Description

Payless is essentially a boring, but consistent business, with a strong competitive position and significant operating leverage from depressed margins.

Essential to the story is the fact that management has shrunk the share count by almost 50% since being spun out of May Department Stores in 1996, including a self-tender for 25% of the stock at $53 in 2000. In the meantime, the company has generated enough cash flow to pay off much of the debt used to finance the buyback. The result is that the operating leverage in PSS will be magnified over the next two years because of the much reduced share count. Augmenting this will be the fact that interest expense will be greatly reduced from a combination of the debt pay-down and from interest rate swaps used to lower the interest rate paid to roughly 4%.

These days, there is a great deal of worry over Wal-Mart’s effect on much of the retail industry, including groceries, music, clothing, and electronics. The basis of the concern is WMT’s ability to undercut on price. PSS, however, enjoys an interesting competitive advantage: PSS is profitable even as the average price of its shoes is less than $20, which is a function of their superior sourcing skills and direct buying experience which reduces middle-man markup. PSS’ locations are often more convenient than those of Wal-Mart. By providing cheap, high quality product in convenient locations, the company has been able to withstand the Wal-Mart tide.

Throughout the 1990s, the company enjoyed operating margins of nearly 8.5%. The events of 2001 and the ensuing recession, though, caused a dip in like-for-like sales, which caused margins to fall to roughly 6%. LFL sales declined 4% through October. Being a retailer, PSS leases most of its stores, so small changes in store performance can have a dramatic effect on margins. Even with the poor operating performance, though, the company generated free cash flow of $50mn last year, and should generate between $50-100mn this year. In past years, the company generated between $100-160mn in free cash flow consistently, which equates to a 7-12% free cash flow yield on today’s market cap.

To my mind, given a relatively static competitive environment, there is nothing that prevents the company achieving historic margins within two years. Applying ‘normalized’ margins and adjusting for reduced interest expenses, and a reduced share count, one arrives at ‘earnings power’ of between $6.50 and $7 per share versus estimates of $4.70 (and rising fast) from the Street for 2002 and $5.40 for FYE Jan '04. A normalized P/E of 8-9x for a consistent, cash generating company with good management and a history of shareholder-friendly capital allocation decisions make PSS a compelling investment.

Catalyst

Time; recognition of operating leverage; cash generation and relatively consistent performance make PSS an attractive candidate for a leveraged transaction.