Sunday, November 30, 2008


Footstar is a liquidation play with tangible equity of $82.1 million ($3.84 per share) and an expected liquidation value of at least $96 million ($4.5 per share). This compares to the current stock price of $2.8. I see a very low chance of getting less then the current stock price with the upside being a 40% return in less then a year.

Footstar runs the footwear departments in 1,383 Kmart and 833 Rite Aid stores. In March 2004, due to poor acquisitions, accounting problems and then liquidity issues, Footstar went into bankruptcy. In February 2006, the company emerged and paid creditors in full. While in bankruptcy in 2005 after years of litigation the contract with Kmart was amended. Originally set to expire on December 31, 2012, the contract now expires on December 31, 2008. After the contract expires Footstar will liquidate.


On April 30th 2008 Footstar paid a $5 taxable dividend. On April 3rd 2008 Footstar sold substantially all of its intellectual property to Kmart for $13 million. On June 30th 2008 Footstar paid a further $1 dividend.

When the contract expires at the end of the year, Kmart will purchase the inventory related to its stores excluding unsalable or damaged inventory for book value. Any seasonal (4 months past season) will be purchased for 40% of cost. Footstar has already reserved $2.4 million for seasonal inventory. Any unsalable or damaged inventory will not be purchased.
The other asset remaining is Footstar’s headquarters building located in Mahwah, NJ and is listed for $19.5 million. Mike Lynch told me that they have had interest in the property but nothing has materialized.

K-mart agreed to hire substantially all store and district managers. Footstar eliminated 3 executive positions and notified 218 employees of termination. The severance cost related to these employees is $8.5 million plus $2 million in benefit costs, with $3.6 million already accrued, $6.9 million in remaining severance is not yet expensed. It is my understanding that this accounts for all of the severance. I spoke to Mike Lynch whose is CFO. This is what he said "All employees are accounted for at this juncture, but it is possible that additional severance/retention measures could still be put in place depending upon the circumstances."

The last item that needs to be accounted for is Footstar’s second half 08 operating earnings. Considering income taxes is virtually nil due to deferred tax assets, operating earnings is the best metric to use. Operating income was $28.4 million for the first half. But, this includes a gain of $22.3 million for the reduced severance after Kmart agreed to hire all store and district managers. A charge of $2.4 million for the seasonal inventory and $3.6 million in severence related to the portion that has already been expensed. Neting out these items gives operating earnings of $12.1 million compared to $21.5 million or the first half last year. The factors effecting second half earnings will be lower operating expenses due to lower headcount and weaker retail environment. In the first half Kmart recorded same store sales declines of 6% compared to Footstar’s decline of 10.6%. Operating earnings declined 40% in the first half. Operating earnings was $32 million in the 2nd half of 07. My best case and worse case 2nd half 08 operating earnings estimate is $19-$25 million.

Here is a chart showing the balance sheet at June 28, 2008 adjusted to the expected liquidation value:


The largest risk is that management will not liquidate in an expedient manner. Footstar will file a plan of liquidation in early 09. But the sale of the headquarters building could delay the liquidation. Also, some have raised the issue that the last two dividends were not tax efficient and that they should have been set as liquidating dividends and not taxable. The OutPoint Group waged a proxy fight earlier this year attempting to name two candidates to the board. The Outpoint group owns 3% of the company. They and raised such issues as the excessive compensation for the top executives, the CEO’s total compensation was $3.5 million last year and the CFO made $700,00. Directors are paid between $110-$160 thousand year. Footstar reimbursed the chairman $160,000 for his failed bid for the company in 2006.

My estimate of second half cash flow could prove to be way off especially given the current situation in the economy. My estimate is fairly conservative but the results remain yet to be seen. But keep in mind that even without the 2nd half cash flow tangible equity is $82 million compared to a market cap of $60 million.

Sunday, November 2, 2008


This is my analysis of K-Swiss:

K-Swiss, Inc engages in the design, development, and marketing of athletic footwear for sports use, fitness activities, and casual wear. It also markets apparel and accessories under the K-Swiss the brand name. In 2001 K-Swiss acquired Royal Elastics.

K-Swiss was founded in 1966 by two brothers dissatisfied with the tennis shoes in the market. The two Swiss brothers developed the K-Swiss Classic. In 1986 Steven Nichols then the president of the Children’s shoe division at Stride Aide recognized the timeliness of the shoe and tried to convince his bosses to buy the company. They refused and Nichols left the company and formed an investor group that acquired K-Swiss for $20 million. At the time K-Swiss was basically in bankruptcy. In 1990 K-Swiss went public. Nichols has grown the company from sales of $20 million in 1986 to $410 million in 2007. The K-Swiss Classic still represents two-thirds of sales with only slight changes to the shoe from the original in 1966. The Classic has since developed into a casual shoe. In the mid nineties Warren Buffett offered to buy the company but Nichols refused to sell. He said that he greatly admires Buffett but that Buffett offered no premium for the company. Nichols owns 22% of the company and insiders control 25%, Third Avenue owns 12%.

The shoe sold today is virtually indistinguishable from the original Classic sold in 1966. The Classic is popular with teens. Nichols has a very different strategy then most shoe companies. The extremely long durability of the Classic shoe is a competitive advantage. The product development costs are drastically lower then its competitors who are constantly introducing new models. The shoe’s distributors also are benefitted because the shoe doesn’t need to be marked down when new models are constantly introduced. K-Swiss is the most profitable vendor for the stores it distributes shoes to. K-Swiss is very selective with the venders they will supply to. K-Swiss avoids saturating the market with the Classic because that degrades the image of the brand. For the past 10 years gross margins have averaged 45% compared to 42% at Nike, 41% at Sketchers and 39% at Steven Madden. Operating margins have averaged 17% compared to 11% at Nike, 7% at Sketchers, 8% at Steven Madden. The 10 year average ROIC and ROE is 22% and 25%.

