Description
VANS is a small-cap branded footwear manufacturer/retailer. The company is in the midst of a transformation and is misunderstood by the market. Currently, the stock is trading at $3.95/share (3/19/03 closing price) vs. $8.63 in tangible book value including approximately $3/share in net cash. With an equity cap of $71mm and an enterprise value of $17mm, VANS is trading at less than 5% of revenue. The company is currently net income and cash flow break-even to slightly positive. However, adjusting for two cost-reduction initiatives results in substantial positive earnings and cash flow – $0.50/share in EPS and a 33% FCF yield. Further earnings upside exists as a result of several product and channel opportunities currently underway. The market is misperceiving the value inherent in VANS.
Biz Description: VANS is a $330mm (FY02 revenue) wholesaler and retailer of footwear for "extreme" sports - skateboarding, snowboarding, etc. 3 businesses: (1) Retail (40% of Rev) - 97 retail stores and 62 outlets; (2) Wholesale (60% of Rev) - 2000 domestic accounts (30% of revenue) and 50 countries internationally (30% of revenue); and (3) Other - 12 skate parks, Warped Tour, etc. (approx. $10mm of revenue which is included in Retail and Wholesale). VANS was founded in 1966 and is based in southern California.
Given the inherent value in VANS, why is the stock trading here? What is the market misunderstanding? Four topics:
(1) Skateparks
(2) Negative comps in retail/wholesale
(3) No current earnings
(4) Technical selling pressure
Addressing each in turn . . .
(1) Skateparks. Beginning in 1998, management decided to open skateparks – 40,000 s.f. facilities with ramps, jumps, etc. – to help market VANS to skateboarders. While profitable early on, the parks are now losing approx. $4.5mm pre-tax annually due to competition from free municipal skateparks. Of the company’s 12 parks 4 are money-losing, while the other 8 are roughly break-even. Management has stated that they will “address” the skatepark issue by mid-year 2003 (prior to the June 1 start of FY04). This will likely involve some combination of shutting facilities (i.e., terminating leases) and/or finding partners to help alleviate the financial burden. The company has not given any estimates as to what this might cost as it doesn’t want to compromise its negotiating position with landlords.
The market views the skateparks as an enormous non-core distraction and fears that the cost of “addressing” them will severely impair the value of VANS. Numbers bandied about with “panic” are as high as $50 - $60mm. While the non-core distraction argument can’t be refuted, the dollar liability is far less than some fear. A reasonable estimate can be derived as follows:
Total company lease expense in FY02 was $17.6mm. Backing out corporate/distribution facility rent of $0.9mm leaves $16.7mm for 97 retail stores, 62 outlets, and 12 skateparks. Retail stores range from 800 – 4,200 s.f. (In prior year’s 10-K the range was 1,400 – 2,700 s.f.). Assuming the average store is 2,000 s.f., average retail store rent is $50/s.f., and average outlet store rent is $15/s.f.. (all three assumptions based on discussions with industry experts), would imply that total retail/outlet rent is ~ $36/s.f. or $11.5mm in total. That would leave $5.2mm for skate park rent which, over 12 parks averaging 43,000 s.f., works out to ~ $10/s.f. Average remaining lease term appears to be ~ 8 yrs. which implies maximum lease exit cost of $42mm. However, industry rule of thumb for lease terminations is ~ 2 years. This is for mall-based retail stores where there is an easy alternative use. Given that the skatepark sites could be less likely to have ready alternative use, conservatively assume 4 years for termination payment. That cuts the total lease exit cost for all 12 parks to $21mm. However, VANS only needs to exit the 4 money losing parks initially (will likely try to find partners to help take-over the other 8), so the cash exit cost should be substantially lower. Given the above, a reasonable estimate of skatepark lease exit cost is $10mm vs. the $50 – 60m “panic” value in the market.
