Description

OVERVIEW
Timberland is a designer of premium footwear, apparel and accessory products for men, women and children. Best known for its rugged yellow boots, the company has since aggressively broadened the product line over the past few years and is currently positioning itself as an “outdoors lifestyle” brand.

I recommend TBL and expect 40-60% appreciation over the next 12-24 months. This appreciation will be driven by growing earnings and cash flow reinvested at very high rates of return. Additionally, solid year end performance could lead to margin expansion in advance of a return to double digit revenue and even higher earnings and cash flow growth.

TBL has a solid men’s boot franchise with opportunities to grow in new boot categories (women and kids boot , performance, athletic), geographies, and in apparel. Furthermore, the business generates extremely attractive returns on equity (with virtually no debt), requires moderate amounts of capital, and is far from having reached it’s full potential, as measured by marketshare of the active footwear market. Finally, though I’m in no way counting on a transaction to drive value, I note that the business is rumored to have been available for sale a few years ago.

FOOTWEAR MARKET OVERVIEW (Source: Standard & Poors Industry Review)
Personal consumption of footwear in the US totaled $45.1 billion in 2000, up 4.2% from $43.3 billion in 1999. Product prices in the US$ declined slightly over the same period as retail consolidation and higher consumer demand for lower-priced, casual shoes had an impact. As overall footwear demands tends to track the economy, expectations for growth this year and next are modest, particularly considering a relatively strong 2000. Longer term, demand in the US is expected to be less strong (given demographic trends) than overseas.

The competitive landscape remains highly fragmented as barriers to entry are relatively low. Sustaining a business, however, is a significant challenge and one which is met by the establishment of a solid brand.

The athletic and sports shoe category, which represents about 30% of total domestic footwear sales, is expected to buck the weakening trend in 2001 and register gains above the rate of GNP growth.

TIMBERLAND BUSINESS REVIEW – FOOTWEAR (78% of sales)
Relative to the dynamics of the overall footwear marketplace, TBL is positioned quite well. First, it competes in the athletic and sports shoe market, a segment that is expected to experience relatively higher level of growth in 2001.

Over the intermediate term, growth will be driven by the success of recently launched categories that are just taking hold in the marketplace. As the market share leader in boots with a very strong following among men, it’s women and kids offerings are natural product extensions. Additionally, TBL has launched a performance category targeted toward the sportsman which sells at higher prices than the traditional line. Over time, if Nike’s successful strategy can be translated into the boot category, buying performance may become the dominant purchase driver. The upshot of this is a richer product mix within the boot category, higher margins and a healthy cannibalization on the margin of the traditional line.

Initial results of these new initiatives are included in TBLs overall performance results through 6/13/01 as reported by Merrill Lynch (Athletic Footwear, 6/13/01),

- TBL has a 2.8% dollar share of the athletic footwear marketplace...there
is plenty of room to grow!
- The “Outdoor” segment experienced the largest YTD change in sales (42%),
followed by “Casual” (26%) and basketball (19%).
- Outdoor has the second highest average YTD selling price ($57) and was
exceeded only by basketball ($61).

Second, TBL is aggressively pursuing growth opportunities internationally. The international business currently represents 28% of total company sales and, in my estimation, can reach 50% of sales over the next 5 years or so. International operations are conducted through operating divisions and distributors. Last year the company re-acquired exclusive distribution rights for the Asia-Pacific region, demonstrating the importance of these markets to the company’s future.

Third, the company’s independent retailer focus in the US enables it to maintain product margins to an unusually significant degree relative to competitors that sell through large retailers. The company also operates company owned specialty stores (21) and factory outlets (51) giving its products broad national exposure. A breakdown of the company’s sales through its various channels is presented below:

US Wholesale 54%
US Retail 18%
International 28%

Finally, TBL launched a global marketing campaign in September centered around the “For the Journey” theme. The campaign features TV, print and outdoor impressions that will promote the “outdoor brand essence...and reinforce the brand’s commitment to equipping consumers with functional, stylish head-to-toe products for all of life’s journeys”, according to TBL’s Chief Marketing Officer.

TBL’s solid market positioning is complemented by excellent manufacturing and product sourcing capabilities. Owned facilities in Puerto Rico and the Dominican Republic supply roughly 15% of TBL’s footwear volume. The remaining footwear volume and all apparel is sourced from independent manufacturers primarily in Asia, Europe, Mexico and Latin America. By concentrating large amounts of its sourced product volume in three manufacturers (Kingmaker Footwear of Hong Kong being one) TBL has been able to benefit from scale manufacturing economies while concurrently improving the efficiency of its supply chain (lower inventories, reduced manufacturing lead times etc).

TIMBERLAND BUSINESS REVIEW – APPAREL (22% of sales)
The apparel business is a potential source of growth. It is also an area where the company must develop new capabilities and channels in order to further its success.

As a percent of sales, the apparel business has performed as follows:
1998 1999 2000
Apparel sales 23.1% 20.9% 22.5%
Sales growth n/a (3.5%) 28.5%

Profitability in by product category is not made available by the company, though it is fair to assume that apparel is less profitable than footwear, perhaps significantly so.

Short of aggressively expanding TBLs retail presence, growing this business will require the company to grow its department store distribution channel and support that business, as it is with the “For the Journey” campaign, with aggressive advertising. For these reasons, I believe this business is inherently less attractive than footwear as growing it will either require additional capital expenditures or costs. Nonetheless, I believe a smart and selective approach to growth it can add significant value to the corporation and enable it to leverage its brand name.

