Description

Steve Madden, Ltd. designs and sells fashion forward shoes in the “better” price category. Though SHOO is debt-free and has consistently generated an ROE around 20%+, it’s now selling at 9.5X FTM EPS and 8.8X’02 EPS. The discount is due to the – ahem – personal legal issues of the founder and former CEO. But these issues have not, and will not significantly affect the company’s performance for the reasons discussed below.

Since going public in 1993, SHOO has been a marvelous performer, generating ROE north of 20% without the use of debt, and increasing EPS by an average of 76% over the last four years. Comparable store sales have almost always been positive, and the company hasn’t reported an earnings shortfall since 1996. Usually, it has beaten forecasts.

But when founder and former CEO Steve Madden was indicted for securities fraud on June 20, 2000, the stock dropped from the low teens to just above $5 a share. Essentially, Madden had conspired with a bucket shop to defraud investors in some 23 IPOs (the gory details are spelled out below). Investors worried that the company would not be able to maintain its strong performance should its founder go off to jail for a while. Fortunately for SHOO, the legal damage was and is limited to Mr. Madden and does not involve the company itself.

In the 13 months since the indictment, however, SHOO has continued to post very good results despite a weak retail environment, and despite the fact that Madden’s legal woes have severely limited his involvement in the company. For the first six months of 2001, sales were up 21%, comps up 4%, income from operations up 21%, net income up 17%, and diluted EPS up 21% on a slightly lower share count.

Why Steven Madden, Ltd. is more than just Steven Madden:

1) “Test and react” strategy – SHOO has essentially converted much of the product design process from an art to a science. In an industry accustomed to ordering product six months in advance, the ability to predict fashion trends can be extremely valuable. But SHOO’s design team doesn’t really need a crystal ball. This is because it tests each of its prototype models in its 67 nation-wide retail stores. Best sellers are then mass-produced and distributed in a manufacturing cycle that takes only 30 – 90 days (versus an industry average of 180 days). The company delivers new lines to stores 9X a year, versus an industry average of 4.6X a year. SHOO gets trend-right product in the channel more often, which avoids production of slow-moving shoes that need to be marked down in order to sell. This competitive advantage isn’t going away.

Financially speaking, trend-right shoes mean higher gross margins and higher inventory turns (see tables below). Shoes reach the right stores at the right due to an IT infrastructure that regularly checks and adjusts inventory. Fast selling shoes strengthen relations with dept. and specialty shoe stores and allows SHOO to expand its wholesale business more quickly. Now that SHOO is firmly entrenched with these retailers, it is methodically putting a stranglehold on the competition that is made up of mostly smaller private companies.

Q1’01 Operating Margins:
Kenneth Cole 6.7%
Maxwell Shoe 6.2%
Reebok 6.8%
Sketchers 13.7%
Vans 5.5%
Steven Madden 11.0%

2000 Inventory Turns:
Kenneth Cole 5.2
Maxwell Shoe 9.9
Reebok 4.4
Sketchers 4.2
Vans 3.6
Steven Madden 8.8

2) Product line now more stable - Earlier in its history, SHOO had to come out with revolutionary styles in order to get noticed. Now, much of the product line simply evolves from previous models. This makes the company easier to manage, both creatively and operationally. Today, the company groups products into three categories: Core, Core-plus, and Fashion. Core styles are available year-round and are stable enough that stocks are replenished via EDI. Core-plus styles change gradually over time, while Fashion styles come and go quickly. SHOO tries to have re-order inventory for its Core and Core-plus styles only. Also, note that the four newer brands in the portfolio have always run autonomously, thus Madden’s absence shouldn’t be a large issue to them.

3) Management team has depth – President Rhonda Brown has been running the day-to-day operations since 1996, which happens to be the last year in which the company reported an earnings shortfall. An experienced new COO from Aerosoles was hired in January 2001. New design talent has also been added, bringing the design team up to about a dozen members. Also, Steve Madden has signed on as the “Creative and Design Chief” for the next 10 years, and will return to work as soon as he gets out of the slammer. (Madden was replaced, by the way, by new CEO Jamieson Karson, a NY lawyer who has had significant involvement with his own family’s retail apparel business.) Insiders own about 22% of the company.


Brands and Distribution:
All of the company’s brands are distinct and target different age groups, yet all are fashion forward and priced in the moderate-to-better price category. This consistent approach allows the company to keep customers as they age. The portfolio looks like this:

A) Steve Madden – 65% of wholesale and almost 100% of retail. Targets 16-25 yr old women. This is the original and still largest line. Models sell at $50-120/pair.
B) Stevies – Launched in June 2000. Targets 5-12 yr old girls. Prices are lower and distribution is broader than for Steve Madden brand. Price points range from $30-45.
C) l.e.i. – Licensed from the maker of l.e.i. Jeans. Targets 6-20 yr old women. Again, prices lower and distribution broader than Steve Madden. Price points range from $29-49.
D) David Aaron – Targets 26-45 yr old women with more sophisticated styling (and higher price points). This brand originally stumbled out of the gate after being acquired in 1996, but has recently been repositioned and seems to be very much on track. Represents less than 2% of revenues. Shoes sell for $70-100.
E) Steve Madden Men’s – Launched in 2001, targets 18-40 year old men with shoes ranging from $69 to $99 a pair. Thus far, the reception has been good.