(2) Retail/Wholesale Decline. After 7 straight years of nothing but positive comp quarters, VANS has experienced 5 straight quarters of retail and wholesale comp declines. (Implosion is perhaps a better word…in the most recent quarter wholesale revenue declined 40%, retail comps were down 9.3%!) The comp decline started in the November 2001 quarter, which mgmt. thought was 9/11 related. 5 quarters later they acknowledge the impact of product and channel specific factors.
The market views the admittedly sobering business declines and fears that VANS’s business will continue to implode. This fear, however, ignores several key factors behind the sales declines…
The wholesale decline is primarily a function of two things. First, the women’s line that previously represented $45mm in revenue now represents ~ $15mm. The decline is largely attributable to the fall-off in the blockbuster Upland shoe line which had represented $20mm+ of revenue. The initial success of the Upland resulted in VANS losing focus on new product introductions in its women’s line. Two positive factors, however . . . first, the sales decline is largely anniversaried; second, the company has recently hired a new product manager to focus exclusively on the women’s line and is working with some external design firms for further product development. New women’s lines are being introduced this Spring and by Spring ’04 the company expects to have a new women’s line every 60 days. Initial feedback from industry sources on the new products has been favorable.
The second factor in wholesale decline is the de-stocking that occurred in the athletic footwear retailers and department stores post-9/11 and as the economy slowed. The de-stocking has been most severe in the large athletic specialty accounts (e.g., Foot Locker). The athletic footwear market has experienced a shift to “classics”, price compression, and more competition in the mid-price segment . . . all of which have contributed to Vans declines in the wholesale channel. However, these wholesale accounts can’t de-stock more than once, thus, this decline is non-recurring and is largely anniversaried as well. Based on order activity to date, management is guiding the street to flat y-o-y wholesale revenue for the back half of this fiscal year (ends 5/31/03).
Finally, any discussion of wholesale needs to also acknowledge that the company is growing internationally, which is ~ 30% of revenue. On a consolidated basis, international revenue looks to have declined. However, if you back out the $2.7mm of sales from the company’s South American JVs (Argentina, Brazil and Uruguay) which were discontinued in 2002, International is growing nicely (+7.6% y-o-y in most recent quarter).
On the retail side, two things are important: First, while retail comps have declined, core footwear comps have declined less than total retail comps as total comps were held back by an intentional under-inventorying of apparel and other products. Second, historically VANS’s retail business has played second chair to its wholesale business. For example, VANS has traditionally had 2 product introductions a year to coincide with the wholesale channel’s Spring buy and Back-to-School buy. However, after hiring a new head of retail VANS plans to focus on retail as a separate channel that will help garner feedback for product development and showcase a more frequent array of new products. While VANS will remain an “extreme sports” focused company they will also attempt to broaden the brand to encompass more “lifestyle” accounts/customers. It would not be surprising to see another quarter or two of negative retail comps as the new initiatives develop over time. However, with new product designs in women’s and men’s VANS expects the fall back-to-school season to show a return to growth.
(3) No current earnings. After earning between $0.62 and $1.02 a share between FY97 and FY01 VANS is projected to earn $0.03 this year (FY ending May-03). While there is no reason to expect upside to the May-03 numbers, focusing that short-term ignores several key profit enhancing initiatives completely within management’s control.
First, by closing the unprofitable skate parks VANS will drop $0.15 to the bottom line ($4.5mm x 60% / 18mm shares). Second, VANS’s marketing budget, at 10.3% of revenue, is excessive. Industry experts say that 5% of sales would be more typical and entirely sufficient. Two years ago VANS spent $20mm (7.3% of revenue). Last year they spent $34mm (10.3% of revenue). Simply reducing marketing by $10mm to $24mm (7.3% of revenue) would drop an incremental $0.33 to the bottom line ($10mm x 60% / 18mm shares). These two initiatives get you to almost $0.50/share in earnings, vs. a stock (ex-cash) trading at $1.51 ($3.95 – ($3.00 of cash - ($10mm / 18mm shares for closing skateparks)). Moreover, this gives no credit to upside from the retail and product initiatives currently underway.
