Description

Weyco Group (WEYS) is a compelling little investment story. WEYS is a wholesaler and retailer of men’s quality footwear. Brands include Nunn Bush, Brass Boot and Stacy Adams. Several Florsheim family members run the company (Thomas Florsheim Sr., is Chairman, and his sons Thomas Jr. and John are CEO and COO, respectively). The Florsheim’s came to the company after selling their namesake brand to International Shoe Corporation in 1952.

I am recommending WEYS for many reasons. First, they are a very profitable small company that offers lots of free cash flow and a pristine balance sheet. Second, the stock is cheap. Third, a recent acquisition will propel sales higher by 50-70% and profits by 77-133%. Fourth, this acquisition brings the Florsheim brand back under family control for the first time since 1952. The exciting part of the story is the tremendous operating leverage WEYS will achieve. Wall Street has yet to recognize this fact.

I first examine WEYS as it is pre-acquisition. Then, I examine how the company will look with the addition of the Florsheim brand.

WEYS PRE-ACQUISITION

WEYS is the eighth largest distributor of men’s quality footwear. 96% of its product is sourced from overseas suppliers. WEYS owns one US plant, used primarily for refit work. The company leaders are all Florsheim’s, a family with over 100 years of shoe business experience. They have figured out what many have not: that while the shoe retailing business can be nasty, the shoe wholesaling business can be wonderful, offering solid profits and gobs of free cash flow. 95% of WEYS sales are derived from their wholesale business. Sales are well diversified. Brown Shoe is the largest customer by far, at 10% of sales. Their small, profitable retail presence exists mainly to keep them abreast of customer tastes. At $32.50 per share, WEYS trades at 13.2X EPS, has no long-term debt and $10 per share in cash, marketable securities and insurance cash value. If excess cash were used to repurchase shares at present prices, WEYS would trade at a P/E of 9.3. Annual growth rates over the last eight years: Sales -- +3%; net income -- +12%; EPS -- +16%. EPS have grown much faster than sales due to share repurchases (free cash flow has been used to reduce the share count by over 40% in eight years) and higher operating margins. Free cash flow averages $10 million per year. The dividend yield is 1.6%. WEYS compares very favorably on all measures to the average industry competitor. Consider:

WEYS Average Footwear Competitor
P/E (TTM) 13.2 21.6
P/Sales (TTM) 0.95 1.32
P/Book 1.65 3.38
P/Free Cash Flow (TTM) 9.6 29.1
Yield 1.6% 0.9%
Current Ratio 4.0 2.9
LTD/Equity 0% 16%
Net Profit Margin 7.2% 6.0%
ROE 13.0% 16.9%
ROE if excess cash distributed 24.0%

Finally, I calculate the present value of WEYS future cash flows (before considering the acquisition) at $184 million versus its market cap of $122 million. This assumes a 12% discount rate and a 10% growth rate that slowly declines and is 5% after 10 years. Of course, we could argue about the appropriate discount rate. Warren Buffett likes to use the 30 year bond rate (too aggressive for me). Others use the estimated cost of equity capital. I chose 12%. Beg to differ if you will.

THE FLORSHEIM GROUP

The Florsheim Group was founded in 1892 and sells an extensive range of shoes to the middle to upper price range of the men’s market. They sell to over 6,000 specialty and department stores and operate 217 company stores. Florsheim is the number one shoe in brand awareness for dress shoes priced over $65 and has three of the top thirteen selling dress shoe patterns in the U.S. Florsheim entered bankruptcy because they were unable to overcome a heavy debt burden and too many of their retail stores were unprofitable.

WEYS POST-ACQUISITION

WEYS is purchasing two things from Florsheim for $45.6 million (deal closed 5/21/02). First, WEYS gets the rights to the Florsheim brand in the U.S. This “wholesale” business has sales of about $45 million (from Florsheim 10-K – U.S. wholesale revenue of $73 million, 38% of which is to Florsheim retail, leaving $45 million of other wholesale revenues). The largest wholesale customers of Florsheim shoes are Sears, J.C. Penney and Nordstrom. Second, WEYS gets 23 profitable retail stores. The key word here is profitable. WEYS handpicked the stores they will buy from the 217 stores Florsheim operates. As an example, included in the deal is the profitable New York store that offers excellent exposure for the Florsheim brand. In all, WEYS management estimates that ’03 sales will range from $200 to $225 million, a 50-70% increase over present sales levels. Below, I present two different 2003 pro-forma income statements based upon the low ($200 million) and high ($225 million) revenue estimates. I exclude 2002 because the acquisition happened mid-year.

