Description

Shoe Pavilion, Inc. (SHOE) presents an attractive opportunity to buy a profitable west coast shoe retailer at 64% of liquidation value, 50% of book value and at a P/E of about 8. This is clearly a case of an ignored, unloved and undiscovered company that is ridiculously under valued. It is simply a Graham and Dodd net net.

Shoe Pavilion, Inc. is the largest independent off-price footwear retailer on the West Coast that offers a broad selection of women's and men's designer label and name brand merchandise. As of December 29, 2001 the Company operated 83 retail stores in California, Washington and Oregon. In addition the company currently operates 38 licensed shoe stores at Gordmans. The Company offers quality designer and name brand footwear such as Diesel, Fila, Ralph Lauren, Rockport, Steve Madden, Vans and Via Spiga, typically at 30% to 70% below regular department store prices. Such price discounts appeal to value-oriented consumers seeking quality brand name footwear not typically found at other off-price retailers or mass merchandisers. The Company is able to offer lower prices by (1) selectively purchasing from manufacturers at significant discounts, large blocks of production over-runs, over-orders, mid- and late-season deliveries and last season's stock, (2) sourcing in-season name brand and branded design merchandise directly from factories in Italy, Brazil, China and Spain and (3) negotiating favorable prices with manufacturers by ordering merchandise during off-peak production periods and taking delivery.

The Company's stores utilize a self-service format that allows inventory to be stored directly under a displayed shoe, thereby eliminating the need for a stockroom and significantly increasing retail floor space. The functionality and simplicity of this format enable flexible store layouts that can be easily reconfigured to accommodate a new mix of merchandise. Moreover, this format allows customers to locate all available sizes of a particular shoe and to try them on for comfort and fit without a salesperson's assistance, thereby reducing in-store staffing needs and allowing customers to make independent, purchasing decisions.

During 2002, the Company intends to open 5 to 10 new stores, primarily in California. It also expects to close 3 Shoe Pavilion stores and all 38 of the Gordmans licensed shoe departments as of June 29, 2002. Net sales for the licensed shoe departments at Gordmans in 2001 were $14.5 million (16.5% of sales) but only $2.9 million of gross profit (10.5% of gross profit). The company does not anticipate any restructuring or accounting charge as a result of this termination. At the conclusion of the agreement the company expects to transfer inventory from the Gordman’s stores to other company facilities. At this point, I would expect a minimal impact to the bottom line.

During the past several years, comparable store sales have been subject to wide fluctuations. Comparable store sales decreased 5.9% in 2001 and increased 9.4% in 2000 after experiencing a 1.2% downturn in 1999.

Income Statements:

(Thousands of Dollars)

Year Ended 2002 2001
Net sales....................................... $88,135 $91,058
Cost of sales and related occupancy expenses.... 60,686 61,662
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Gross profit.................................... 27,449 29,396
Selling expenses................................ 17,606 19,134
General and administrative expenses............. 6,861 7,014
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Income from operations.......................... 2,982 3,248
Interest and other expense, net................. (626) (1,295)
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Income before income taxes...................... 2,356 1,953
Provision for income taxes...................... (895) (779)
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Net income...................................... $ 1,461 $ 1,174
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Net income per share:
Basic........................................ $ 0.21 $ 0.17
Diluted...................................... $ 0.21 $ 0.17
Weighted average shares outstanding:
Basic........................................ 6,800 6,800
Diluted...................................... 6,801 6,810


The company’s balance sheet is solid. The current ratio is 3.1. Long term debt and lease obligations are $6.5 million compared to stockholders' equity of $21.7 million ($3.19 per share). Over the past year the company’s cash flow and inventory reduction have allowed the company to reduce long term debt by $9.4 million. As of December 29, 2001, the Company had $22.8 million in working capital and $16.4 million of net current assets ($2.41 per share).

In 2002, I would expect earnings to come in flat at about $.20 per share as the company replaces the Gordmans sales and profits. The balance sheet should continue to improve with expected cash flow of about $3 million and free cash flow of about $2.5 million ( $.37 per share). I would expect growth to return to higher levels once the economy picks up in the second half of this year.

The negative here is that the stock is not very liquid. Management owns about 68% of the company. Patience is required to establish a position.

In summary we have a stock with the following valuation parameters:

P/E = $1.54/.20 = 8

P/(Free Cash Flow) = $1.54/.37 = 4

P/(Liquidation Value) = $1.54/2.41= 0.64

This company is a huge cash generator that will generate enough cash over the next few years to more than fund growth or for a management led buyout of the public shareholders. My price objective here would be $2.75 to $3.00 over the next year as earnings rise toward $.30 per share in 2003. This would imply a P/E of about 10, which would still make the stock a good value.

Catalyst

The catalyst to drive a doubling of the share price for SHOE should be the company's return to strong growth during the second half of 2002. If the market does not discover the huge under valuation of the company over the next year or so a management led buyout or a sale of the company at a price over $3 will become a high probability.