Description

K-Swiss is a classic value trap and ripe for shorting with limited upside potential even in the unlikely event of a near-term consumer recovery or more likely event of another bear market rally for the retail sector. The company is in massive secular decline and needs to execute a fashion/product turnaround in an environment where the consumer spending pie is shrinking and retailers are being extremely tight on inventory control and completely unwilling to take chances on unproven product. Europe had been the savior of this company but it is rolling over now. The stock is a favorite among some deep value investors, for its strong balance sheet, straight-shooting and honest management who own a lot of stock, and its history of prior turnarounds.   This company certainly isn’t a zero because of the $6.10 on its balance sheet, but given a sales trajectory of -18% in 2007, -17% in 2008, and -18% in 2009E, combined with substantially negative EBITDA in 2009, it is unclear how much value above cash the stock should trade at.

My basic thesis here is that the business is imploding, and there is no viable plan or trajectory for a turnaround. Even if there was a good plan, it would be extremely hard to turn a company when the baseline for industry sales is going to be -5% to -10%, as is the outlook for footwear generally in 2009.

Evidence that business is imploding:

1.        total sales down 15% YTD and 27% in Q3 (acceleration to the downside in the most recent quarter)

2.        domestic sales down 32% YTD and 29% in Q3…the only reason for sequential improvement in Q3 was massive closeout sales which hit company level gross margins by almost 700 bp in Q3 (GM went from 46.8% to 39.9% yoy)

3.        international sales up 3% YTD and up 7% in Q3, but excluding a French acquisition that closed in Q3, international sales were down 11% in Q3…international which had been the savior of this company but has turned negative

4.        futures orders (backlog) down 29% overall in Q3 and 35% in the US and 25% internationally…it would have been worse internationally if not for the acquisition they did in France

Even after all the closeout sales in Q3, they still had an inventory problem coming out of the quarter with DSI up 13 days yoy and almost 5 months of inventory on hand versus next 12 months sales level. A more typical DSI level for this company would be 90 days.

In addition, there is a massive FX headwind here: 60% of sales are international and mostly in Europe, so the strengthening dollar hits revenue translation as well as gross margins as product is sourced in dollars and sold in euros. I tried to get the company to comment on the magnitude of this headwind but they repeatedly refused. For other companies in the industry that have been more transparent, the impact has been significant and is guided to continue into the next few quarters.

So for all the reasons above, the company is clearly in massive decline, the question is…do they have a plan to stop it? The company is investing heavily in the running and fitness categories which are highly competitive and dominated by much bigger companies with more advertising power, like NKE and ADS.GR, or niche specialty players with great brand loyalty like Saucony and Brooks. Even in good times, this would be a tough segment to crack given the well-established megabrands with their giant ad budgets and celebrity endorsers. The K-Swiss marketing/endorsement strategy seems flawed as they are trying to reach the weekend athlete through sponsorships of athletes with limited reach, e.g., Ironman triathletes. Also, they are trying to build up the tennis business but their biggest name player is Mardy Fish, who is not very well-known. I had the chance to see their new spring product at WSA in July (shoe trade show) and it appeared they have nothing to reinvigorate the brand. FINL, FL and other key athletic footwear retailers that I have spoken with agree that there is nothing exciting on the product front with K-Swiss. Additionally, as these retailers prepare for a negative comp outlook, they will be very judicious in both inventory levels as well as inventory composition…in this environment, the inclination is to not take risks and instead buy more of what is currently selling, which is decidedly not K-Swss.

K-Swiss is approximately breakeven on EBITDA and EPS in 2008, and will lose around 35c per share or $18 mm in EBITDA in 2009. My estimates are the company should be around FCF breakeven in 08 and burn 20 mm or 57c/share in 09.

The main bull case here is that the company currently has about $6.10 net cash, so even in an extended downturn, it will not go bankrupt. My interest in the short derives from the fact that in a status quo situation for the economy, there is probably 25-35% downside from a valuation perspective based on the further deterioration of results, if the stock were to just trade down to a multiple inline with its peers, many of which are performing much better than K-Swiss. If the economy and consumer spending turn out to be even worse than the currently low expectations, the downside could be a little greater, but unlike many retail-driven companies in that scenario, K-Swiss will not be a zero. However, if there were to be a recovery, K-Swiss results would likely still be dismal…this is a secular issue compounded by the economic ones…if the economy were to improve, that rising tide would not likely lift K-Swiss’s boat in the short term. So this is a great risk/reward short if you think we are going to continue to bounce along this bottom in the economy, and eventually get better. If you believe in consumer retail Armageddon, you probably can find better shorts, as there is no zero potential here.

It should be noted the company has been a huge buyer of its own stock historically, but won’t generally do it until they see a turn in their business. Notably, they did not buy any stock in Q3, although they did decide to dividend out $2 per share in a special dividend (cash levels had been $8.10). I thought it was interesting they decided to do this, instead of buy back stock

The other risk to the upside is that the company has been brought back from the dead on two occasions before, which is why a lot of value guys believe if you sit here and wait, you’ll be OK. I happen to think this time is different, but for a full explanation of the bull case I would refer you to mpk391’s KSWS write-up from 12/31/07, exactly a year ago, when the stock was $18.10. The case to be made by the bulls is pretty much the same today as it was a year ago.

Since I don’t believe in the turnaround, and I think the protection from the cash balance doesn’t truly kick in until several dollars below the current quote, the main real risk I see is if KSWS could massively ratchet back SG&A and give up on developing new athletic businesses which would temporarily pump up earnings. This is unlikely to happen since management is deadset against it. Also, it would be a only a temporary fix because what they have (the Classics business) is shrinking.

Valuation

EV/Sales is the only way to value KSWS because of its lack of profitability…on that basis it is trading .58 EV/2008E Sales for no profits and sales down 17% in 08 on top of -18% in 07. SKX, another cash-rich, small cap shoe company (which has been written up twice in the last year on VIC) is trading at .24 EV/2008E Sales despite being profitable and growing sales 4% in 08 even with the economy as it was and 16% in 07. If KSWS were to trade like SKX (which should also end the year with around $6 in net cash, and currently also trades around $12), it would be at 25% EV/2008 Sales for a price target of $8.50, or 27% downside from here. The upside case here is if KSWS were to trade at 70% EV/Sales, which is the EV/2008 Sales multiple of SHOO, a small cap footwear company with strong current business momentum and a good balance sheet. This would be an absurd comparison because SHOO will grow 2H08 sales by 16% while KSWS will experience an 18% decline in 2H08 sales. At 70% EV/2008 Sales, KSWS would trade at $12.90. So basically I think there is about $3 in upside, and $1 in downside to the short.

Catalyst

• They need to take a bath on inventory in one of the next two quarters to get inventory inline with sales…gross margin would plummet and eps would miss
• The sellside needs to come down and is at least 5% too high on revenues and 10c light on the 2009 loss
• One of the top 5 mutual funds could give up…they all own at least 2 mm shares and given how thinly KSWS trades, it would take them over 7 trading sessions being 100% of the volume to get out. If these funds continue to get redemptions other than the lack of solvency concerns, I just don’t see why they would hang onto this one given the terrible fundamentals and the rest of the world being just as cheap now. Notably, two long-term deep value shareholders were net sellers in the third quarter according to filings (these sellers were #1 holder Third Avenue Management and #4 holder Royce).