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Subject:  K-Swiss KSWS Date:  5/16/2004  10:37 PM
Author:  kitkatklub Number:  671 of 1264

K-Swiss history

K-Swiss was founded by two brothers, Swiss skiers, Art and Earnest Brunner. They left Switzerland, moved to Southern California, sold their skis and became avid tennis players. In 1966, they introduced the K-Swiss classic shoe. This is an all-leather tennis shoe with a one-piece rubber outsole and a unique D-Ring lacing system. In 1986, K-Swiss was purchased by an investment group led by the current President(Steven Nichols--not GW Bush).

K-Swiss earnings really took off in 1998--from 35¢ per share in 1997 up to $1.10. The price of the stock began a serious climb in 1999. By 2000, the price dropped back to levels seen for most of the 90s. The chart does look something like the Matterhorn.

They began a long recovery which lasted until April 28 2004. Until April, the company had raised guidance more often than not--almost every quarter since 2001. On April 28 they were forced to lower second quarter earnings and revise full year earnings down, but that is not the entire reason the stock declined almost 27%. For that we need to go back to a lover's spat between Foot Locker and Nike that started in 2002.

Eternal Triangle-FootLocker, Nike & K-Swiss

The CEO of Nike, Phil Knight stopped shipping several of the popular Nike brands to Foot Locker in retaliation for Foot Locker's decision to give more shelf space to less expensive shoes. It was, no doubt, partly the result of low demand for the $200 Air Jordan XVII shoes. Sales were disappointing(big surprise-- $200 sneakers?).

The Nike move hurt both companies--price per share of Nike and Foot Locker declined significantly in 2002. Of course, the entire market was in decline.

Shares of Nike fell 6.8 percent after the company said the feud with Foot Locker Inc, its biggest customer, was hurting orders.

Foot Locker predicted orders of Nike products would fall as much as $400 million. As a result, Foot Locker had extra shelf space to fill, and one of the things that it filled it with was shoes from K-Swiss. K-Swiss has a large offering of products around $50. Just the ticket for Foot Locker's empty shelves.

Shares of K-Swiss did very well in 2003, gaining 122%. Sales to Foot locker grew and accounted for approximately 29% of domestic revenues. No other customer accounted for more than 10% of total revenues during this period.

Foot Locker and Nike have recently signaled that their relationship is on the mend. The six-month backlog for product from Foot Locker for K-Swiss shoes dropped 4% in the fourth quarter of 2003 and future orders are down about 30%. Presumably, more space will be given back to Nike. This was a severe blow to K-Swiss and the guidance for the second quarter and full year 2004 were lowered. That is when the bottom fell out of K-Swiss.

K-Swiss expects to earn 28 cents to 33 cents on sales of $111 million to $117 million for the second quarter. Analysts had expected 40 cents a share and sales of $129.2 million. For 2004, K-Swiss forecast a profit of $1.40 to $1.50 a share on sales of $460 million to $480 million, down from its prior outlook for earnings of $1.50 to $1.65 a share on sales of $490 million to $510 million. These are big misses on Wall Street and the investors headed (stampeded) for the exits.

Income Statement Ratios

2003 2002 2001 2000 1999
gross margins 45% 45% 42% 40% 43%
operating margins 20% 18% 17% 16% 20%
net margins 12% 10% 10% 9% 12%
growth revenue 48% 22% 6% -22%
growth gross 48% 32% 10% -27%
growth operating 68% 30% 15% -38%
growth net 75% 23% 10% -38%
growth COGS 48% 15% 4% -18%
growth SGA 34% 30% 3% -15%
growth EPS diluted 81% 28% 16% -35%
growth EPS cont operations 75% 42% 16% -35%
inventory/COGS 31% 33% 32% 33% 27%
growth depreciation -16% 6% 20% 7%
growth taxes 66% 29% 15% -38%
tax rate 39% 39% 40% 40% 40%

*Good margins(all of them) and net and operating margins increased. If margins were shrinking it would raise concerns about pressure from competition

*Growth in revenue and income was phenomenal for 2003--the Foot Locker effect?

*Inventory to COGS stable ratio-if inventory was outpacing cost(higher ratio)you would have to wonder why inventory was accumulating. When a company sells retail apparel, there is always a risk of being suck with out of style merchandise. In one instance, fictitious inventory can be created to create a lower COGS on the income statement (more “inventory” and stable COGS=lower price per unit) This allows a company to maintain the illusion of high margins even as they are trying to unload out of date merchandise at a discount. If COGS was increasing out of sync you would wonder about the company's ability to keep margins high.

