K-Swiss

**teenvestor2** Mon Feb 13, 2006 8:59 am

K-Swiss
I wrote this K-Swiss(KSWS) report about 6-8 months ago, I purchased K-Swiss when it was undervalued, but it's currently within 10% of its fair value. I'm just wondering what you think of the write-up.

K-Swiss (KSWS)
Market Cap: 1.13 Billion
Price: $33.09

HG History
K-Swiss was a watch list stock in the May 2004 Motley Fool issue.

Peter Lynch wrote that you should buy what you know and you should buy the stock of the company who is selling its products like crazy – maybe not in those exact words…

As a teen and soon to be High School Sophomore I've been looking for companies that are popular with teens, and have a teen friendly annual report.

5-Minute Test

Criteria Pass1. Auditors Opinion Yes2.Lawsuits Yes3.Unusual Losses Yes4.Earnings Re-Statements No K-Swiss re-stated earnings in'02 & '015. Intangible Assets Ratio Yes 6. D/E Ratio Yes7. Revenue Growth Yes8. Stock Based Compensation Ratio Yes9. Short Ratio Yes

For more info on this 5-minute test, see “It's Earnings That Count” By Hewitt Heiserman

K-Swiss History
I'll take this right out of the last 10k

“K. Swiss was founded in 1966 by two Swiss brothers, who introduced one of the first leather tennis shoes in the United States. The shoe, the K. Swiss Classic, has remained relatively unchanged from its original design, and accounts for a significant portion of our sales. The Classic has evolved from a high-performance shoe into a casual, lifestyle shoe. We have emphasized in our marketing the commitment to produce products of high quality and enduring style and we plan to continue to emphasize the high quality and classic design of our products as we introduce new models of athletic footwear…

On December 30, 1986, K. Swiss was purchased by an investment group led by our current President. Thereafter we recruited experienced management and reduced manufacturing costs by increasing offshore production and entering into new, lower cost purchasing arrangements. Our products are manufactured to our specifications by overseas suppliers predominately in China. In June 1991 and September 1992, we established operations in Taiwan and Europe, respectively, to broaden our distribution on a global scale…

In May 2001, we formed a joint venture to license, produce and market a men s, women s and children s collection of National Geographic outdoor-oriented and casual footwear. In the fourth quarter of 2003, we agreed with National Geographic to end our licensing agreement. Operations of the National Geographic brand have been accounted for and shown as a discontinued operation in the accompanying financial information…

In November 2001, we acquired the worldwide rights and business of Royal Elastics ( Royal ), an Australian-based designer and manufacturer of elasticated footwear. The purchase excludes distribution rights in Australia, which were retained by Royal Management Pty, Ltd.”

That about tells their story, I'm really pumped about their Royal brand...

The Business
K-Swiss's business is “… two pronged.” The first prong combines “… classic styling to reduce the impact of changes designed to meet performance requirements of specific sports.” Also, “We endeavor to use classic styling to reduce the impact of changes in consumer preferences as we believe that this strategy leads to longer product life cycles than are typical of the products of certain of our competitors. We believe that long product life cycles reduce total markdowns over the life of the products, thereby enhancing their attractiveness to retailers.” K-Swiss also believes this strategy helps them maintain inventory with less risk of obsolescence that's typical of more fashion-orientated products.

The second strategy involves fashion-orientated footwear sold only on a future basis, with little or no planned inventory position. This strategy allows them to take advantage of trends in the marketplace without the usually associated risk that is involved with selling fad products.

Currently, K-Swiss competes in the Classic category (casual), training, basketball, tennis and children's footwear. Each category has certain styles designated as the core products, and each category has styles for men and women – men represent about 50% of revenues and women about 31%.

K-Swiss believes these core products offer style continuity and often include on-going improvement. They also believe the Core Program “…critical factor in attempting to achieve our goal of becoming the retailers most profitable vendor.”