For example, TBL might find it more profitable to expand the apparel business in lesser developed and consolidated retail markets overseas. According to a company presentation, per capita TBL apparel spend in Western Europe far exceeds that in the Eastern US currently. I also believe the re-acquisition of the Asian distributor was largely about developing the wholesale channel for apparel in that part of the world.

Other opportunities might involve partnerships with and/or selective acquisitions of apparel retailers in specific regional markets.

Although apparel remains a potentially very attractive opportunity, the company needs to do more to articulate its long-term strategy in this area.

HISTORICAL FINANCIAL REVIEW

1996 1997 1998 1999 2000 CAGR
Sales 690 797 862 917 1,091 12%
GP 272 331 359 416 567 20%
EBIT 51 84 95 117 184 38%


Sales n/a 16% 8% 6% 19%
GP 39% 42% 42% 45% 48%
EBIT 7% 11% 11% 13% 17%


WC 194 144 140 106 122
CAPX 15 26 21 20 30

DEBT 190 100 100 100 0

NI 3.0% 5.9% 6.9% 8.2% 11.6%
AT 1.5 1.9 1.8 1.9 2.3
LEV 2.7 2.0 1.8 1.8 1.5
ROE 12.3% 22.0% 22.2% 27.6% 39.8%

The financial summary highlights the following :
- Lumpy sales growth averaging over 12% during the five years. Though
shoes are a cyclical business, at least some portion of the lumpiness is
likely to be attributable to a pattern of inventory building and draw
down at the retail customer level. Nonetheless, I think it is reasonable
to assume average growth over the next five years in the 7-10% range.
- Improving gross margins. This trend is attributable to scale purchasing
economies, mix improvements and average product price increases. It’s
unreasonable to expect this improvement trend to continue much further.
In the near term, gross margins are likely to deteriorate a bit as TBL
discounts product prices to maintain sales momentum.
- Minimal debt. TBL has ample financial flexibility with which to pursue
share buybacks or growth initiatives, including potential niche
acquisitions (international distribution, apparel ).
- Moderate CAPEX spending. Net CAPEX (after depreciation) has averaged
$2.0 million per year over the period, with a large increase in 2000.
Expect net CAPEX to increase over the historical average in the near
term to support growth initiatives, particularly on the apparel side of
the business.
- Robust ROE. Given slower near term earnings growth, ROE will certainly
decline but will still be quite significant. What’s more exciting is
that the business continues to have growth investment opportunities (new
products, geographies, and apparel) which will compound reinvested
earnings at excellent rates.

YTD FINANCIALS
2001 2000 % Change
Sales $842 $761 10.6%
Gross Profit 375 356 5.3%
EBIT 116 124 (6.5%)
Diluted EPS $1.89 $1.95 (3.1%)

GP Mgn 44.5% 46.8%
EBIT Mgn 13.8% 16.3%

WC $315 $122
Total Debt 65 0

- Seasonal inventory building and weaker than expected sales accounts for
current working capital levels.
- Margins have weakened and are likely to end the year at close to 1999
levels.
- Seasonal cash flow needs resulted in a draw down on a line of credit.
- Consensus EPS estimates for the year is $2.71


VALUATION REVIEW
Share Price $33.66
Basic Shares 38.95
Equity Market Cap $1,311
Cash $15.8
Book Debt ($65.0)
Enterprise Value $1,262

P/E (2000) 11.6
P/E (2001E) 12.4

I estimate, based on discounted cash flows, an equity value range of $48-53 per share, representing appreciation potential of approximately 40-60%. My model assumptions are as follows:

Low High
5 yr sales growth 8.0% 10.0%
EBIT Margin 15% 15%
Tax Rate 33.5% 33.5%
WC/Sales 10% 10%
Net CAPEX/Sls 7% 7%
Discount Rate 10% 10%
Perpetuity Growth 4% 4%

This stock could potentially trade at significantly higher levels or reach my target valuation more quickly should management step up share buy backs, make a well priced acquisition, or have an unexpectedly solid fourth quarter. Furthermore, this stock has traded as high as $74 per share during the past year and at more than twice the current P/E.

SHARE OWNERSHIP
The founding Swartz family own 44.9% of the Class A shares and all of the super voting Class B shares. The family patriarch and Chairman of the Board, Sidney Swartz is 65. His son, Jeff is the CEO and is 41 years of age.

Rumor has it that the business was available for sale a few years ago. There is no reason to believe, given Jeff’s performance, that the business is currently on the market or will be in the foreseeable future. Should it ever be offered for sale it is reasonable to expect a transaction price well in excess of the high end of my valuation range.

WHAT COULD GO WRONG
- New initiatives to grow the core business (new categories, geographies)
could prove costly mistakes.
- The company might spend aggressively here in the US to build its retail
presence. Such a move would drain valuable resources from the boot
business and require significant amounts of capital to accomplish.

WHAT COULD GO RIGHT
- Strategic partnership or acquisition in the apparel business ensures its
future profitable growth.
- International sales growth far exceeds expectations.
- The family patriarch offers the business for sale.

CONCLUSIONS
TBL has a solid franchise in boots and is positioned for continued growth in the core and in the apparel businesses. Furthermore, an exceptionally strong balance sheet avails management of a range of opportunities to reward shareholders and enhance the strategic positioning of the apparel business.

Catalyst

Solid yearend performance in a difficult retail environment could lead to multiple expansion. Otherwise the inherent value will get recognized in the market over time. That value is based on an exceptional brand franchise and credible opportunities for further growth at rates of return well in excess of capital costs.