Description

Footstar (FTSTQ) is a discount footwear retailer that operates about 1500 licensed shoe departments in K-Mart and about 1000 departments in Rite Aid stores (all through its 51% owned Meldisco subsidiary; K-Mart owns the other 49% of Meldisco). In addition, Footstar supplies shoes under the "Thom McAn" brand name on a wholesale basis to Walmart. All shoes are contract manufactured in China, so this is really a marketing and logistics company. It's cost structure is mostly variable as even the rent that Meldisco pays K-Mart is based on a percentage of retail sales, further reducing volatility of Foostar's cash flow stream.

We estimate asset value for Footstar is about $445 million, as follows ($ in millions):

$ 88 cash (from recent sale of Athletic business to Foot Locker)
13 escrowed funds from sale of Athletic business to Footlocker
6 sale of 27 Shoe Zone stores in Puerto Rico to close mid-summer
10 remaining proceeds of 75 Footaction, 88 Just For Feet liquidations
306 Value of 51% of Meldisco business (assume $80mm EBDIT, $5mm CAPEX)
20 Value of excess real estate being liquidated
3 cash build for one year remaining in Chapter 11, after fees
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$445 TOTAL

We estimate about $227mm of claims against the estate, including:

$ 6 mortgage debt outstanding
6 operating working capital adjustment to PSS competitor's level
29 Athletic liabilities (Not subject to compromise - assume 100%)
106 Athletic liabilities (subject to compromise - assume 100%)
53 Meldisco liabilities (subject to compromise - assume 100%)
18 Due K-Mart for K-Mart's share of 2003 net income, rents
9 Due K-Mart for 2004 est YTD
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$227 Total

$218 Residual value for equity = $10.84/share

Further upside:

1) Recovery to equity could be higher to the extent that any of the liabilities that are subject to compromise can be settled for less than 100% of claim.

2) Excess real estate proceeds could be higher. The company has a surplus Athletic distribution center in Gaffney, SC that is being sold (some 434,000 square feet)that adds incremental estate value. Also, Foostar recently announced the sale of Meldisco's distribution center in California for $20 million in connection with an outsourcing agreement. We believe that this could add some incremental estate value since the facility will now service other retailers and, therefore, have higher capacity utilization. Foostar claims that the some $15 million per year that it will pay in the outsourcing deal will be less than its costs would be to keep distribution in-house.

3) Our $80 million EBDIT assumption at the Meldisco level assumes an 8.5% margin on about $950 million of sales. The recent May operating report showed an 8.5% margin, but Meldisco has historically operated at 10% margin.

4) Meldisco will be the largest licensed shoe department operator and will be in a good position to bid on contracts to handle other discount retailers' needs.

5) Footstar will have about $100 million of NOLs exiting C-11.

Risks to our analysis:

1) K-Mart could close or sell more stores than anticipated. We note that of the 1500 remaining K-Mart stores, K-Mart owns only about 100 and leases the remainder.

2) The May operating report showing the 8.5% margin is just one month and may not be sustainable.

3) K-Mart could try to recut the licensing deal with Footstar, but we think if they were going to do this that it would have happened by now. Interestingly, Eddie Lampert (the Chairman of K-Mart) owns 10% of Footstar through his ESL Investments hedge fund.

Please note that we do own this security and are prevented from buying any material amount of new shares because there is a Bankruptcy Court order in effect that limits new shareholders to less than 5% of the equity. If we could buy more we would, since it is trading at less than 50% of intrinsic value.

Catalyst

sale of excess real estate above expectations, filing of reorganization plan, continued improvement in monthly operating results