Revenues (... ----------------------------------------------- Year Ended December 31 ------------------------------------------------------- 2004 2003 --------------- --------------- K. Swiss Footwear $ % $ % $ % Category --------- --- --------- --- --- ------------------ (Dollar amounts in thousands) Classic $ 313,833 67 % $ 277,398 66 % Tennis/Court 28,867 6 23,395 6 Training 38,487 8 35,914 8 Children s 86,113 18 78,046 19 Other 5,661 1 4,735 1 - ------- --- - - ------- --- - Total $ 472,961 100 % $ 419,488 100 % - ------- --- - - ------- --- - Domestic $ 392,889 83 % $ 368,701 88 % - ------- --- - - ------- --- - Foreign $ 80,072 17 % $ 50,787 12 % - ------- --- - - ------- --- - -------

This is taken right out of the 10k

The main points:

-- Consistant Classic sales
-- Growing Foreign sales.

Footwear
Through 1987 K-Swiss's product line was primarily “The Classic.” More about the Classic: “…The Classic was originally developed in 1966 as a high-performance tennis shoe. Since that time, the Classic has become a popular casual shoe. The upper of the Classic includes only three separate pieces of leather, which allows for a relatively simple manufacturing process and yields a product with few seams. This simple construction improves the shoe s comfort, fit and durability. We have from time to time incorporated certain technical advances in materials and construction, but the Classic has remained relatively unchanged in style since 1966. In 2000, we launched Classic Luxury Edition, which sells for slightly more than the original version.”

Fueled by new products, The Classic has morphed into a whole category of shoes.

K-Swiss entered the training category in 2001 and the basketball category in 2004.

K-Swiss also has a limited apparel line that goes with their Tennis shoes.

K-Swiss sells through sales executives and “…independent sales representatives primarily to a limited number of specialty athletic footwear stores, pro shops, sporting good stores and department stores.” They also sell through their website and to foreign distributors.

International

We see from the table above that K-Swiss's international sales grew 58% over the past year and are now 17% of sales. Also K-Swiss's Euro unit was profitable for the first time this year.

Royal Elastics

K-Swiss acquired Royal Elastics in 2001. Royal Elastics is an Australian-based designer and manufacturer of elasticated footwear.

The Royal Elastic shoe uses innovative stretch-fit shoes to fasten the shoes to your foot. They are designed for fast slip on and off comfort.

In 2004 Royal Elastics cost K-Swiss a $.15 per share loss, but Value line expects that loss to be cut in half, and expects the Royal Elastics brand to give K-Swiss a small profit by 2006.

Also, Royal Elastics signed “No Doubt” lead singer and solo artist Gwen Stefani to create a brand name for her. I believe the Royal Elastics brand represent strong growth for K-Swiss.

Industry

Here are my notes on the Shoe Industry, from Value Line:

Companies in the Shoe Industry are constantly managing which companies are selling their shoes. Ex. Champs, Foot Locker, Sports Mart, etc...
The new fad in the shoe industry is singing celebrities, we may not be surprised if companies like K-Swiss and Skechers start signing celebrities.
Operations in Overseas markets play markets play a key role in current and future growth.
Value line says investor may find “interesting opportunities” in the Shoe Industry.

K-Swiss's Royal elastics recently signed celebrity Gwen Stefani, and International sales grew 58% over the last year.

Competitors

Here I will compare: Revenue Growth-FCF Growth-Gross Margin-Operating Margin-Net Margin-SG&A as a % of Sales-ROE-ROC-ROA and D/E, with K-Swiss and three competitors. The Three competitors are Nike, Reebok and Saucony – I couldn't find five years of Data for Adidas.

Revenue Growth ------------------------------ 2004 2003 2002 2001 2000 ------- ------- ------- ------- ------- K-Swiss (KSWS)] 13% 48% 23% 7% Nike (NKE)] 12% 15% 8% 4% Reebok (RBK)] 9% 11% 5% 4% Saucony (SCNYA) 22% 2% 1% -21%

While kind of erratic K-Swiss' revenue growth was the best in 2001-2003, and second this year but still higher than Nike.

