Description

Sport-Haley (SPOR) stock represents an opportunity to purchase a business with improving earnings prospects at a price that is less than 70% of working capital. The company has recently experienced a solid sales recovery and has favorably settled a major class action lawsuit that has been a “thorn on its side” for many years. The improved prospects and performance have clearly not been reflected in the company’s share price.

Business

Sport-Haley designs, markets and distributes high quality men's and women's fashion golf apparel and outerwear under the HALEY label and premium men's golf apparel under the Ben Hogan label. HALEY fashion golf apparel is primarily marketed in the premium and mid-price markets, through a network of independent sales representatives and distributors. Appeal for the HALEY brand name is enhanced because golf professional shops generally prefer to sell quality apparel that is not broadly distributed in the retail market. Ben Hogan apparel is marketed to elite golf professional shops, upscale resorts and exclusive department stores. Sport-Haley is currently designing and developing lines of good quality men's and women's golf apparel under the Top-Flite label. Top-Flite apparel will be marketed primarily in the lower-price markets. Sport-Haley anticipates introducing the Top-Flite apparel lines during the second half of its fiscal year ending June 30, 2004.

Background

SPOR was written up in VIC over two years ago when the company looked cheap relative to its balance sheet but faced several major uncertainties. In 2000 the company announced that due to inventory valuation errors it would need to restate its financial statements for 1998, 1999 and 2000. Trading in the shares was subsequently halted. The company voluntarily restated the relevant financial statements and regained NASDAQ compliance. As one would expect in such a situation, a class action suit was filed. To add to the company’s problems during the period sales were plummeting from about $30 million in 1998 to about $22 million in 2001.

Unfortunately, the company’s troubles related to the restatements recently compounded as the “timely” SEC weighed in. On September 26, 2003, over three years after the announcement of the restatements, the SEC filed suit against Sport-Haley, its Chairman and former Chief Executive Officer, Robert Tomlinson, and its former controller, Steve S. Auger. The suit seeks an injunction against future violations and other relief, including disgorgement, civil penalties and an order barring either Mr. Tomlinson or Mr. Auger from serving as a director or officer of any publicly held company. The suit alleges that the Defendants misrepresented inventories, period costs and losses on the sale of headwear equipment in annual and/or quarterly financial statements for Sport-Haley's fiscal years 2000, 1999 and 1998.

Over the past six months prospects for the company have materially improved on the legal and earnings front. On December 17, 2003 the company announced the signing of a memorandum of understanding to settle the putative class action lawsuit. The agreement calls for a payment of $1 million, which is totally covered by the company’s D&O insurance. This should certainly have a positive impact on legal expenses and management focus. The only remaining “fly in the ointment” is that the SEC suit is still open. Based on my research, it appears (and I should note that I am no legal expert.) that this case will probably not have a significant impact on the company, but will result in the company’s chairman, Robert Tomlinson being barred from being an officer of any public company. His son, Kevin, who took over as CEO in March 2002 and has engineered the company’s sales rebound, should be able to continue as CEO as he is not involved in the SEC action.

Over the past three quarters sales growth has ranged from 14% to 26% and gross margins have improved nicely over the prior year. Losses per share have been significantly lowered and the company looks to be on a solid path to profitability in 2004. The sales growth has been driven by the success of the company’s high-end Ben Hogan line.



Valuation

The balance sheet is immaculate. The company has working capital of $18.9 million, which includes $5.7 million of cash. There current ratio is 14.8 and there are no long term liabilities. The company has about 2.45 million shares outstanding, but it also has about 1.1 million of in-the-money options outstanding which are exercisable at about $3 per share. If we assume full exercise of these options, the company would have net working capital per share of about $6.24. At the current price of $4.25 the company sells for less than 70% of working capital. The book value, adjusted for the options exercise, is about $6.50 per share.

On the sales front, the prospects for continued high double digit growth look extremely encouraging. From June 30 to September 30, 2003 inventories increased $1.6 million or 20% to $9.4 million. The company stated that this increase resulted from the increased demand for Ben Hogan apparel. We should see this inventory increase reflected in sales growth over the coming quarters. Management has not made any estimates of earnings for 2004, but has acknowledged that it expects continued positive trends in sales.

Concerns:

1)The SEC case is still open. The probability is high that the resolution will not have a materially negative impact on the company, but if they continue to fight it, the company will continue to incur legal costs and management will continue to be distracted from its business focus.

2)Management has significantly diluted shareholders with its large option grants over the past few years. Will they continue to do this? The argument is that these grants have been necessary to retain management talent during a difficult period. This assertion is supported by the fact that salaries for management have been moderate over the past few years and Chairman Tomlinson has voluntarily reduced his compensation. My expectation is that given the current SEC scrutiny and improved company prospects, these grants will be lower in the coming years.

3)Given the current SEC suit, the restatements and the class action suit one has to have some concerns about the ethics of management.




Summary

In the current market where unambiguous undervalued equities have become scarce, Sport-Haley represents an attractive opportunity to buy shares in a company that is clearly experiencing double digit sales growth at less than 70% of working capital. These types of opportunities are rare in the current environment.

Catalyst

There are several catalysts that should drive a significant increase in the price of the company’s shares:

1)Continued strong sales growth in 2004 resulting in a return to profitability.

2)A settlement or resolution of the SEC suit.

3)Removal or resignation of Tomlinson as Chairman.