August 23, 2010 - 9:01am EST by
2010 2011
Price: 11.30 EPS -$1.035 $0.00
Shares Out. (in M): 36 P/E N/A 0.0x
Market Cap (in $M): 401 P/FCF N/A 0.0x
Net Debt (in $M): -166 EBIT -41 0
TEV ($): 235 TEV/EBIT N/A 0.0x

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At current prices, KSWS presents an attractive risk reward as a potential turnaround where long-tenured members of management have recently made large insider purchases.  KSWS manufactures footwear with a focus on tennis, running and casual fashion. After years of declining revenue, the company has begun investing in reinvigorating the brand and is poised to begin a material recovery in 2011 driven by the company's exciting new products in both running and Palladium boots and a recovery of the Classic.  If this turnaround is successful, I believe the stock has the potential to more than double while the company's strong balance sheet provides some downside protection if the company fails to ignite sales.

Strong New Products

KSWS needs to grow its revenue base to be a successful investment and the company has 3 major plans in place to drive revenue growth  If KSWS is successful in introducing their Tubes and Blades mass market running shoes, broadening Palladium distribution, and/or reintroducing the Classic, then KSWS could dramatically increase revenues and profits in 2011 and beyond.

Over the last few years, KSWS has been making inroads into the running segment by first focusing on high-end performance shoes on tri-athletes.  While the company has won numerous awards for its running shoes, the financial impact has been modest due to the product's niche market focus and minimal distribution solely at specialty running shops.  Recently however, KSWS has begun making inroads into the mass market running segment through the introduction of the company's Tubes and Blades product line.  The company has been positioning the Tubes product line as a high-quality running shoe at an entry level price ($75) and the company has been investing serious marketing dollars in promoting the brand, most recently beginning a large marketing campaign with Kenny Powers which includes print, TV, and a large internet campaign.  K-Swiss has positioned the Blade series at more series runners and the product has already received accolades including the "Best New Running Shoe" in the Fall Shoe Review at Running Network.  The Tubes product is being placed in the mass market channel for BTS 2010 and 2011 and the Blades market will remain in the specialty channel until 2011.  If KSWS is successful in marketing these products  through mass-market channels in 2011, Blades and Tubes have the potential to generate material revenues for KSWS and help reinvigorate the K-Swiss brand.

The second avenue for growth is the company's fashion boot brand, Palladium. KSWS acquired French boot manufacturer Palladium in 2008 with the idea that the company's core Pampa boot was a timeless shoe like the original Classic and could have a similarly successful run with the required investments to increase marketing and improve manufacturing.  Since their launch in the US market and the restructuring of the European business, Palladium has performed very well in very limited, high-end distribution as KSWS has intentionally restrained distribution to create brand cachet.  The strategy has worked so far and the shoes have achieved very strong sales on small distribution as well as a brand that is very hot currently.  For 2011, the company is working to build on this success and will dramatically increase the distribution of the brand (ex. URBN distribution going up from 20 stores to 120). If Palladium can translate its brand strength to a broader audience, its sales could have a meaningful effect on KSWS's results. 

Finally, the third pillar for a recovery in KSWS sales is a recovery of the Classic.  While demand for the Classic has been weak over the last few years, signs of life have begun to appear.  Conversations with athletic retail contacts have suggested that they have seen a small recovery in demand for the Classic and have begun to increase their placements of this critical product for KSWS.  For example, the Classic has begun to reappear in numerous Foot Locker and Finish Line stores after being almost non-existent over the last year.  Due to the low amount of current sales, any reintroduction of the Classic in the major footwear retailers could dramatically increase sales. At its peak, FL represented $116mln of revenue to KSWS (mainly Classics) versus a very small amount currently (less than 20mln).  The return to FL is also important because FL is generally considered to be the first mover in athletic Footwear.  As Steven Nichols noted when KSWS was hemorrhaging FL business in 2008, "They (Foot Locker) really get a very clear look at the United States, and we generally find in a downturn they are ahead of everybody on our brand, and in an upturn ahead of everybody on our brand." Due to this increase in demand and placements for the Classic, it is possible that we are beginning to see a turn in this shoe which previously represented over $300mln of KSWS revenue.                                                                                                                                               

