business ($15-20mm of revenue).  I understand that Meldisco’s business at Rite Aid is performing extremely well and perhaps could be expanded in the future (Rite Aid recently added ~1,850 stores with the Eckherd and Brooks acquisition and is growing organically too). 

Last, Footstar currently sells to Wal-Mart in Puerto Rico and may increase their Wal-Mart business in the future.  To cut a long story short, in 2003-2005, Meldisco sold shoes in about 50% of the Wal-Marts in the U.S.  This trial run unfortunately coincided with Footstar’s Chapter 11 filing and changes in management at both Footstar and Wal-Mart that resulted in the contract being terminated despite Thom McAn shoes selling well in Wal-Mart.

4)      Footstar has around $200mm of federal NOLs ($164mm at December 31, 2005 plus another $51mm of expenses realized at the company’s emergence from Chapter 11, per the latest 10-Q).  Per Section 382 rules, I think annual use of Footstar’s NOLs to an acquirer would be equal to the purchase price of the equity multiplied by the long-term tax-exempt rate (approximately 4.4%).  Assuming a $125mm purchase price for Footstar and using a 10% discount rate, I get to a present value of the NOLs of ~$20mm ($5.7mm of NOLs used/year and $2.0mm of tax savings/year).

5)      The company should collect $11mm of federal tax refunds in 2H 2006.  These are described in the DS, but not clearly addressed in the K or Qs.  Of the $17-18mm in total refunds that Footstar was owed, $5mm was collected as of June 30, 2006, a portion came in during 3Q, and the remaining amount (buried in prepaid assets) will be collected in the next few months.

6)      The 129,000 square foot Mahwah building was appraised at $20.6mm in October 2004 (see DS).  I’ve spoken to real estate consultants that estimate the building’s current market value is approximately $25mm (my conservative case is $22mm).  The mortgage balance on the building is around $4mm currently, so I’ve netted out this amount.  The company will sell it outright if the business effectively closes down in ’08, but could do a sale-leaseback before then.

7)      Unrestricted cash figure on the B/S.

Uses of Cash

A)  Balance sheet figure (liabilities subject to compromise) is $5.2mm but $8mm plus interest (described in 10-Q) appears to be the more likely figure.

B)     Balance sheet figure.

C)    On balance sheet for $5.2mm.  As discussed in the 10-K, this is paid out as $11k for each store Kmart closes/converts but after a threshold number of store closings, Kmart pays Footstar a larger amount.  I’ve assumed 50 store closures or $0.55mm between now and 12/31/08.

D)    $10mm of wind-down costs (excluding severance which is addressed separately).  Considering the nature of the business, this seems very reasonable, especially considering that a wind-down can be easily effected (there will be plenty of notice and not a lot of leases).  Moreover, not all of the business is likely to be closed even if the Kmart contract is not extended i.e., some portion would survive if the company just entered into a wholesale arrangement with Kmart, for instance.

E)     and F) Total SERP pay-outs in 2008 (discussed in DS) will be $5mm (at most) more than the amounts expensed in SG&A over the next two years.

Retiree medical costs are discussed in the DS but captured on the balance sheet in an unintentionally misleading manner.  These benefits are for former employees of Thom McAn, and Footstar can walk away from these with no recourse and from my due diligence, I’m confident that this is the gameplan.  The face amount of these liabilities is roughly $27mm and they are included in $38mm of “other long-term liabilities” on the balance sheet.  (Note: another $4-5mm in the $38mm figure is the mortgage on the Mahwah building accounted for above and another $4-5mm is SERP accrual).

Meldisco Business