SHOO sells its products both at retail and at wholesale. Wholesale channels are about 65% of sales and include better department stores and specialty shoe stores. The largest of these wholesale customers, Federated Stores and May Department Stores, accounted for about 13.7% and 11.7% of total sales, respectively. The company-owned retail operation is 67 stores and should grow by about 10 stores per year. Their largest store is actually their website, which now sells over $4M/annually and is still growing very rapidly. Retail is very profitable and sales average about $153/sq ft. Comps have been positive in every quarter since SHOO has reported comps, with the exception of Q398.


Full story on Mr. Steve Madden’s legal trouble:
Madden profited off some 23 IPO scams pushed by the now-defunct Stratton Oakmont, a boiler room run by an old school friend of Madden’s. In boiler room parlance, Madden was a “flipper” – his buddies would control the stock float of the securities issued by hiding their positions in nominee accounts, one of which was Madden’s. Once shares were successfully placed with unwitting buyers, these insiders would dump their shares. One of these scams was the 1993 IPO of Madden’s own company, which is ironic since – unlike most of the other IPOs – his company was the real thing, and actually turned out to be a huge success. Madden will be sentenced on September 6th, and will serve between 41 and 51 months (I have no idea about eligibility for parole). He has agreed to pay $8.2M in disgorgements and fines, and will be barred from serving as a corporate officer for the next 7 years.


Valuation:
As mentioned earlier, income from operations and net income for 1H01 have grown by 21% and 17% year over year. So far, industry reception to the new fall product has been very good. Management is comfortable with diluted EPS of $1.47 for 2001 and $1.68 for 2002. But before we figure out the P/E multiple, we need to make two adjustments. First, SHOO has about $26.8M in excess cash on the balance sheet, which equates to $2.10 per share. So after subtracting the cash, you’re paying $13.33 for the business itself.

Second, we need to adjust for stock option expense, since it’s material. I’ll start by using a Warren Buffett rule of thumb to estimate the option expense for 2000. (I realize there are many ways to estimate the true cost options – I’ve chosen this one since it’s quick, and since it results in a slightly more conservative number than the Black-Scholes output in the 10K.) Buffett multiplies the number of options issued in the year by the strike price of the option, then divides the product by 3. So, (550,000 options X $9.09 avg. strike price)/3 = $1,666,500. 2000 earnings were $16,043,000, so option expense is running at about 10% of net income. Thus, our forecast drops to $1.32 and $1.51 for 2001 and 2002, respectively.

So, the fully adjusted P/E comes to 9.5 and 8.9 for the FTM and 2002, respectively. (Fiscal year ends 12/31.) Since earnings should grow at about a 15% rate through 2002, this is cheap. Plus, there is a good chance that 15% growth could turn out to be 20%+ growth, especially if the retail environment improves. Note that income from operations was up 21% for the past six months, despite the fact that management deliberately trimmed wholesale sales starting in Q4’00 in response to the slowdown in the economy. I’d say the low end of the range for fair value is 15X adjusted FTM earnings – in line with expected growth through ’02 – which gets you to $23. The high end would be about 20X, in line with my optimistic growth rate, for $28 a share.

Remember that: 1) it’s a small company ($200M sales) with plenty of market left to penetrate 2) ROE is high, and balance sheet is debt free, 3) new brands are showing good results. 4) earnings growth has averaged 76% over the past 4 years. In rough order of importance, growth drivers include: 1) new retail stores 2) growth from new brands, and 3) increased penetration by wholesale division.

SHOO also looks cheap on a comparables basis. Close competitors include Kenneth Cole, Nike, Nine West, DKNY, and Guess, though the latter three don’t make for good comparables as much of their business is clothing and accessories, not just shoes. The following table (at bottom) shows how SHOO’s forward multiple compares to other public shoe companies. . I’ve compared SHOO to Kenneth Cole, Nike, Vans, Timberland, Genesco, Reebok, and Sketchers using consensus estimates. I’ve subtracted cash per share from each price. To be conservative (and to save time), I adjusted SHOO earnings for option expense but didn’t touch estimates on the other companies. (In case the formatting get screwed up when I submit this to the VIC, I’ll summarize the results here.) The average multiples are 14.1X and 12.2X for ’01 and ’02 earnings, respectively. SHOO’s numbers are 10.1X and 8.9X. The average PEG (using consensus estimates for long-run growth) is 85%, while SHOO is at 49%. These discounts doesn’t seem justified when you consider that – compared to the group averages – SHOO has higher expected growth, better margins, and faster inventory turnover.


Ticker 8/24 Price 2001E 2002E LT growth P/01E EPS P/02E EPS 01 PEG KCP $ 15.56 1.24 1.44 17% 12.5 10.8 74%
VANS $ 16.29 1.22 1.46 20% 13.4 11.2 67%
TBL $ 33.53 2.80 3.00 18% 12.0 11.2 67%
GCO $ 22.47 1.60 1.88 19% 14.0 12.0 76%
NKE $ 49.88 2.38 2.69 14% 21.0 18.5 150%
RBK $ 23.77 1.76 2.05 13% 13.5 11.6 102%
SKX $ 20.87 1.71 2.07 20% 12.2 10.1 61%
Average 17% 14.1 12.2 85%

SHOO $ 13.03 1.32 1.51 20% 9.9 8.6 49%

Catalyst

These shares have risen substantially over the past 8 months as management changes have solidified, and as investors get comfortable that SHOO can deliver without its founder. The stock is still quite cheap, however. Continued solid execution will change this.