Description

K-Swiss, the venerable shoemaker headquartered in Westlake Village, California, won't turn any heads at cocktail parties. You won't find LeBron James or Carmelo Anthony sporting the latest pair of K-Swiss; you certainly won't nod your head in a appreciation at the newest K-Swiss spot during the Super Bowl.

What you will find in this less-than-glamorous, 40 year old manufacturer of athletic footwear, however, is a very solid business, sporting an extremely conservative balance sheet while yielding superior returns on invested capital. Following a cyclical downturn, the stock trades at an attractive valuation-- 5.76X EV to EBITDA-- as fickle retailers absorb a glut of supply that hit the shelves in 2003.

K-Swiss is a niche player in the world of athletic footwear. At $460 million in sales, the company is "... not in Nike's league," as the CEO unabashedly declares, and harbors no intentions of swimming in the same waters. The company's strategy is simple: K-Swiss targets the 14 to 24 year old crowd with a very basic styles that have not changed much over the years, allowing the company to minimize design costs and avoid fashion world "flops" that sometimes accompany new product introductions. Secondly, the company further minimizes capital investment by working exclusively with a series of low-cost contract manufacturers based in Asia. Finally, the company consistently attempts to be the "...retailer's most profitable vendor" ( CEO Steven Nichols).

It's proven to be a successful approach. On a ttm basis, the company has produced a 32% ROE with zero debt. Sales have escalated from $236 million (2001) to $290 million (2002) to $429 million in 2003. Free cash flow on a ttm basis was $59 million, while net margins are consistently in excess of 10%.

KSWS's approach also leads to operating margins that compare favorably with those of the competition. The company's margin on a ttm basis is 20.3%, vs. 11.8% for Nike and 6.5% for Reebok.

The balance sheet is a dream: $81 million in cash (about $2.50 a share) contributes to current assets of $213 million, versus total liabilities of $55 million, and again, the company is debt free. The icing on the balance sheet cake is that management continues to buy back shares, further bolstering that impressive ROE: K-Swiss bought back almost $18 million of its shares in 2003, and has repurchased an additional $14 million thus far in 2004. An additional $12.3 million of shares are authorized under the current plan.

So what's wrong with this picture? Simply put, sales have flattened after a glut of inventory hit the market in 2003. K-Swiss's largest customer, Foot Locker, which accounts for 16% of sales, has cut back its orders in 2004. Although KSWS predicts new highs in annual sales and earnings in 2004, the curve has flattened: the company has given guidance of $450 - $470 million of sales and $1.39 - $1.47 EPS for 2004.

CEO Nichols and his team are veterans, and speak frankly about the situation (I strongly recommend a sampling of the company's 2Q2004 earnings call). The company has seen this before -- it's part of the ebb and flow of the footwear industry, a cyclical flattening that affects every manufacturer (including Nike). Nichols says that the company has gone through this "...four or five times." In 1999 - 2000, for example, KSWS sales dropped 25% before rebounding and eventually doubling over the next three years. Management highlights the fact that even in the 25% sales downturn of 2000, the company still earned 10% after taxes. The company's squeaky-clean balance sheet, and the resulting absence of pressure from lenders, affords management a lot of flexibility in difficult times. Nichols and his team frankly expect a "couple of difficult quarters," and will tighten their belts by reducing inventory through relationships with discount retailers such as Marshalls.

While domestic sales are expected to be sluggish over the next couple of quarters, the company is enjoying a 66% increase in backlog in international markets. The company intends to "stick to its knitting," and will not alter its fundamental strategy: providing affordable, "classic" styles; of maintaining a network of relationships with contract manufactureres to minimize CAPEX; of advertising lightly on TV and in magazines; and continuing its position as retailers' most profitable vendor.

As we turn to valuation, the net result of this cyclical downturn is that it's a good time to buy K-Swiss. One obvious Buffet-esque question is "What would a private buyer reasonably expect to pay for the entire company?" The answer is that the company trades at a multiple that's very attractive if the company were for sale at private auction, at 5.76X EV to EBITDA. As those of us in the private equity world can attest, a growing, public company trading at less than 6X EBITDA is an attractive buy.

As of this writing, the stock stands at $17.96-- that's 11.7X ttm earnings, and 11.3X 2005 projections for a company with 30+ percent ROE and very limited risk of financial distress. For patient, value-oriented investors, KSWS is a solid buy.

Catalyst

Cyclical downturn affords a classic value investment opportunity in this well-managed shoe manufacturer that consistently delivers superior returns on invested capital.