Vote with Feet

**lzhang** Tue Aug 07, 2007 6:37 pm

Vote with Feet
Vote with Feet

Introduction

It was late June that we went to a shopping mall to buy shoes for all of our family members. After hours of shopping around shoe stores, department stores, etc., we finally bought four pairs of shoes at an outlet store of SKECHERS USA Inc. (SKX). The store was having store wide promotion, `buy one pair, get another pair 50%-off', a usual trick for a shoe store. We were glad to have new shoes, and I was satisfied with the prices.

Just days ago I read an article from this blog, talking about another shoe company, K-Swiss Inc. (KSWS), a long time favor of the author of that blog. The price of KSWS has dropped from a high of around $35/share this year to a low of around $23/share recently. It looked interesting to have a look at these shoe companies.

Overview

It is needless to say that the shoe-making business is highly competitive and fragmented. There are several famous brands, like, NIKE (NKE), New Balance, Adidas, Reebok (part of Adidas), and so on and so forth. There are business shoes, sporty shoes, causal shoes, shoes for kids, shoes for adults, etc., etc. All of them are competing for people's feet, where you can usually put at most a pair of shoes on at any given time. I, like most people, do recognize some of the most famous names, but I might not weight on the name too much, as I weight on its price first. Those shoes we just bought were the first we bought from Skechers, but this brand name was not new to me, so it did have some kind of brand recognition. But the reason we bought them were not its brand, but its price. We put our feet in many shoes, walked around, looked through mirrors, and checked the price tags. Finally we thought those shoes from Skechers had the best quality/price ratio we could find in that shopping mall. Anyway, people buy all kinds of shoes, we all have different values.

Now let's turn to the theme of this article: try to find if there are any values in the stocks of those shoe-makers. KSWS and SKX both have pretty severe price decline recently, which is very intriguing to me as they might be potential value candidates. Let's have a quick look at these three companies, NKE, SKX, and KSWS.

NIKE, Inc. was incorporated in 1968 under the laws of the state of Oregon. Its principal business activity is the design, development and worldwide marketing of high quality footwear, apparel, equipment, and accessory products. NIKE is the largest seller of athletic footwear and athletic apparel in the world. It sells its products to retail accounts, through NIKE-owned retail stores, and through a mix of independent distributors and licensees, in over 180 countries around the world. According to its latest annual report (fiscal year 2007 ending 05/31/2007), its total revenues are about $16B, with $8.5B from footwear; its US footwear sales are about $4B; and its market cap is about $28B, with about $2.8B cash. (EV/Sales=1.6).

Skechers USA Inc. was incorporated in California in 1992 and reincorporated in Delaware in 1999. It designs and markets Skechers-branded contemporary footwear for men, women and children under several unique lines. Its footwear reflects a combination of style, quality and value that appeals to a broad range of consumers. In addition to Skechers-branded lines, it also offers nine uniquely branded designer, fashion and street-focused footwear lines for men, women and children. These lines are branded and marketed separately from Skechers and appeal to specific audiences. Its brands are sold through department stores, specialty stores, athletic retailers, and boutiques as well as their e-commerce website and their own retail stores. According to its latest annual report (fiscal year 2006 ending 12/31/2006), it operates 50 concept stores, 61 factory outlet stores and 33 warehouse outlet stores in the United States, and 10 concept stores and two factory outlets internationally. Its objective is to profitably grow its operations worldwide while leveraging its recognizable Skechers brand through its product lines, innovative advertising and diversified distribution channels. According to the annual report, its total revenues are $1.2B, with most from footwear; its US footwear sales are about $773M; and its market cap is about $950M, with about $218M cash. (EV/Sales=0.6). In recent years, its market shares and revenues are growing at comfortable rates. Recently its profits were under analyst's expectation, primarily due to two reasons: 1) Higher SGA for one of its new shoe lines, Cali-gear; 2) Its revenues, $1.2B, get to a point that it needs to invest into its infrastructure to support higher revenues.