FCF Growth 2004 2003 2002 2001 K-Swiss (KSWS) 170% 27% 24% -25% Nike (NKE) 77% -8% 136% Reebok (RBK) 32% -54% 32% -3% Saucony (SCNYA) -39% 7% -39% 712%

Also erratic, K-Swiss's FCF growth is better than the other three competitors. Nike's FCF growth was good in 2003 and 2001, but negative in 2002.

Gross Margin 2004 2003 2002 2001 2000 K-Swiss (KSWS) 46% 45% 45% 41% 40% Nike (NKE) 45% 43% 41% 39% 39% Reebok (RBK) 40% 38% 37% 37% 38% Saucony (SCNYA) 41% 38% 34% 32% 37%

K-Swiss has the best gross margin, and has had it for the past five years.

Operating Margin 2004 2003 2002 2001 2000 K-Swiss (KSWS) 20% 20% 16% 14% 19% Nike (NKE) 14% 12% 10% 10% 10% Reebok (RBK) 7% 7% 6% 5% 5% Saucony (SCNYA) 11% 10% 7% 0% 10%

Like the gross margin K-Swiss's operating margin is better than the competitors, and has been for the last five years.

Net Margin 2004 2003 2002 2001 2000 K-Swiss (KSWS) 15% 12% 10% 10% 10% Nike (NKE) 9% 8% 4% 7% 6% Reebok (RBK) 5% 5% 4% 3% 3% Saucony (SCNYA) 6% 6% 4% -1% 5%

This is turning into a theme, as once again K-Swiss has, and has had, the best margin.

SG&A % of Sales 2004 2003 2002 2001 2000 K-Swiss (KSWS) 25% 25% 29% 26% 26% Nike (NKE) 31% 30% 29% 29% 28% Reebok (RBK) 32% 31% 31% 31% 32% Saucony (SCNYA) 30% 29% 28% 31% 26%

Not only does K-Swiss have the lowest numbers, but they are also going down. SG&A is an expense, and this ratio is better lower.

ROE 2004 2003 2002 2001 2000 K-Swiss (KSWS) 31% 28% 21% 19% 17% Nike (NKE) 21% 20% 12% 17% 17% Reebok (RBK) 16% 15% 14% 14% 13% Saucony (SCNYA) 15% 11% 8% -1% 14% ROC 2004 2003 2002 2001 2000 K-Swiss (KSWS) 31% 28% 21% 19% 17% Nike (NKE) 19% 17% 10% 15% 15% Reebok (RBK) 12% 11% 10% 10% 8% Saucony (SCNYA) 15% 11% 8% -1% 14% ROA 2004 2003 2002 2001 2000 K-Swiss (KSWS) 24% 21% 16% 14% 13% Nike (NKE) 14% 12% 7% 10% 10% Reebok (RBK) 8% 8% 7% 7% 6% Saucony (SCNYA) 11% 8% 6% -1% 11%

K-Swiss also has superior returns on Equity, Capital –defined as Income/ Equity + LT Debt – and Assets. Showing the K-Swiss's management is better at allocating capital.

D/E 2004 2003 2002 2001 2000 K-Swiss (KSWS) 0 0 0 0 0 Nike (NKE) 0.12 0.14 0.14 0.16 0.12 Reebok (RBK) 0.30 0.34 0.40 0.49 0.57 Saucony (SCNYA) 0 0 0 0 0

The debt to equity category was closer, with K-Swiss tying with Saucony and the other two barely having any debt to matter.