K-Swiss is currently getting hit on two fronts. They are out of style and facing a consumer spending slowdown. In addition the popularity of Crocs, canvass shoes and flip flops has disrupted the market. In 2006 with the stock soaring Nichols started telling shareholders that their product and marketing was not satisfactory. He said this before Wall Street realized it. Sales slowed in 2007, falling 18%, domestic sales were down 37% and international revenue was up 14%. Net income plunged 50% in 2007. For the first half of 08 domestic sales fell 33% and international fell 17%. Nichols response to this situation has been to pull back on supply and even cut off some of the vendors. He said this resuscitates the brand and allows the company to come back stronger. He maintains spending on marketing and product development.

Nichols has done this four or five times in the past with success. Around ‘94 K-Swiss was hit by softening demand. Nichols hired new marketing people who introduced the Classic Limited Edition. That drove sales up until the next slump which occurred in 2000. K-Swiss pulled back on the limited edition and focused on the original. Sales grew until 2006 when once again K-Swiss is facing softening demand. Pulling back on supply in bad times also serves to prevent large markdown activity. This further hurts sales in the short run. But it's an intelligent long term strategy. Many of K-Swiss’s competitors have introduced cheaper shoes to try to boost sales in the short run and save a quarter. Nichols said during the 4th quarter conference call that he thinks the opposite. Instead of trying to save the quarter, K-Swiss thinks long term. "We do almost no short term things. Everything we do has a long term mentality to it." In the first quarter conference call he said "We think our problems are self manufactured. We didn’t move our product and marketing ahead to a point where our brand was in demand." Total backlog for the 2nd half of the year is down 32%. Manegment estimates that 3rd quarter EPS will be $0-(-$.15) and full year revenue of $300-$320 million and EPS between $.5 and $.65.

In the past year or so new marketing people have been hired. A remastered K-Swiss Classic is set to be introduced in mid 2009. K-Swiss has also made a foray into running and Free Running shoes. K-Swiss has been dominant in tennis but tennis shoes represent only 6% of the athletic shoe market, running shoes represent 30%. So far the reception they’re getting at running shops has been good. Also, K-Swiss has signed on athletes such as Anna Kournacova and others, something that they haven’t done before. Nichols said they are still working on improving the marketing, which has become stale.

Steven Nichols and George Powlick are two of the most candid and honest managers out there. Insiders own a large amount of stock and have a long history of making shareholder friendly decisions. The shareholder letters and conference calls are some of the best I’ve come across. The honesty, candor and long term focus of the manegment comes out strong. During the last conference call Nichols said that 97% of the reason for K-Swiss’s current problems is his fault. Since 1996 management has repurchased 25.5 million share at an average price of $6.55 bringing the shares outstanding from 53.16 million on December 31, 1995 to 34.7 million today. I encourage readers to look at the last three conference calls and the three articles I linked to:

Three articles worth reading

and the last three conference calls:

During the second quarter K-Swiss acquired a 57% interest in Palladium for $8.4 million with the option to acquire the remaining 43% for a pre-determined multiple of EBITDA in 2012. Palladium is a French shoe company that looks a lot like K-Swiss did when Nichols took it over in 87. Palladium started making a military hiking boot for the French government in 1947 and the company still sells the same shoe today with the same manufacturing systems as they used in 1947. Nichols said the shoe, called the Pampa, is timeless like the Classic but like K-Swiss in 87, Palladium has been mis-managed. The manufacturing process is out of date, the shoe is uncomfortable, to heavy, to expensive and doesn’t fit well. K-Swiss can change all these things and still keep the shoe’s timeless look. K-Swiss will also be able to use Palladium’s distribution and sales force to increase sales in Europe.

K-Swiss product is distributed in 66 countries but K-Swiss has only begun to tap the potential of the brand internationally. International revenues have gone from $67 million in 2003 to $208 million in 2007. Before the slowdown during the past 2 years, international revenue had been growing at 50% plus a year. Revenue from Europe was $143 million in 2007 up from $17 million in 2002. Sales come primarily from Germany, Benelux and the U.K. The company has struggled in Italy, France and Spain. K-Swiss is only in about half the markets in Europe and Nichols expects that the other half will become more meaningful in the years ahead. There are signs of success in some of those countries. The company introduced the Free Running line of shoes across Europe and the most successful country was Italy where it was extremely well received. Palladium should also help boost sales in Europe because K-Swiss will also be able to use Palladium’s distribution and sales force to increase sales in Europe. Other international represents the rest. Sales are also very strong in Asia (South Korea, Japan, China, Taiwan), Mexico, Canada, etc. Sales in for this segment have gone from $25 million in 2002 to $65 million in 2007. In South Korea there are 200 K-Swiss concept stores managed by a distributor. In China a distributor opened 12 stores in 2007. K-Swiss clearly has a vast untapped market in these countries.

Net Income for the last five years are as follows (2003-2007): $50.1 million, $71.3 million, $75.2 million, $76.9 million and $39.1 million in 07. K-Swiss has a market cap of $421. K-Swiss has no debt and $295 million in cash. For the worst case I’ll assume European and other international sales stay where they are at $150 million and $65 million respectively and domestic sales of $300 million down from $400 million in 04 and up from $200 million in 07. For the worse case total sales are $515 million. At a 20% operating margin, operating income would be $105 million. For the best case international sales at $250 million up from $208 in 2007 and domestic sales of $400 million. Total sales would be $650 million under my best case scenario and operating income would be $130 million. Applying a multiple of 14X on operating income after tax and adding cash, yields an intrinsic value of $1250.5-$1478 million or $36-$42.6 per share.

The author has an investment in K-Swiss.