Payless Shoesource PSS S
December 30, 2005 - 3:28pm EST by
2005 2006
Price: 25.22 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,730 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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This is a recommendation to short PSS. As opposed to a “smoking gun”, “gotcha” type short, this falls into the category of “good risk/reward.” We believe PSS is an overvalued no-growth retailer that is priced for perfection. Trading at 20x current earnings, bulls are more than pricing in a much anticipated turnaround that, if it happens at all, will take several years to materialize. If everything goes the bulls's way, we think PSS has the potential to be a $30 stock a few years down the road. However, we think there are reasons to believe that the bullish turnaround scenario won’t fully materialize, and even if it does, it won’t occur without experiencing hiccups along the way. As a result, we think that short sellers of this stock at current levels will be well rewarded.

The Business: PSS is a discount shoe retailer. They operate 4,600+ stores primarily in the US, making them the largest shoe retailer in the world. Their basic business model is to knock off successful designs from other competitors, source the shoes directly from Asia, and sell them at a big discount. Average price point is ~$11-12. Competitors include other shoe retailers (e.g., SCVL, DSW, etc.), as well as general discount retailers (e.g., WMT, TGT, SHLD, etc.).

Capitalization / Nums: Equity cap is approx. $1.7B. Cash is ~ $400mm, and debt is around $200mm, for a TEV of $1.5B. (N.B. – this ignores the $1B+ of off balance sheet lease obligations.) Revenue this year is projected to be $2.7B, with $1.14 of EPS, implying a 22x P/E ratio. Gross margins are in the low 30% range (33% est for ’05), while SG&A is in the high 20% range (29% est for ’05), resulting in an operating margin of approximately 4%.

The Bull Case: The bull story revolves around belief in a turnaround. From 1997 – 2000, PSS earned an 8% EBIT margin. Gross margins were slightly lower than today; SG&A was significantly lower. From 2001 on, the EBIT margin has been 6.1%, 7.1%, 1.2%, 3.4%, and this year is projected to be 4.2%. The bulls project returning to an 8% EBIT margin at some point down the road which would yield ~ $2.00/share in EPS.

In general, footwear retailers have traded for 10 – 15x P/E ratios. Putting 15x on $2.00 of earnings gives you a $30 stock. (PSS’s size would suggest that once the turnaround is complete there will not be much growth ahead. Thus, arguably the multiple that is placed on “full-potential” earnings should be at the lower end of the 10 – 15x range, which would mean the stock is fully valued already. Nevertheless…).

The Bear Case: The bear case is primarily one of premature valuation. It’s not at all clear that PSS can return to the 8% margins it once enjoyed. The category has gotten a lot more competitive over the past several years as department stores have lowered price points, and WMT and others have expanded their focus on apparel and footwear. Even if PSS could return to those levels, we’re talking several years down the road. (Anlaysts are modeling 4.5% - 5.2% for ’06). The discount rate embedded in paying $25+ for a stock that could be worth $30 a few years down the road – if everything goes perfectly – is insufficient.

The second part of the thesis revolves around execution risk. It is extremely rare to have a retail turnaround that works perfectly in a straight upward line. As PSS tries to re-jigger their merchandising (playing with price points, mix, etc.) and their store format, the potential for a hiccup is not insignificant. In their most recent conference call management reported that the “overwhelming response” from a “wide spectrum” of focus groups was that PSS represented “cheap shoes.” They went on to say, “This is a mindset we are committed to change.” Changes in “overwhelming” perceptions are not easy to pull off – especially when they involve trying to go up-market – and are certainly not risk free. Moreover, PSS management has been talking about trying to move up-market for several years, without realizing success. Why should it be different this time around?

The third part of the thesis is that margin expansion will be difficult and somewhat out of management’s control, as it will require top-line growth. Management does not believe there are significant opportunities to reduce operating expenses. Thus, margin improvement will require changes on the top-line – either higher gross margins, or higher SSS to better leverage the cost structure. Current gross margins are the highest they have been in the past 12 years, so…we don’t think there’s much upside there. SSS have been running negative low single digits for the past 4 years. This year, they are up about 3% YTD. A portion of that increase, however, is merely the benefit of retained revenue from store closings (i.e., as they closed stores over the past year, their remaining stores picked up some of the revenue from the closed stores. While this is good and profitable revenue to pickup, the SSS boost is one time in nature.) A meaningful and consistent uptick will be required to generate the hoped for EBIT margin improvement. With the increased competitive landscape, we don’t believe the uptick is likely to occur.

Fourth, PSS has an old store base that needs reinvestment. The average age of their stores is 15 – 20 years. Visiting a handful of stores reveals an old tired feel. Management has acknowledged that they plan to invest in their store base and that CapEx spending will be going up, but they have not quantified the magnitude of the needed reinvestment. Some industry commentators speculate that somewhere between $50K - $200K/store is needed to make an impact. That implies $230mm to $920mm of capital spending. While PSS has $400mm of cash on its balance sheet presently, embarking on a meaningful capital spending program raises the risk profile of the company. Moreover, if such capital spending is required to achieve the aspirational 8% margins, there are valuation implications.

Conclusion: We believe that given the nature of the business and the risks involved in the turnaround, a more appropriate price for PSS is in the mid-teens. Shorting the stock in the mid-20s provides good risk/reward.


- Realization that the turnaround dreams are too optimistic.
- Disappointments along the turnaround path.
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