By comparing these measures we have found that K-Swiss – when compared to these 3 competitors –

-- K-Swiss appears to be growing faster than Nike and Reebok, but is closer to Saucony.
-- K-Swiss's margins, while higher, are also expanding faster than these three competitors
-- K-Swiss's management – at first look – is better at allocating capital, with superior returns on capital and assets, and better at managing expenses with the lowest SG&A as a % of Sales
-- To cap it off K-Swiss has the best balance sheet – with Value line saying, “… K-Swiss has the best balance sheet in the industry.”

Competitive Advantage

Being in one of the most fragmented industries, at first look it wouldn't appear that K-Swiss could have any sustainable competitive advantages, but…

K-Swiss's CEO admitted that K-Swiss is “... not in Nike's league,” but K-Swiss operates in a niche. I targets consumers between the ages of 14 and 24, and has barely changed the design of its most profitable -- 67% of sales – “Classic” shoe in the past 40 years. This puts in near the top of its industry as it doesn't suffer from “fashion flops” that happen to the other companies that depend on getting their sales from fads.

The company also lowers expenses by working with low-cost contractors in Asia; this expands their margins and raises their returns on capital and assets.

Financials

I have the last nine years of data on my spreadsheet, So I will have the last five years, as well as the five year average and nine year average for the ratios and the last five years and the nine year average for the growth numbers.

Growth

2000 2001 2002 2003 2004 9y Average Revenue -22% 7% 23% 48% 13% 24% Income -38% 10% 23% 75% 42% 123% OCF -14% -23% 26% 25% 159% 103% FCF -11% -25% 24% 27% 170% 25% Gross -18% 4% 16% 47% 12% 21% 2000 2001 2002 2003 2004 9y AverageOperating Expenses -16% 6% 37% 28% 15% 19% Operating Income -43% 18% 25% 88% 13% 117% Cash -4% -4% 8% 21% 38% 16% Receivables -9% 20% 22% 37% -3% 18% Inventory -1% 0% 21% 39% -12% 15% Current Assets 9% -1% 16% 31% 27% 15% Intangibles -5% 110% -4% -10% -36% 5% Total Assets 7% 2% 14% 28% 26% 15% Current Liabilities 24% 1% 41% 19% 45% 23% Total Liabilities 6% -1% 21% 25% 24% 17% CapEx -57% 33% 58% -5% -28% 32% Defensive Income -55% 129% 16% 11% 245% 73% Enterprising Income - - 7% 0% 397% 135% Shares 0% -10% 15% 17% 0% 5%

* Operating Expense are growing, but not as fast as any form of Sales or Earnings.
* Cash Flow grew a lot over the past year mainly because of a negative change in Working Capital

* The 9y averages are high for OCF and Net Income mainly because of 500% and higher growth in the late nineties.

* Cash is growing at a good steady rate.

* Receivables and Inventory, which were growing at high rates, have tailed off lately and are growing slower than sales.

* Current Liabilities are growing faster than Current Assets, but the current ratio is still very high – averaging over 6.

* CapEx is growing fast, and very erratic, but is not growing faster than OCF and Income.

* K-Swiss is having some trouble with share dilution, it didn't grow at all over the last year but grow in double digits the two years before that and also decreased by 10% a year before that. Like other things Share Growth has been erratic

Defensive and Enterprising income come from the book “It's Earnings That Count” (McGraw Hill, 2004) by Hewitt Heiserman. For this analysis I subtracted fixed capital and the change in working capital for defensive income and I multiplied the ROIC-WACC spread by invested capital for Enterprising Income.
The main thing I see with K-Swiss's growth numbers is how erratic they are, erratic growth makes future cash flow harder to predict and makes me a little un-easy in predicting K-Swiss's future.

Margins

2000 2001 2002 2003 2004 5y 9y Gross Margin 40% 41% 45% 45% 46% 43% 42% Operating 14% 16% 16% 20% 20% 17% 14% Net 10% 10% 10% 12% 15% 11% 9% Tax Rate 40% 40% 39% 39% 29% 37% 42%

I threw the tax rate in there to show it isn't volatile – a red flag – as show before the margins are healthy and expanding, all current margins are higher than the averages.

