Description

Weyco is a wonderful little company, well-managed and highly profitable – no net debt, 20% returns on capital, gobs of free cash, high insider ownership, all for 10x EPS and 6x EBIT. The gravy is that there is a host of catalysts on the horizon.

WEYS is a designer and distributor of men’s shoes…..wait, wait just a minute. Didn’t Warren Buffett get burned in this industry and warn others to stay away? Yes, but I’m pretty sure this is a different animal, and I’ll tell you why below. By the way, this stock was recommended on VIC a couple of years ago in an excellent write-up by wizard877, and rather than do the “incorporate herein by reference” thing, I’d like to give an updated background before discussing the current catalysts.

Let me start over. WEYS is a designer and distributor of men’s shoes. It owns the Florsheim, Nunn Bush, Stacy Adams, and Brass Boot brands. I assume most of you are familiar with one or two, if not all, of these brands – they are mid-tier dress and dress casual shoes, generally retailing in the $40-110 range. WEYS does sell some shoes directly to consumers through its 33 retail stores, but the majority of revenues derives from wholesale distribution to run-of-the-mill mid-market retailers, like department stores and shoe stores, which account for 88% of sales. Sales last year were $216 million, and the stock market capitalization is $181 million. Despite the unavoidable reality that it’s in a boring industry, WEYS has just about every trait you can look for in a good investment.

The financial profile is superb. Over the past ten years, its return on equity has averaged 15%. However, WEYS operated with a large net cash position most of that time, so a more appropriate measure would be return on invested capital (essentially backs out the net cash), which has averaged 20%. They took on some debt a couple of years ago for an acquisition (which has been a big financial success, and which I’ll discuss more later), but they’ve paid half of it down already, and are now back to a slight net cash position – as of June, they had $23 million debt, $19 million in cash, and $10 million in net prepaid pension and insurance cash values. That’s about $1/share in net cash. Given their prodigious cash flow (free cash flow tends to equal net income, and net margins are 8%, one of the highest in the shoe industry), WEYS could pay down the remaining $23 million debt through generated cash flow in less than 18 months.

The reason why its cash flow is so good is that it outsources all its manufacturing overseas, so capex needs are low. This was Dexter’s downfall after Berkshire Hathaway purchased them in 1993 – Dexter tried to maintain its U.S. manufacturing base way too long, and they became uncompetitive. WEYS was ahead of the curve in that regard, and hasn’t manufactured any significant volume of shoes here in the U.S. in quite some years. They spent some money on expanding and modernizing their distribution center over the past several years, and they should be able to increase sales volume by at least 20-25% without spending any more than maintenance capex. And maintenance capex is an astonishingly low $1-2 million a year, or 0.5-1.0% of revenues.

These strong financials and cash flows are sustainable. Weyco’s laser-like focus shields it from the wild swings seen in other segments of the shoe and apparel industry. Men’s dress/dress casual shoes is a very steady business – I wouldn’t want to claim that there is NO fashion risk here, but I can’t imagine the kind of sudden drop-off in demand or shifts in market share that happens all the time in shoes for women or for a younger demographic. WEYS’s competitive advantage isn’t from just one thing – it’s a combination of its strong brands (Florsheim has been around since 1892, and is generally acknowledged as having the #1 awareness factor among men’s dress shoe brands), distribution (decades-long relationships with all the major mid-tier retailers), and good management.

The management team is wonderful – stable, disciplined, and highly incentivized. Insiders, predominantly the Florsheim family, own over a third of the shares and control 61% of the votes. Chairman Emeritus Thomas Florsheim bought the company in 1964, and ran it until 1999; he basically created the Weyco pre-Florsheim, having engineered the acquisitions of Nunn Bush and Stacy Adams a few decades ago, and the stripping down of the company into its niche focus on men’s shoes wholesale distribution. In 1999, his now 46-year old son Thomas Jr. took over as CEO, remains in that slot, and has more than proven his skills through solid earning growth and the Florsheim acquisition and integration. Thomas’s brother John is the COO. So they all have plenty of skin in the game. Rather than see the control issue as a negative, I see this as a huge positive. Their track record is excellent. They treat minority shareholders like they treat themselves. They run a tight ship with low overhead. They maintain a long-term objective, and are straightforward and conservative with the accounting and finances. They’ve proven to be astute in their allocation of all that free cash they generate. Over the past ten years, repurchases have shrunk WEYS’s share count by 37%, from 9.4 million to 5.9 million shares. Since revenues have doubled and net income has tripled in that time, a shareholder from a decade ago just sitting on his shares would now own a two-thirds larger stake percentage-wise in an entity with three times the profits. Even with the share repurchases, WEYS keeps plenty of financial reserves on its balance sheet, and that worked like a charm in 2002 when it made the opportunistic purchase of Florsheim. Florsheim has been a financial home run, as I’ll demonstrate later. With all the insider ownership, management has no intention of di-worsifying, so it should retain its niche focus.