Balance Sheet Ratios

2003 2002 2001 2000 1999
current ratio 5.86 5.30 6.43 6.45 7.54
quick ratio 2.23 2.18 2.81 3.04 3.05
AR growth 38% 21% 20% -9%
DSO 43.3 46.6 46.9 41.7 35.6
inventory days 114.1 122.1 116.4 120.2 99.1
growth in payables 40% 30% 9% 113%
growth in inventory 39% 21% 0% -1%
CCC 127.4 136.8 135.0 135.0 124.4
ROE 28% 21% 19% 18% 31%
ROA 21% 16% 14% 13% 23%
ROIC 30% 23% 19% 17% 30%
debt/equity 0.0% 0.0% 0.0% 0.8% 0.8%
debt/capital 0% 0% 0% 1% 1%
book value 5.0 3.8 3.3 3.0 2.6
cash/share $2.30 $1.87 $1.66 $1.69 $1.23
NC WC 95.9 65.3 57.4 54.2 61.6
change in NC WC 30.6 7.9 3.2 -7.4 61.6
increase/decrease total shares -0.8 -0.8 -2.9 -3.1 43
payable days outstanding 30.0 31.9 28.3 26.9 10.3

*Current and quick ratios are excellent as debt is low
*AR is growing, but not faster than revenue
*Days sales outstanding(DO)improved and is only a little over one month
*Able to extend payables
*Inventory turns are improving. It does take them 150 days to get orders filled and they need to keep inventory on hand to fill orders.
*ROE,ROA and ROIC are excellent
*Book value increased
*Debt low
*Total shares decreasing. K-Swiss returns value to shareholders.
*High amount of cash on hand that has increased

Cash Flow Statement Ratios

2003 2002 2001 2000 1999

growth in operating cash flow 25% 26% -23% -14%
operating cash/revenue 8% 9% 9% 12% 11%
operating cash/net income 66% 92% 90% 129% 92%
growth capex -5% 58% 140% -76%
capex/operating cash 5% 7% 6% 2% 7%
free cash flow 31.2 24.6 19.8 26.7 29.4
common shares 35.4 36.2 37 39.9 43
free cash flow/share $0.88 $0.68 $0.54 $0.67 $0.68
increase dividends 0.7 0.1 0 0.1 0.7

*Increasing dividends although the yield is only 0.51%
*Operating cash is not being consumed-remains proportional to revenue
*Declining capex-but this is not a company that needs to spend a lot on PPE. The shoes are made by independent contractors. All K-Swiss needs are offices and warehouses.
*Free cash flow is positive and increasing
*Number of shares decreasing

Customers and outlets

Products are sold 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--

The independent sales representatives are paid on a commission basis,and are prohibited by contract from representing other brands of athletic footwear and related products. These representatives sold to approximately 3,000, 2,900 and 2,900 separate accounts as of December 31, 2003, 2002 and 2001.

During 2003, the Foot Locker group of stores and affiliates accounted for approximately 29% of domestic revenues($115 million). No other customer accounted for more than 10% of total revenues during this period. It is easy to see that loss of sales to Foot Locker may hurt sales for the foreseeable future.


They buy shoes from independent manufacturers located predominantly in China. It takes approximately 5 months to fill orders(150 days). Footwear is generally shipped in ocean containers and delivered to their warehouse in California. In some cases, large customers may receive containers of footwear directly from the manufacturer. Distribution to European and certain other distributors is based out of the Netherlands

In 2003, approximately 99% of their footwear products were manufactured in China and 1% in Taiwan. This off shore production has allowed them to keep competitive prices in place(they have a lot of shoes that are in the $50 price range) while also keeping margins high.


Backlog is an important measure of potential future business. It is not guaranteed revenue as customers may cancel orders without penalty. These figures were for shipping dates of January through June 2004. The backlog for the year ending 12/31/03 was up 33.5% over 2002(total). Domestic backlog increased 31.2%. Much of this was from Foot Locker and the future orders are going to decrease by at least 30% according to the company.That will work out to around a 10% decrease in future orders.This will be mostly domestic and the company is looking to increase the European sales to help fill the shortfall.

They operate very efficiently. That is no doubt why ROA is good.Headquarters is in Westlake Village, California. The facility, which is owned by K-Swiss and is approximately 50,000 square feet. They occupy approximately sixty percent of this facility and lease the remaining portion.

They lease a 309,000 square foot distribution facility in Mira Loma, California. This lease expires in January 2007, subject to one option, which would extend the term of the lease for three years. The Mira Loma facility is the main distribution center and the effective monthly commitment is approximately $82,000. The do not have a lot of off balance sheet rent/lease obligations.

Bits and Bobs

Inventory is LIFO--last in first out which is more conservative. The main impact is on COGS.LIFO means inventory price has risen over time and and the remaining inventory (FIFO or first in) is at lower cost. The COGS(cost of sales) will be higher which is a more conservative statement of earnings.