Year 2001 Year 2003 Year 2003
Actual Low Estimate High Estimate
(000’s) (000’s) (000’s)

Net Sales 131,693 200,000 225,000
Cost of Goods Sold 94,107 137,414 153,264

Gross Profit 37,586 62,586 71,736

SGA 24,231 34,231 35,231

Operating Profit 13,354 28,355 36,505
Interest Inc/(Exp) 726 (2,282) (2,282)
Other Inc/(Exp) 622 0 0

Income before Taxes 14,701 26,072 34,222
Taxes 5,200 9,222 12,105

Net Income 9,501 16,850 22,117
Net Margin 7.2% 8.4% 9.8%

Shares Outstanding 3,861,667 3,861,667 3,861,667

EPS 2.46 4.36 5.73

EPS Growth from 2001 77% 133%

Cost of Options 418 500 500

Net Income (incl. options) 9,083 16,350 21,617

EPS (Incl. options) 2.35 4.23 5.60

I tried to be conservative with my assumptions. And, because they are rather extensive, I won’t list them here but will discuss them through messages.

It is important to understand why the profit growth is so dramatic. First, the sales growth, itself, is large. WEYS has taken advantage of their very strong balance sheet. Second, the price they paid for the assets was very attractive. No other company made a bid for the assets. So, there was no bidding war. WEYS paid approximately 0.55X sales for the assets. WEYS presently trades at 0.95X sales, while competitors average 1.32X sales. Third, this acquisition offers substantial operating leverage. Why? Florsheim's wholesale business can be added to WEYS with virtually no increase in SGA expenses. Let me explain. WEYS management believes that the addition of the Florsheim wholesale business will only require them to add a handful of people to their home office staff. In discussions with WEYS management, I learned that extra costs will be negligible. This becomes clear if you consider how beautifully Florsheim fits into WEYS. Both companies source their product from many of the same suppliers. Also, WEYS opened a state-of-the-art warehouse facility in ’99 that can easily and efficiently handle the additional volume that Florsheim represents. And, the end markets for WEYS existing brands and Florsheim are the same. Management indicated that they would need to add an accountant, some sales people, and additional warehouse employees to handle the additional volume. In other words, not much. The retail stores will require the usual expenditures to operate them (store employees, rent, etc.). But, very little additional SGA expenses (other than advertising) will be needed to handle the retail operation. In fact, the purchase agreement does not require WEYS to hire even one employee from the Florsheim Group.

I estimate the present value of WEYS future cash flows after the Florsheim purchase to be at least $250 million versus its present market cap of $122 million. As a check, this would value WEYS at 1.18X year 2003 sales versus an industry average of 1.32X.

I have avoided assuming any unusual synergy benefits WEYS may get from the Florsheim acquisition. Though I believe synergy can be a dirty word, I do think synergy benefits may be achieved and would make my calculations even more conservative. What synergies might accrue to WEYS? (1) WEYS may be able to achieve purchasing efficiencies. Clearly, the company will be much larger and may be able to receive better volume discounts on their leather purchases. They may also be able to get better pricing from their manufacturers. (2) WEYS may benefit from cross-selling opportunities. They may be able to sell some of their existing products through the new retail stores. (3) WEYS may be able to add new wholesale customers. Some wholesalers were reluctant to carry the Florsheim brand because of Florsheim’s extensive retail presence. Only 23 Florsheim retail stores will remain out of 217 now in existence. Thus, WEYS should have an easier time of getting new wholesale clients. A broader product line won’t hurt either. (4) Florsheim’s international revenue in 2001 was $32 million. WEYS may be able to acquire some profitable pieces of this business from the bankruptcy court. Negotiations are in progress to buy some assets for $1.1 million. WEYS is likely to get another bargain here.

OTHER IMPORTANT INFORMATION ABOUT THE WEYCO GROUP

- Management owns 33% of the outstanding shares and should be very motivated to see the share price increase.

- WEYS shares are illiquid. On average, only 2,500 shares trade per day, $400,000 per week. Tread cautiously. The spread is large and even small purchases can move the price substantially. Try to get someone to work the order for you if you can.

- The Florsheim Group carried an enterprise value of $224 million as late as 1997. While it may never achieve such a level again, it is intriguing that most of this business is being purchased by WEYS for less than $50 million.

- With their extensive Free Cash Flow, WEYS should be able to pay off the debt from this purchase in less than three years (of course they could pay it off almost immediately if they used their cash hoard).

Risks

Try as I might, I can find very little risk of any sort to this investment. Financially, the acquisition is very affordable for WEYS. They could almost complete it with cash if they wanted to. Also, Florsheim is an easy fit into WEYS. I see virtually no chance that the company will experience operating problems trying to integrate Florsheim.

Catalyst

The acquisition of Florsheim assets will propel sales and earnings much higher, resulting in a much higher valuation.