And finally, a necessary ingredient for a “good” investment – the price. WEYS earned $2.91 last year, and has grown earnings by 11% in the first half of 2004. Let’s be conservative and say $3.10 or so in earning this year. If you subtract the $1/share in net cash from the $30.92 share price, the stock’s trading at a P/E of 9.7x. Free cash flow may lag net income a little this year, but that should even out over the coming years, so I’m comfortable saying that the stock is essentially trading at the same P/FCF as the P/E. But for those Type A folks (me included), my guess is that free cash flow this year will lag net income by 15-25%, so the P/FCF on this year may be as high as 12x instead of 9.7x. The EV/EBIT multiple is 6x. The company is certainly “underlevered” – I’ve never done an “LBO analysis” like many others do, but there’s no doubt with its cash flow that this thing could be LBO’d for a nice fat return.

So let me summarize so far. Steady, simple business with experienced, conservative, high-insider-ownership management team. Ten-year historical growth 7% sales and 16% EPS, with 20% returns on capital, and significant net cash on the balance sheet most of that time. The stock is available for less than 10x price-to-earnings and less than 10-12x free cash flow.

The ONE knock on the company is growth, or the lack thereof. The industry probably grows at a rate slightly below GDP. Weyco has compounded revenues at 7% a year for the past ten years, but backing out the Florsheim acquisition, organic growth has been more like 3%. I’m comfortable that even with 3% top-line growth, WEYS is worth more than the current stock price (a relatively safe, 10% free cash yield with 3% growth would be simple way to look at it). However, there are four catalysts that should help the P/E multiple and boost growth, and I list them in descending order of importance as I see it.

Catalyst #1: In July, the company hired an IR firm for the first time ever, to start getting its message out. It’s a non-fundamental catalyst, but it never hurts to have one like this. Management has never been the type to promote their stock or go on investor roadshows, but for whatever reason, they’ve decided enough’s enough on the low multiple. This coming week, the executives have a slate of institutional investor meetings, and if things go well, I imagine they might do some more. I can’t imagine that catalysts #2-4 won’t excite investors once they know about them, but I admit to not having the foggiest idea sometimes what other investors are looking at.

Catalyst #2: In 2006, or 2007 at the latest, WEYS will re-take control over its Canadian Florsheim business. It currently licenses it out, and receives a straight 5% royalty. When WEYS takes it over, it will just fold in the Canadian Florsheim business into its existing Nunn Bush Canada operations, and will start to generate approximately 25% incremental EBIT margins on that business. Florsheim Canada has about $5 million in sales volume, so basically, a $250,000 pretax revenue stream will virtually overnight, turn into $1,250,000 pretax. That’s a 3.5% bump to earnings, or about $0.11 in EPS. I think this will understate the impact, since if they can grow Florsheim Canada like they hope to, sales will be quite a bit more than $5 million by 2007.

Catalyst #3: They will resume significant share buybacks within 12-18 months. The buyback was put on hold after the Florsheim acquisition to prioritize debt paydown. WEYS bought back $3 million of shares in 2003 (using just a fraction of its free cash flow), but hasn’t bought any back so far in 2004. The debt could be paid down in 18 months, but management has signaled to me that it’s unlikely to pay it all down, so I expect share repurchases to re-start within a year. Remember, this company reduced its share count by 37% in the past ten years – and in reality, it only took them 7 years to do that, since it hasn’t bought back any shares for 2-3 years now. Paying down debt is great, and I encourage it, but you’re not adding much value paying down 1.5% debt, especially when compared to buying back stock at a P/E below 10x. At the current share price, they could buy back over 500,000 shares annually, on a 5.9 million share base.

Catalyst #4: This is the most important catalyst. Florsheim sales should turn from negative to positive this fall, and should boost sales growth over the next few years. After WEYS bought Florsheim, it pruned back on the lower-end retail distribution that was hurting the brand image. The impact of this is hitting reaching an end, with Florsheim sales down 5% in the 2Q. But the turn is here. Backlog is up, and they have won a big new account – May Department Stores. May did not carry Florsheim until late last year, when it began testing it in 20 stores. Due to good results, May is stocking Florsheim in 200 doors this fall. This by itself should add about 5% to Weyco’s sales. May has a total of 350 stores. Keep in mind that Florsheim is much higher margin than the rest of Weyco. And this is only the first step. Several other large retailers come to mind as logical Florsheim customers, that currently aren’t – Federated Department Stores being the key one. Nothing besides May has been announced yet, but one decent new account a year would be significant. Given the low P/E multiple, I can’t imagine that investor expectations are for anything greater than flattish top-line growth. Any pick-up in sales growth should provide a nice double boost – to earnings and to the stock multiple. One can envision the good feelings on the Yahoo! chatboard when it becomes generally known that Florsheim has gotten into May Department Stores. I know I’m going beyond my value investor license here, but imagine that followed up by a Federated Department Stores announcement a year or two from now, and then a Marshall Field’s after that, and so on.

Well, that’s it for this post. Rather than take up room in this write-up, I’ll post an addendum on Florsheim, since it’s an interesting case study of a brilliant acquisition, and maybe some more stuff depending on how I loquacious I feel. I look forward to questions.

Catalyst

1) IR firm hired
2) Canadian license brought in-house
3) Resumption of share buybacks
4) Pick-up in Florsheim sales growth and new accounts, including May Dept Stores