Balance Sheet ratios

Debt/Capital 0 0 0 0 0 0 0.0 Current Ratio 6.58 6.43 5.32 5.85 5.11 6 6.2 Quick Ratio 3.47 3.62 3.12 3.62 2.39 3 3.6 Flow Ratio 3.38 3.03 2.39 2.44 2.96 3 3.1 DRP 2.55 1.12 1.36 1.45 0.61 1 1.58 Asset Turnover 1.41 1.47 1.58 1.83 1.64 2 1.50 Inventory "" 5.06 5.37 5.46 5.82 7.46 6 5.47

D/E was shown before, is at 0 and the average is .00043. Current Quick and Flow ratio are all high, showing good management of current assets and liabilities. The DRP (Debt-repayment-period) shows that it should only take 1.45 years for K-Swiss to pay off its debt.

Management Effectiveness

2000 2001 2002 2003 2004 5y 9y
ROE17% 19% 21% 28% 31% 23% 19%
ROA 13%14% 16% 21% 24% 18% 14%
ROC 17%19% 21% 28% 31% 23% 19%

All of these returns show good management, which is very capable at managing capital – just like Warren Buffet likes with no debt involved to skew ROE – but can they create value for shareholders…

ROIC 10% 28% 28% 23% 72% 32% WACC 8.95% 8.95% 8.95% 8.95% 8.95% Spread 1.50% 19.05% 19.05% 14.05% 63.05% 23%

K-Swiss has no debt so I used the cost of capital for the whole shoe industry of 8.95% for WACC. High ROIC compared to WACC show that K-Swiss creates – a lot – of value for shareholders.

The bottom line on the financials is: K-Swiss has great expanding margins, value creating management and a pristine balance sheet that was called “… one of the best in the industry” by Value Line.

[/i]

**dahhuilaudavid** Fri Feb 17, 2006 1:36 pm

Excellent!

All the best,
Dah Hui Lau (David)
http://dahhuilaudavid.blogspot.com/

**Bernard2222** Wed Mar 29, 2006 8:07 pm

Re: KSWS
Excellent write-up, I just purchased KSWS as well and feel quite confident about the company. The management gives honest answers during the conference calls and their numbers are quite impressive.

FCF = 92,715,000
Enterprise value = 809,658,000
EV Yield = 11,45%

Net Margin = 14,80%
ROIC = 29,32%
ROE = 29,32%
ROA = 23,54%

They have no debt and their sales YoY in Europe nearly doubled last FY. Their domestic sales have been flat but there's quite a lot of room for them to expand in Europe and Asia. With such a nice margin of safety, I think this stock is one worth taking a look at.

**teenvestor** Wed Mar 29, 2006 8:11 pm

K-Swiss is a great company, but not one I'd recommend at thecurrent price, I bought at about $18.5 when it was undervalued, today it is not.

-Mike

**Bernard2222** Wed Mar 29, 2006 9:46 pm

Hi Mike, I agree it's not as good as a buy as it once was but what makes you think it's not undervalued at this point? From the DCF valuations I've done, it seems to me like its intrinsic value is around 45. Would you mind elaborating? Thanks a lot

**teenvestor** Fri Mar 31, 2006 9:15 am

What were the assumptions you used in your DCF?

**Bernard2222** Fri Mar 31, 2006 11:57 am

I just redid the valuation and here is what I got:

Growth Rate (analysts estimate 14,5%, I used 10% to be conservative)
Years 1-5: 10%
Years 6-8: 8,25 - 6,5 - 4,75
Years 9+: 2%

Discount Rate
8%

This actually gave me a 2221,23 current value compared to a 1021,92 market cap. This means 64,88 per share.

**DonQuixote** Sat Apr 01, 2006 2:06 pm

KSWS' presence is pretty good. I was in Tokyo two weeks ago and I went down to Harajuku. I found K-Swiss in some of the small, trendy shoe shops where I expected to only see Nike, Adidas and Puma.