K-Swiss Inc. was founded in 1966 by two Swiss brothers, who introduced one of the first leather tennis shoes in the United States. The shoe, the KSwiss Classic, has remained relatively unchanged from its original design, and accounts for a significant portion of its sales. The Classic has evolved from a high-performance shoe into a casual, lifestyle shoe. On December 30, 1986, KSwiss was purchased by an investment group led by its current President. KSWS is a corporation and was organized under the laws of the State of Delaware on April 16, 1990. Its current product strategy is two pronged: combination of its classic styling with high quality components and technical features designed to meet performance requirements of specific sports; fashion-oriented footwear sold principally on a futures only basis usually with little or no planned inventory position taken on these products. According to its latest annual report (fiscal year 2006 ending 12/31/2006), its total revenues are $501M, with $326M from its classic shoes; its US footwear sales are about $319M; and its market cap is about $790M, with about $270M cash. (EV/Sales=1.0). In recent years, KSWS suffers a lot from US footwear sale decline, partly offset by sale increase in European market. But the total revenues have declined for the past three years.

It is needless to say that almost all of the shoes are actually made in factories in China for all the brands.

Evaluation

To evaluate the operation values of these companies, we have listed in this spreadsheet their operation results from fiscal year 1999 to fiscal year 2007 (if data for fiscal year 2007 are not available, available quarter results are used to estimate the annual results). Based on the 8 years average, we estimate that the revenue growths for NKE, SKX, and KSWS are 8%, 16%, and 6%, respectively. Considering the huge negative revenue growth, the 6% growth rate for KSWS is quite optimistic, even it might be unrealistic to assume it will continue its current negative revenue growth with the same magnitude. The revenue growth for NKE is very stable, and very sustainable. SKX experienced some kind of bumpy road around year 2002~2003 after some phenomenal growths in early years. As a relative young and small company, we expect this kind of growing pains. Right now its growth rates are very reasonable. We still expect growing pains, as we are seeing right now. So we think the growth rates we have are sustainable rates for those three companies (with quite optimistic expectation for KSWS to restore its revenues).

We use net profit margin, net earning/revenues, to estimate their profitability, and their net earnings. We have 7.4%, 4.3%, and 12.3% for NKE, SKX, and KSWS, respectively. NKE has relatively high net profit margin. SKX is using aggressive growth strategy to increase its market share, so it has more expenses in marketing, store openings, etc., and its net margin is relatively low, around 4.3%, however, the margins in recent years are higher, about 5~6%. KSWS has very high net profit margin, around 12%. The reason is its production strategy. Major revenues (more than 60%) are derived from its `classic' shoes, so they have considerably low expenses on marketing, R&D, etc. However, they experience revenue decline due to the relatively concentrated production lines, and their profit margin is getting lower and lower as revenues decline. So they have to spend more on marketing, R&D, etc., to boost revenues and profit margin. Otherwise, their relatively high profit margin can not be sustained. In either case, 12% is very optimistic profit margin for KSWS. (spend more to restore revenues, lower profit margin; revenues decline, lower profit margin).

Then we use the expected growth rates, profit margins, to estimate their operation values. The discount rate is 10%. We consider outstanding share growth as negative effects to deflate the per share value, so we discount this expected outstanding share growth as well (for SKX and KSWS only). We assume the expected growths last for the next 8 years and the revenues go flat afterwards. We have $21B, $1.4B, and $830M, as the market caps for NKE, SKX, and KSWS, respectively. NKE is about 30% over-valued per our estimation. SKX is about 35% under-valued per our estimation. KSWS is about fair-valued.

For SKX and KSWS we determine our estimation uncertainties. Based on the growth nature of SKX, we assign 33% uncertainty on its operation value, which is about $400M. For KSWS, we use 25%, or $140M. So on per share basis, we estimate the fair values of SKX and KSWS are $(29.8±8.5)/share and $(23.5±4.0)/share.

Qualitative Discussion

There are several issues related to these evaluations. First, to predict the future income flows more accurately, we need to consider more detailed fluctuations of revenues, profit margins, etc., etc., so more detailed Monte Carlo simulation procedures are needed. However, we think the average numbers we get from historical data are good approximation of their operations, as they are very sustainable. For KSWS, we need to realize that current averages are relatively high compared to its current operation trends, so if its management can restore its historical profitability is a key issue. For NKE, we totally ignore the very valuable brand name of NIKE. If we realize that it is very costly to establish a famous brand name like NIKE, we should have given it a higher valuation. Anyway, it is a harder problem to solve. It should then sound like bargain if NKE could drop to our fair value estimation. SKX is now trying hard to expand its business, its brand awareness, but it is costly, and its profit margin is not as high as KSWS or NKE. But we think it is worthy it as it is to build long term value for the business.

