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K-Swiss... Running to Value

November 15, 2011 | About:
Value is rarely found in the sexy corners of the market. Trying to get value from a security that everyone else is buying is like getting blood from a stone. There just isn’t any. That is not to say that you can’t make money this way, but these people aren’t buying value, they are buying into a greater fool’s game.

If we are to believe Kenny’s quote from above, he could have associated himself with Nike (NKE), Under Armour (UA), or any of the other well known athletic product companies. Instead, he chose K-Swiss (KSWS). K-Swiss is not sexy. K-Swiss is, however, a company that has developed a small but devoted following to their “classic” sneaker. The classic was first designed in 1966 by two Swiss brothers as one of the first high performance leather tennis sneakers in the U.S. In the almost 50 years since it was introduced, the classic has changed very little in form and function. However, if you are feeling generous it has evolved into a “lifestyle” or casual sneaker rather than an athletic sneaker. If you are not feeling generous, it failed to evolve with the cutting edge of performance footwear. Regardless, it occupies a niche in the footwear world and continues to account for a large part of the company’s sales.

In 1986, current CEO and Chairman of the Board Steven Nichols was an executive with shoe retailer Stride Rite when he tried to convince Stride Rite to buy K-Swiss. Stride Rite was not interested, and Nichols led a group of investors in buying the company for $20 million. Twenty years later revenue peaked at just over $500 million per year.

On the back of sales of the classic, K-Swiss has began to expand its offerings to modern performance footwear in recent years. Of note are concentrations in tennis and running (specifically geared toward triathalons). Perhaps most well known is the Tubes offering, which has been supported by the Kenny Powers ad campaign. Tubes attempt to distinguish themselves from other performance sneakers such as Nike’s “air” offering by providing a “regionalized cushion system that mirrors your natural gait cycle.” In addition, the company has been attempting to position their Blades offering as the go-to sneaker for the triathlon market.

Outside of sneakers, in 2008, the company bought Palladium, essentially a boot maker, which the company describes as making footwear for “for adventurers for all terrains” and in 2010 the company bought Form Athletics, a maker of apparel geared toward mixed martial artists. Form Athletics has since been shut down and written off.

CEO Steve Nichols has said that he wants to be in the “milking business.” What he means by this is that most of K-Swiss’s offerings are built around the same “lower” or sole of the shoe, and then the “uppers” can be re-worked to incorporate different styles. The primary lowers are the pampas, tubes, blade, and classic. When the lowers are established, they can be milked through reworking the uppers.

Since revenues peaked in 2005-2006, they slipped into a steady decline to $216 million in 2010, and appear to be rebounding with $218 million in revenues through the first nine months of 2011.

K-Swiss is not a good business. Footwear is extremely competitive, fashion conscious consumers are fickle, and there are 800 pound gorillas (NKE) that can dominate a niche through increased spending and marketing.

K-Swiss does not appear to be a well managed business (at least in recent years). Inventory has consistently been allowed to pile up. The company defends this by noting that they do not discount their “Classic” models, and that they would rather hold the inventory than cheapen their product. This makes sense to an extent, but inventory carry costs are real. Additionally, holding the Classic (which has hardly changed in 40 years) in inventory may make sense to an extent, but holding their more modern offerings does not as styles change quickly. Current inventories are at $90 million which the company acknowledges should be at $50 million. Margins will likely suffer as this inventory is moved out.

K-Swiss will never be a competitor to the NKEs of the world. While true, this is okay. Historically K-Swiss positioned themselves as a more exclusive brand by selectively limiting distribution of their products.

However, they do have a very real opportunity to establish themselves as a go-to brand in some of the darker corners of the athletic footwear world. It is clear that the company is aware of this by their efforts to build relationships with the triathlon community, as well as the MMA community. While the Form Athletic venture was a failure, it is evidence that management is looking for under saturated markets. I believe that athletes who compete in sports that are not mainstream — triathlons and MMA — will be predisposed to use products from a non main stream company. There is a certain badge of honor that comes with being a triathlete. K Swiss has the opportunity to become a brand that one wears to identify one’s self as a triathlete, thus earning the respect of others that are in the know regarding the tri community.

This is a target niche that is known to be affluent (potential for higher margin products), and growing very fast. According to USA Triathlon, “Triathlon participation in the United States is at an all-time high, following unprecedented growth over the past decade. USA Triathlon can easily track the surge through its membership numbers, which surpassed 135,000 annual members in 2010. To put that into perspective, annual membership hovered between 15,000 and 21,000 from 1993-2000.”