From a FCF perspective, D&A of $10mm ($5.4mm through 2 quarters) roughly equals CapEx (CFO guides to less than $10mm). Thus, Net Income is roughly equal to FCF. A 33% potential FCF yield ($0.50 / $1.51) – again giving no credit to the product initiatives underway – seems to more than fully discount the issues facing VANS.
(4) Technical selling pressure. Over the past couple months a number of large holders have decided to exit the stock. Market sources claim the selling comes primarily from a Top 10 holder who won’t hold sub $5 stocks, and another large holder who is facing redemptions. On 3/18/03, 2 of the sellers allegedly got cleaned up as 2.2mm shares printed (obviously far fewer traded due to double counting) vs. 125K avg. daily volume.
What could go wrong / What’s not to like?
(1) Skatepark closures consume more cash. Until the lease negotiations are completed this will remain a potential concern. However, as shown above, $10mm is a reasonable estimate for this liability.
(2) Core business continues to decline. The athletic footwear market in general, and the skate inspired footwear market in particular, are competitive. However, the VANS brand has been around for 35+ years. It is the largest/most well known skateboard related brand that has the best distribution relationships etc. While one may think “skateboard fad” or “niche product” when they think VANS, less than 10% of VANS revenue comes from core skate shops. Certainly a large chunk of its revenue comes from skateboarders. However, it is a more mainstream broad-based audience than one might think. For example, PacSun carries VANS shoes and has a JV with VANS on the apparel side. Additionally, both Fox and NBC sponsor and televise skateboard related events.
(3) Lease Obligations. With 157 retail stores, VANS has lease obligations (estimated above at $11.5mm annually). Should the retail business take a dramatic turn for the worse, these leases could become significant cash obligations. Taking this one step further, another way to look at VANS is to include a PV of the lease obligations as debt. The PV of 8 years (approximate average life) of $17.6mm of lease expense discounted conservatively at 8% is $101mm. $71mm equity cap + $101mm of PV leases - $54mm of net cash = $118mm enterprise value. Current EBITDAR = $0 of EBIT + $10mm of D&A + $17.6mm of leases = $27.6mm. So, TEV / EBITDAR = 4.3x. This is prior to making any adjustments for skateparks, marketing cost reductions, etc. Making the same adjustments outlined above for the skateparks and marketing expense (again giving no credit for the product and channel opportunities) results in TEV = $71mm equity cap + $91mm PV of leases - $44mm of net cash = $118mm enterprise value. Adjusted EBITDAR = $14.5mm of EBIT + $10mm of D&A + $15.9mm of leases = $40.4mm. TEV / Adjusted EBITDAR = 2.9x. Thus, even after bringing VANS’s operating leases on balance sheet the company is still trading at a very attractive valuation.
(4) Management. VANS is not a model of corporate governance, to say the least. Chairman and CEO are father (aged 71) and son (aged 39). As Chairman, the father is paid $288K + $54K for country club dues and a home office. The BoD includes the coach of the Toronto Raptors and the President of the Seattle Mariners. It seems irrefutable that improved corporate governance would help ensure the success of the VANS turnaround and be well perceived by the market. Nevertheless, some observers close to the company say that the management team is personally embarrassed with recent performance and determined to rebuild the core brand and franchise.
Conclusion
Paying $17mm for a $330mm revenue business that is FCF break-even is an interesting proposition. Layering on top the catalysts of exiting skateparks, reducing marketing costs, reinvigoriating the women’s line and the US retail operations should yield substantial profit opportunity. Finally, with only 97 full-price retail stores, if the company can successfully return to its historic growth, one could easily envision doubling or tripling the store base over several years.
N.B. – VANS will be reporting its 3Q results today after the market closes on 03/20/03.
Catalyst
See above.