Description

This company was written up back in 2006 by jacob828, and I just noticed has a fairly active thread.  I do not want to replicate ideas, but I feel there is meaningful upside due to a high liklihood of a contract extension with little downside.  Further, the info below adds some additional analysis/perspective.  So, I thought I would go ahead submit this write-up.  For those not familar with the story, I have gone through some of the background.

Summary:

Due to a recent past, thinly traded stock, no research coverage, and the restructuring of the company’s main contract which accounts for 90+% of revenue, the company is not being appropriately valued in the market.  In fact, the company is valued below its expected liquidation value; thus, the market has priced into the company no chance of continuing its business.

Business:

Footstar has run the licensed footwear departments for discount retailers for 40+ years.  The company sells around 50% of the shoes under its own brands (Thom McAn, Cobbie Cuddlers, Texas Steer, Cara Mia).  The Thom McAn brand accounts for the majority of sales (approximately $200-300mm). The company has a strong management team post bankruptcy (mostly the surviving business’ management).  In 2003, due to poor acquisitions, accounting issues and ultimately liquidity problems, FTAR went into bankruptcy.  In 2005, the company emerged, paid creditors in full, and rolled the stock over.  The bankruptcy allowed the company to sell off all but the core, profitable Kmart and Rite Aid business.  Now the company operates the shoe departments in approximately 1,400 Kmarts (approximately 2,800 sqft. each) and 854 Rite Aids ($20-30mm of Revenue).  The company’s competitive advantage is their contacts and reputation in sourcing cheap, quality goods from China (approximately 97%) along with the company owned brands.  In addition, the company has consistently outsold other departments per sqft in Kmart (3.5% of Revenue, 1.7% of sqft).

Kmart Contract:

In 2005, the contract was restructured.  Originally, the shoe departments were operated under 51/49 (Footstar/Kmart) JVs.  However, in bankruptcy this changed.  Lampert failed in multiple attempts to purchase the business below value, and the contract ended up changing significantly via 2 years of litigation.  Footstar became 100% owner, pays Kmart 14.6% revenue royalty, spends 10% of revenue on staffing, and expires 12/31/2008 (originally 12/31/2012).  Originally, Lampert’s idea was to convert most Kmart stores to the Sears Essential platform.  However, that model has not been successful and Kmart store numbers have stabilized.  In addition, same store sales at Kmart have begun to stabilize.  Making up over 90% of FTAR’s revenue, this is a significant driver of the business.

Operating Performance:

The company’s current market cap is around $95mm with a net cash position of about $5mm (EV around $90mm).  As the Kmart business stabilizes and non-recurring items fall off, the business should have a forward FCF yield of 50+% and an FCF growth of 10+% from 2007 to 2008 (margin improvement).  The margin improvement should come from a no growth capex until clarity on Kmart contract and better inventory management as the store base and comps stabilize (less conversion to Sears Essential format).

Terminal Value / Liquidation:

The market has clearly discounted any chance of a continuation of the Kmart business when the Kmart contract expires at the end of 2008.   However, even in a liquidation there is upside.  Under a liquidation, I have valued the owned office building at $200-225 sqft. (based on comps).  The brands (primarily Thom McAn) were valued very conservatively at 30mm.  The value under a license agreement of 5% of revenue of $200mm and Iconix operating margins 60%, in perpetuity at 20% this would yield a value of $30mm.  The inventory under the contract with Kmart will be purchased at book value.  On the liability side, the only reduction in amount was the $27mm of other liabilities which as dictated in the disclosure statement is a true liability of $750k.  This yields a liquidation value of $87mm.  The present value of the FCF and a probability weighted terminal value in 2008 (as detailed in following pages) is $168mm (approximately a 100% increase from today’s equity value).

Contract Continuation:

There is significant value in the possibility of Kmart extending the contract, and I believe there is a greater than 50% chance of this happening.

1.        The shoe department makes up only 3.5% of the revenue of Kmart.  I believe effectively direct sourcing shoes from China or vertically integrating manufacturing would be more costly/risky for Kmart than it is worth.

2.        Kmart/Lampert clearly wants to keep the Thom McAn brand.  He tried to purchase the company in Bankruptcy, he is focused on developing brands within Kmart.  In addition, you can look at arrangements like Kmart licensing the Joe Boxer brand from Iconix to support Kmart's desire to have Kmart only brands.

3.        Under Footstar’s management, the shoe department has done extremely well, makes up approximately 1.7% of sq.ft. and 3.5% of sales.

4.        Currently, Kmart does not have to provide staffing; thus, the $120mm in payments that Kmart receives goes straight to the EBITDA line (approximately 20% margin).  Based on Kmart’s TTM EBITDA margins (6.6%) adjusted for incremental SG&A (Kmart's SG&A as a % of sales minus SG&A for the shoe departments or 21%-10%) only (17.6%), this is a significant value add, which does not even incorporate any start-up inefficiencies to bringing this business in house. 

Risks:

Some risks are that Footstar violates the contract causing early termination or management does not promptly liquidate (if no contract renewal).  The main catalyst will be news on the Kmart contract and/or clarity on management’s intent to liquidate.

Catalyst