As for mixed martial arts, while Form Athletic has been written off, spokesmen Urijah “The California Kid” Faber and Jon “Bones” Jones remain K-Swiss spokesmen. Faber and Jones are two of the most elite athletes in MMA, and their endorsement may help elevate the brand. I believe that this will be a market that other shoe companies are slow to enter due to the polarizing nature of the sport. However, its rapid growth and appeal to affluent men in their 20s is undeniable.

Valuation: Options for valuing an asset light company whose revenues have declined for several years and whose earnings have been negative for two years are somewhat limited. I rely primarily on a P/S ratio and what I believe will be a normalized free cash flow multiple.

P/S is most traditionally associated with a technology company whose revenues stay somewhat stable while the price suffers due to a decreased multiple assigned to what is seen as a product nearing the end of its life cycle. In the best case, the stock later benefits from increased revenues and multiple expansion tied to the company’s next generation of technology.

For K-Swiss I believe that the company’s efforts to transform their image to a “California sports” company and to establish their new offerings as high end performance products equates to a next generation of technology. With a 12 month trailing EV/Sales ratio below .30, the company trades well below peers.

ksws-ev-sales.bmp

For an idea of what the company’s EV could look like versus a variety of sales scenarios see below.

ksws-ev-sales-multiple.bmp

One times sales through the first nine months of 2011 is almost three times current EV of $75 million.

For an extremely basic look at what normalized free cash flow based on the last 10 full years looks like (in millions):

ksws-fcf-history2.bmpAnd what EV could like based on a series of cash flow scenarios:

ksws-fcf-multiiple1.pngA ~33% discount to 10 year average cash flow at a paltry 7.5x leads to an EV approximately twice the current EV.

It is obvious that the company is extremely cheap by the above metrics, but the numbers alone do not present the very real risk that the company will at best need to raise capital (preferably debt but possibly equity due to difficulties securing bank financing and limited new issuance) to survive, and at worst has entered a terminal decline. Ilook at KSWS as a company that will either bleed to death, or manage to reverse its fortunes and become a five bagger. In a case like this, management is essential. The company needs to either 1) completely rework their product offerings in order to boost sales 2) drastically improve margins or 3) both.

Management: CEO and Chairman of the Board Steven Nicholsis an interesting case. In 1986, Nichols was the president of shoe retailer Stride Rite when he tried to convince Stride Rite to buy K-Swiss. Stride Rite was not interested, so Nichols resigned and led a group of investors in buying the company for $20 million. Twenty years later revenue peaked around $500 million per year. Of note, Nichols still holds approximately 92.7% of the voting power of Class B common stock and approximately 69.2% of total voting power. However, the Class B stock does not appear on Bloomberg or Yahoo finance under the holders list, so at a glance one would not know that the CEO owns approximately 22% of the company.

It is clear that Nichols recognized the value in the struggling K-Swiss brand, and the fact that he resigned from a cushy job to take on the K-Swiss challenge tells me that this is a man with extreme faith in his abilities. His initial purchase can only be described as an enormous success. Additionally the company does have a history of shareholder friendly actions — they repurchased $165million in stock from 1997-2007, and Nichols has been quoted as saying “Everything we do has a long-term mentality to it.” However, the company is back where it was in 1986: floundering.

An examination of conference calls since the drop off in revenues began shows that Nichols has been open and honest about his missteps, the problems the company has faced, and the need to make changes to overcome these problems. Additionally, Nichols recognized the need to evolve before revenues began to crater as evidenced by his 2006 decision to hire a new product design team in an attempt to expand into new markets (fiscal 2007 “training” was 4% of sales. In the third quarter “performance” which I equate to training was 39% of sales). Despite this early recognition, the company did not move fast enough. Again Nichols has been honest about this shortcoming saying in the first quarter 2009 conference call, “I do not think that our problem… at our company is strictly based on the economic environment. I think a vast majority was our own doing and not moving ahead fast enough into new products, into innovation and our new brand positioning.”

The third quarter 2009 conference call offers more insight into Nichols’ attitude. By this point the company had launched its Tubes and Blades offerings. Nichols was very open about the fact that the company would need to spend money to get results. To quote him he said, “If we do everything as aggressive as possible we will consume cash. And I’m we hoping we do. I’m hoping that we see the opportunities in this Palladium and Tubes in running that we just step to the plate and we spend the money in 2010 to get us the results in 2011 and 2012. So if we don’t burn cash the business is weaker than if we, if we start really burning cash then we believe in things and we’re going to just make it happen.”