When Business Turned Previously, It Turned Hard

KSWS has faced two major downturns in its business since Steven Nichols acquired the company.  From 1994-96, sales declined 31% and from 1999-2000, sales declined 22% y/y as the brand became out of fashion.  In the recovery from those two downturns, sales dramatically rebounded, increasing 167% and 94% respectively over the next 3 years.  These dramatic sales increases are due to KSWS's strategy of withdrawing from distribution during times of weakness as well as the company's small market share in athletic footwear (0.8% currently).  Thus, when demand recovers and the company increases the size of its sales network, KSWS needs to increase its market share by 1% to more than double revenues.  It is also important to remember that KSWS previously reached over $500mln in sales without any contribution from running or Palladium which could both add material incremental sales.  

Insider Buys

One of the largest factors giving me confidence in the likelihood of a KSWS turnaround has been the action of insiders who I hold in very high regard.  In the last 3 months, CEO Steven Nichols and CFO George Powlick have bought 245,000 shares of KSWS shares at prices from $9.76 to $10.85.   I believe Steven and George are very shareholder friendly and possess a better understanding of KSWS than anyone else (both been at KSWS for over 20 years).  Therefore, I am very encouraged by these material insider buys (George Powlick almost doubled his stock ownership with these purchases).  If anyone has special insight into whether KSWS will succeed in turning the brand around, it is Steven and George.   


If KSWS fails to turn the business, the stock will clearly decline.  However, KSWS has a very strong balance sheet (over $4.50 per share of net cash).  While the company has burnt some cash this year, much of that burn was due to the company's marketing investment to support the attempted turnaround and the company could be run near cash flow breakeven at current revenue levels if necessary.  For a company like this, I believe some share price support should exist near tangible book value (~$7.50 per share at the end of the year as the company will burn some cash during H2 2010), an assertion I believe is supported by KSWS's trading during this period of weakness. Thus, at current share prices, I believe downside is ~$4 per share.  However, if the K-Swiss brand is completely unsalvageable (which I don't believe but is possible), then the company could continue to whither away in which case LT downside would certainly be more material.


On the other hand, I think KSWS could provide material upside if the busienss turns.  Because I believe upside is difficult to estimate with precision, I have purposely excluded talking about specific revenue estimates for KSWS's turnaround initiatives.  However, I believe a sensitivity analysis based on historical numbers can provide a framework for understanding the potential returns if the turnaround is successful.  For example, if KSWS revenues return to $500mln and a 20% margin (historical levels), the KSWS would be worth $27 at 8x EBIT.  Below is a table showing the implied share price at 8x EBIT under a variety of sales and EBIT margins as well as the company's performance under prior strong periods.  I do not believe there is anything that would preclude KSWS from returning to previous levels of profitability if revenues rebounded. 


KSWS Share Price Sensitivity          
      EBIT Margin
EBIT Multiple 8.0x   12.5% 15.0% 17.5% 20.0%  
  Revenues 350  $         15  $       17  $       18  $       20  
  400  $         16  $       18  $       20  $       23  
  450  $         17  $       20  $       22  $       25  
  500  $         19  $       22  $       24  $       27  
  550  $         20  $       23  $       26  $       29  
  600  $         22  $       25  $       28  $       32  

  2001 2002 2003 2004 2005 2006
Sales 237 290 429 484 509 501
Growth   22% 48% 13% 5% -1%
EBIT 39 51 87 99 107 100
EBIT Margin 16% 18% 20% 20% 21% 20%

Overall, due to the potential turnaround, an investment in KSWS appears to have ~$4 of downside and ~$10-20 of upside if this turnaround which I believe is an attractive risk reward.


Q1 and Q3 2011 Futures (announced at Q3 10 and Q1 11 respectively)
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