Revenue is recognized appropriately when ownership has passed to the customer.
Provisions for returns and uncollectable accounts are accounted for.

Depreciation schedules for property, plant and equipment are carried at cost. For financial reporting and tax purposes, depreciation and amortization are calculated using straight-line and accelerated methods over the estimated service lives of the depreciable assets. The service lives of the building and related improvements are 30 and 5 years, respectively. Equipment is depreciated from 3 to 10 years and leasehold improvements are amortized over the lives of the respective

The company has been repurchasing stock and the number of shares outstanding is decreasing.In October 2002, the Board of Directors approved a $25 million stock repurchase program. This program expires in December 2007. At December 31, 2003, the number of shares purchased under this program was 1,760,600 and
the remaining available yet to be purchased is $1,715,000.

In October 2003, the Board of Directors approved an additional $25 million stock repurchase program. There was no activity under this program during 2003.

Advertising is expensed, not capitalized.

28.39% held by insiders

Management takes very reasonable salaries and bonuses. The president/CEO is paid a bit over $800,000 per year


(706,976) options were exercised @ $2.48 dilution to number of shares at end of 2002 was approximately 2%

3,669,270 shares are outstanding @$10.87
35.4 common shares outstanding means total dilution is 10.1%

Value of total options is $36.1 million or $1.11 per share

Discounted cash flow evaluation

K-Swiss is a modest well run small company. There are is no obvious malfeasance. The accounting principles are conservative and appropriate. The officers do not take big salaries. There is high inside ownership. The returns to investors are good. The price has afforded large gains to anyone lucky enough to buy several years ago.

Foot locker's defection is of concern. K-Swiss has had to lower guidance for this very reason. Growth in 2004 will be a lot less spectacular. The question we have to ask ourselves is if the current price is discounted enough for us to buy. At $19, it is certain that the investor will be hard pressed to realize a doubling or trebling of his/her investment. So if you are looking for a 10-bagger, K-Swiss isn't it. The dividend is not high enough to make it the sole reason for purchase. What should we pay?

Foot Locker's K-Swiss sales in the fourth quarter came to almost $18 million, just about $4 million more than the drop from the third quarter in its order backlog. This implies that Foot Locker ordered slightly less than $4 million of K-Swiss shoes in the fourth quarter and further suggests K-Swiss could see a falloff in its sales to Foot Locker.

K-Swiss sold approximately $115 million to Foot Locker in 2003. There are thoughts that the backlog ascribed to Foot Locker will decline at least 30%.That might imply that sales to Foot Locker will decline to $80 million. Unless K-Swiss has another outlet, they could see revenue decline in 2004. The company has guided down to $460 to $480 million for 2004. if we subtract $80 million from $429 million in revenue we get $349 million. This may be a little pessimistic and assumes the company will not grow and will not replace the Foot Locker shortfall.

6% 22% 48%--those are the growth rates in revenue 2001-2003. The 6% growth in 2001 was without benefit of Foot Locker and perhaps that is what they are capable of in the short term.I don't think Foot Locker will completely cut K-Swiss off and the opening of the 350 retail outlets from the defunct Foot Star may provide some shelf space for K-Swiss. For K-Swiss's part, they plan to provide product that retailers will have difficulty saying no to. The white on white logo/shoe color is passé and and K-Swiss is beginning to introduce color. The shoes are unquestionably well made. The fashionista aspect must be addressed. They seem to realize it.

Giving them 9% growth, (which is what they were capable of before Foot Locker+ GDP growth) for the first stage and 3% stable growth, we get a value of $19.75. It would seem that the market has priced in the uncertainty. The other inputs were a 9.92 risk (4.2% risk free +5.5% market premium); capex, noncash working capital and depreciation grow at the same rate as revenue,; capex exceeds depreciation by 75%; and a beta of 1.

At the current prices(not deducting for options) they appear to be fairly valued. If you agree with deducting for all outstanding options the fair value would be $18.64. They are a strong company, well run and shareholder friendly. The size of the discount would depend on what you believe they can do without Foot Locker. I would rather pay $14.91 with a 20% discount, but I doubt they will get there.
They are a little bit like Saucony. They cater to a more eclectic shoe buyer and are not found at a lot of retail outlets. There is an aura of exclusivity. This works for them in the sense they are considered "good quality". They won't be found for $9 at WalMart( where I buy my tennis shoes). Since I looked at Saucony, the company has climbed slowly by about 18%. This is in a dynamic market. I would compare K-Swiss' growth to a company like Saucony-- a limited distribution of quality products that have a loyal following.

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