The financials show that Nichols was true to his word — the large increase in SG&A was primarily geared toward ad spending including the Kenny Powers campaign. The fruit of that campaign is the increased revenues in 2011.

Clearly there is no way to quantify the attitude of “just make it happen.” However, the fact that the CEO owns a large part of the company gives me comfort in the face of the bear case which is terminal decline/dilutive equity raise. The fact that Nichols has righted the ship in the past must not be forgotten.

However, on the downside, one could argue that Nichols has been conflicted between lining his own pockets and doing what is best for the company in the past. As noted above, Nichols was early to realize that K-Swiss needed to be revitalized. In 2008, as the company logged its second massive revenue decrease in a row, Nichols announced that “the brand has slowed down and needs to be ignited.” At the time, the company had more than $200 million in net cash on the books — plenty of dry powder to put to work. However, Nichols awarded a special dividend of $2 a share totaling approximately $70 million. Ordinarily I would applaud this action, but when the CEO receives almost $15 million in cash while the company continues to languish, I question the short-term benefit to the CEO versus the long-term benefit to the company. Especially now when the greatest risk of the company is running out of cash before the turnaround is complete.

Also of note, in March of 2009 the regular dividend was suspended. In November of 2009 a $70 million buyback was approved, but shares outstanding have not decreased.

Margins: Gross margins have suffered significantly over the last five years down from approximately 47% in 2005-2007 to 39% in fiscal 2010 and ~36% so far in 2011. Historically, 47% margins were impressive — on the same level as NKE — a company with greater pricing power due to their brand quality. K-Swiss maintained these high margins by restricting their distribution channels to carefully selected partners and by resisting marking down inventory by relying on the “classic” which they were comfortable holding in inventory because they believed the style was timeless. Margins will remain depressed in the immediate future due to the inventory overhang which needs to be cleared out at some point.

In more recent years, increased material costs are a factor for all players in the space. Margins at K-Swiss have suffered more to increases in advertising costs, which as discussed above was a conscious decision by management to rebuild the brand. Management recognizes the need to improve margins, and said on the third quarter conference call, “Our expense outlook going forward, we are going to be very aggressive, and we will not lower it modestly, we’ll lower it aggressively.” “expenses in general will be viciously attacked.” “SG&A from the $155M will be at least $30M to $35M lower”

The question becomes, can the Tubes and Blades offerings continue to thrive with a decreased ad budget? The answer is not clear. The company believes that the answer is “yes” as they have made significant inroads with specialty running shops and have begun to build brand equity in the performance world. Additionally, the viral nature of the Kenny Powers ads should help keep them fresh. Furthermore the company believes a new “clean classic” offering will help revitalize their lifestyle segment.

It should also be noted that in the most recent quarter European sales were up 52% and accounted for 40% of global revenues. This should continue to accelerate as the European crisis is eventually resolved.

Another impossible-to-quantify possibility is the return of a retro chic trend. I am the first to admit that I have no business spotting fashion trends, but today’s climate of uncertainty is reminiscent although not parallel to the climate of uncertainty that existed post 9/11 that saw an explosion in retro sneaker styles. The “classic” is nothing if not retro and could benefit accordingly.

In the event of a cash crunch: While the company has little debt as of now, as has been noted the company has been burning cash. They are presently negotiating with their bank to obtain an asset based credit line in order to enhance liquidity. However, in the event that they are unable to secure this lending due to a global credit crisis or other reasons, they are not without levers to pull.

The Palladium subsidiary (purchased for $8.5 million in 2008) is based on the “Pampa” lower which is unrecognizable in the U.S., but well known in Europe as it was originally developed for the French Foreign Legion and has been in production for over 50 years. K-Swiss purchased the company including the same machinery that was in use for the prior 50 years. After updating the manufacturing process and developing multiple “uppers” on the Pampa sole this subsidiary is profitable in Europe and the company expects it to be profitable globally in the second half of 2012. This subsidiary could be sold off to raise cash.

Historically KSWS has tightly controlled its distribution and limited it to somewhat more upscale retailers such as FL, DKS, and FINL. At present, their inventory levels are undeniably higher than they should be. In the event of a cash crunch the company should be able to monetize much of their $94 million in inventory by discounting it and distributing it through less specialized retailers such as KSS, TGT, etc. This of course would require the company to take a significant haircut and likely dilute the value of the brand, but it would provide the company with needed cash in a crunch.