**DonQuixote** Sat Apr 01, 2006 2:18 pm

Bernard2222 wrote: I just redid the valuation and here is what I got:

Growth Rate (analysts estimate 14,5%, I used 10% to be conservative)
Years 1-5: 10%
Years 6-8: 8,25 - 6,5 - 4,75
Years 9+: 2%

Discount Rate
8%

This actually gave me a 2221,23 current value compared to a 1021,92 market cap. This means 64,88 per share.

Is it possible to post a screenshot of your DCF calculator? I'm really confused with all this DCF stuff.

**Bernard2222** Sat Apr 01, 2006 3:51 pm

Hi Don,

My spreadsheet isn't really clear but here is a good link that explains how a DCF valuation works:
http://www.fool.com/news/commentary/2005/commentary05051108.htm?source=mppromo

Basically it comes down to finding the present value of the future cash flows and adding them all together.

**teenvestor** Sun Apr 02, 2006 12:29 am

Your discount rate is kind of low. I never go below 11% and for small companies like K-Swiss I use 13-15%.

I wrote an article about form,ing DCF spreadsheets here.

Your growth assumptions are good and conservative, but K-Swiss faces heavy competition and I'm not sure if they are just a fad or not, I rate them as a hold; not a buy.

-Mike

**Bernard2222** Sun Apr 02, 2006 11:07 am

Nice article Mike. Yes KSwiss is in a highly competitive sector but as you wrote in your article, they follow this particular strategy:

Our product strategy is two pronged. The first combines classic styling with high quality components and technical features designed to meet performance requirements of specific sports. We endeavor to use classic styling to reduce the impact of changes in consumer preferences as we believe that this strategy leads to longer product life cycles than are typical of the products of certain of our competitors. We believe that long product life cycles reduce total markdowns over the life of the products, thereby enhancing their attractiveness to retailers. This strategy also enables us to maintain inventory with less risk of obsolescence than is typical of more fashion-oriented products. The second product strategy uses fashion-oriented footwear sold principally on a futures only basis usually with little or no planned inventory position taken on these products. This strategy allows us to take advantage of trends in the marketplace that we identify while attempting to minimize the risk generally associated with this type of product.

I think this strategy somewhat protects them in from the "fad factor" and puts them in a certain niche market. I believe the growth potential in Europe will also help them in the future.

As for the discount rate, I was wondering if you could explain why you use 11% for most stocks (which gives me a 42.06 value btw). Thank you

**teenvestor** Sun Apr 02, 2006 6:54 pm

11% is my generic discount rate b/c it works and is the historical return of the stock market - I also believe Buffett uses it.

-Mike

**DonQuixote** Wed Apr 12, 2006 6:09 pm

Hi, I just did some of my own calculations and came to the conclusion that the FCF/EV yield is 11.29% for KSWS. Does this look correct?

Also, what exactly does it mean? I know it's compared to the 30 year bonds at 4.5%, but does that mean if everything stayed the same for KSWS it would theoretically return 11.29% per year?

Thanks

BTW: I just got The Intelligent Investor, One Up on Wall Street and Common Stocks and Uncommon Profits in the mail today!

Peace!

**Bernard2222** Thu Apr 13, 2006 10:24 am

Yep that figure looks about right to me. I also got around 11%. FCF yield is just like Earnings Yield (the inverse of the P/E ratio). In this case, it's the inverse of the Price/FCF ratio and it represents the amount of FCF you buy with one dollar of shares. (i.e. if you buy KSWS at 29.23, you in fact buy 11.45%*29.23 = 3.37 of FCF for the year). It's another way to evaluate a stock just like the P/E ratio but it is based on FCF rather than earnings.

I'm not an expert at this but this is how I understand it from what I've read. Perhaps someone has a better explanation?