Just last weekend, we went to another shopping mall in the Bay Area. Unlike before, I was a more eager shopper this time, looking around shoe stores. I found shoes from SKX were well positioned with relatively large shares, competing very well with other major brands, in styles, colors, etc., and most importantly, in prices.

Conclusion and Discussion

Based on our estimation, the fair values of SKX and KSWS are $(29.8±8.5)/share and $(23.5±4.0)/share. It is fair-valued per our estimation for KSWS (with optimistic expectation for KSWS to restore its revenues). It is under-valued for SKX at current price. Even it is about 30% over-priced per our estimation for NKE, we think if we consider the very valuable brand name of NIKE, that brand alone might be worth of $8B. So if it can reach to our fair valuation, it might be considered as greatly under-valued.

FD and Disclaimer

The author has a long position in SKX, established as of July 31 2007. The position can be changed without further notice.

This is not an investment recommendation to buy or sell any of the securities mentioned therein. All materials presented here are for information purposes only.

References

Spreadsheet:

http://spreadsheets.google.com/pub?key=pBWqCNQoWBZo8UEmmExYuCg

NKE:

http://www.sec.gov/Archives/edgar/data/320187/000119312507164166/d10k.htm

SKX:

http://www.sec.gov/Archives/edgar/data/1065837/000095012407001540/v28136e10vk.htm

KSWS:

http://www.sec.gov/Archives/edgar/data/862480/000119312507090388/d10q.htm

**lzhang** Tue Aug 07, 2007 9:52 pm

Forbes article on NIKE brand value
After I finished the article, I searched online about the brand value of NIKE, and I found an article on Forbes as of 06/02/2005, where it gave the brand of NIKE a valuation of $7.1B. Considering the appreciation of brand value, we think it is fair to value the brand at $8B right now. With this consideration, NKE is fair-valued at current price.

References

Forbes article:
http://www.forbes.com/business/media/2005/06/01/05bbsbrandsland.html

**fuzzac** Sat Aug 11, 2007 10:30 am

lzhang,

Great writeup, thanks for sharing. I like Sketchers as well, both the shoes and the stock.

I've been following the stock for a while, and I finally bought towards the end of July, after the earnings report, when it got pretty cheap.

**lzhang** Sat Aug 11, 2007 5:32 pm

Hi fuzzac,

Thanks. I hope it can go lower so I can buy more. But it might disappoint me.

fuzzac wrote:
Great writeup, thanks for sharing. I like Sketchers as well, both the shoes and the stock.

I've been following the stock for a while, and I finally bought towards the end of July, after the earnings report, when it got pretty cheap.

**fuzzac** Wed Aug 15, 2007 3:39 pm

It might disappoint in the short term, but long term I think it will turn out good. Looking to add to my position if there is any significant drop from here.

lzhang wrote: Hi fuzzac,

Thanks. I hope it can go lower so I can buy more. But it might disappoint me.

fuzzac wrote:
Great writeup, thanks for sharing. I like Sketchers as well, both the shoes and the stock.

I've been following the stock for a while, and I finally bought towards the end of July, after the earnings report, when it got pretty cheap.

**lzhang** Thu Aug 16, 2007 3:24 am

Hi fuzzac,

I meant it might disappoint me by not going lower. Anyway, the market is doing a good job to drag down everything. Hopefully it can go to $16/share so I can add more.

fuzzac wrote: It might disappoint in the short term, but long term I think it will turn out good. Looking to add to my position if there is any significant drop from here.

lzhang wrote: Hi fuzzac,

Thanks. I hope it can go lower so I can buy more. But it might disappoint me.

**fuzzac** Thu Aug 16, 2007 12:49 pm

Sorry, I misread your post. The market is definitely doing its best driving prices though the floor.

Trying to save some dry powder; got out of NRG on Tuesday and I'm not doing any merger arbitrage (even though Blast is probably correct). Lot's of opportunities ahead.

lzhang wrote: Hi fuzzac,

I meant it might disappoint me by not going lower. Anyway, the market is doing a good job to drag down everything. Hopefully it can go to $16/share so I can add more.

fuzzac wrote: It might disappoint in the short term, but long term I think it will turn out good. Looking to add to my position if there is any significant drop from here.

lzhang wrote: Hi fuzzac,

Thanks. I hope it can go lower so I can buy more. But it might disappoint me.