Additionally, the company does not own any of its manufacturing or distribution centers and could quickly limit expenditures if needed.

Summary: K-Swiss will never be a competitor to the NKEs of the world, but they do have a very real opportunity to establish themselves as a go-to brand in some of the darker corners of the athletic footwear world. It is clear that the company is aware of this by their efforts to build relationships with the triathlon community, as well as the MMA community. While the Form Athletic venture was a failure, it is evidence that management is looking for under-saturated markets. I believe that athletes who compete in sports that are not mainstream — triathlons and MMA — will be predisposed to use products from a non main stream company. There is a certain badge of honor that comes with being a triathlete or a mixed martial artist. K Swiss has the opportunity to become a brand that one wears to identify one’s self as a triathlete or MMA practitioner, thus earning the respect of others that are in the know regarding these two somewhat elitist communities. These are target niches that are known to be affluent (potential for higher margin products), and growing very fast. The real question is can management turn the ship around. I believe that the combination of high ownership, track record of success, and open and honest communication are a combination worth getting behind. While the downside risk is very real, the potential for a three or five bagger is also very real and justifies betting on management as a small portion of a well rounded portfolio.

Stock Action: KSWS is down more than 30% in the last week, more than 70% in the last 3 months, and more than 70% YTD. Investors have given up on waiting for Nichols to turn the ship around despite the fact that he has said all along that he might need until 2011 or 2012. Last week’s earnings disappointment (-.38/share on lower than expected revs) led to a massive sell off and a huge spike in volume. More than 5,000,000 shares traded on earnings day vs an average of 200,000 shares per day in the preceding months. More than 2,000,000 additional shares traded in the 2 days following earnings. Clearly there were some very motivated institutional sellers that had decided to just dump the shares following another disappointing earnings release. While it is certainly possible that these holders lost faith in management’s ability to turn the ship around, I believe that this action is tied to tax loss selling as the stock had already massively underperformed on the year. I believe that some of these sellers will turn buyer in early 2012 resulting in a quick pop for the stock.

Disclosure: I am long stock at $3.25. This is not a recommendation to buy.

www.chasingbrucegreenwald.com

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Rating: 3.7/5 (12 votes)

Comments

fekafiemd
Fekafiemd premium member - 3 years ago
Excellent information...thank you
Adib Motiwala
Adib Motiwala - 3 years ago


Interesting post. Here are my thoughts from looking at numbers on M*. I am just commenting based on a glance at the numbers. You know the business better....

1) Sales have been declining since 2006..5 years is a long time. Smells like a value trap. Gross margins have been declining as well. Another smell.

2) The last time they had operating profit was in 2007 with $400 million in Sales. They certainly need to increase sales a lot (from $200million) before they will generate an operating profit unless their cost structure has changed? Does management guide as to what sales they need to turn an operating profit?

3) While balance sheet has $30 million excess cash, the burn rate is $20 million a quarter. As you said, pretty soon they will have to borrow money / issue equity...possibly at poor terms.

4) I see the stock cheap on a book value and P/S basis. But, I am not seeing any signs of a turnaround from the numbers. I have invested in a cylical crappy business but when the cycle turns in that business, its very profitable. This one seems like a bad business and ill managed as you said, but also needs a turnaround. Just seems like a lot of negatives.

As Buffett said, time is the friend of a good business and the enemy of crappy business. So, a turnaround in a crappy business in the best of times..sounds like a lot of risks. However, maybe the potential upside make up for these risks ?

On a different note, SKX is similarly cheap on P/S and P/B

And ill throw in another faddish Shoe company. Heelys (HLYS) is trading not only below book value...its trading below cash and has negative enterprise value. Its cash burn rate is only $2 million annually and it has $60 million in cash...

Hey maybe one of these will turn into the next Crocs (CROX)
Chasing Bruce
Chasing Bruce - 3 years ago
hi Adib - there is no question that there is turn around risk, and the investor really has to have faith in the management team. i look at this as a dud or a 5x... one or the other - and it is a small part of my portfolio as such.

management says they need $300M in sales to break even in 2012.

As for HLYS, i have looked at that as well - they are getting killed by cheap chinese replicas. "Healy's" doesn't have any brand value in my opinion. 8 year old kids don't care if they have Healys or the cheap knockoffs.

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