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Author: educatedidiot Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 70  
Subject: VANS Date: 3/17/2003 1:32 PM
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This board has been dead for a while, but maybe there are still a few people lurking. I feel that VANS is an attractive investment at current prices.

Overview

Vans is a shoe manufacturer that primarily targets the extreme sports market (skateboarding, snowboarding, BMX, mountain biking, etc.). Revenue is generated from three different categories: retail, national, and international, in equal proportion (each represents 30-35% of total revenue). Retail sales consist of sales made through company owned Vans stores (149) and company owned skate parks (12). National sales consist of all other US sales (i.e. sales made through Footlocker and other similar accounts). International sales consist largely of sales made through seven outlet stores in Europe.

Why invest in VANS?

I view this investment as a turnaround. As such, I will first go through the primary factors that have lead to poor business performance, and I will then explain specifically how I see the turnaround taking place.

What has happened?

Let's start with a simple table:
        Sales    EPS   Gross   Operating    Net
Margin Expenses Margin
May-02 332.4 -$0.15 48.3% 44.4% -0.8%
May-01 341.2 $1.02 45.3% 35.2% 4.4%
May-00 273.5 $0.84 43.7% 35.0% 4.4%
May-99 205.1 $0.64 44.0% 37.3% 4.2%
May-98 174.5 -$0.20 37.8% 33.3% -1.5%
AVG 43.8% 37.1% 2.1%

Gross margins ramp up nicely for 5 years. Despite this, in FY02, a 9% increase in operating expenses as a percentage of sales wipes out the 4% net margin.

What caused the margin decline?

In general, the company tacked on a lot of fixed costs (predominantly occupancy and some selling expenses) while sales were comping negatively – the result is obvious. In FY02, retail SSS were down 3.5% and skatepark SSS were down 25.2%. The decline in retail sales can be partially, but not entirely, justified by weak consumer spending. The skate parks, however, have seen sales drop off a cliff due to competition from free community skate parks. Three years ago there were 300 community skateparks across the US; today there are over 1000.

Also affecting margins in FY02 were an increase in advertising and promotions by 37% over the previous year. When sales didn't pan out as planned, marketing as a percentage of sales ballooned from 7.3% to 10.3%.


Skateparks

Even though they represent less than 7% of revenues, the skate parks are probably the most significant factor eating away at margins, so this area of the business deserves more detail. The company operates 12 skateparks across the US (to be 11 when Bakersfield is officially shut down). The twelve parks brought in around $20 million in revenue, but generated a $4.5 million operating loss ($2 million EBITDA loss). Of the twelve parks, 7 parks are around breakeven with the remaining 5 responsible for the huge losses. One of these 5, a park in Bakersfield, California, is currently being shut down.

From this we can deduce that the total operating costs for a skate park run around $2 million. The five worst parks are generating around $6 million in revenue on around $10 million in operating expenses. Shutting down one of the underperforming parks should yield around $1 million in pre-tax earnings, or around $0.03-$0.04 EPS (after-tax).

It isn't quite that easy though. First of all, the skateparks can't be readily converted into retail stores by the company. Vans' retail stores are around 2000 sqft, but the skateparks are an order of magnitude larger, with most of them exceeding 45000 sqft.

Secondly, the leases vary, but they generally have an initial 10 year term with a 10 year renewal option. The oldest park is only 4.5 years old. Also, landlords have already footed a substantial portion of the bill in building these parks, so they obviously aren't going to be very enthusiastic about letting Vans out of one of their leases or loosing up on its terms. Despite this, Vans was able to get out of the Bakersfield lease, so there is certainly hope for some of the others.

Management clearly made a huge mistake with the skatepark expansion, and not just because they didn't foresee the increase in competition. The economics of running a skatepark make very little sense to begin with. Here's a table of Vans' rent expense over the years:
      Rent
2002 17,618,000
2001 13,149,000
2000 8,934,000
1999 5,717,000
1998 4,897,409
1997 5,830,000
1996 5,068,000
1995 4,279,000
1994 3,888,000

Combining these figures with the increases in retail store and skatepark square footage, you can determine that the rent on a skatepark is fairly close to what Vans pays on one of its retail stores, around $25 per square foot. Given that the average park is 43,000 sqft, we're looking at around $1.1 million in rent per park. As I mentioned earlier, total operating expenses run around $2 million, so rent is about 50% of this. In a case like Bakersfield (a 59,000 sqft behemoth), revenue wasn't even covering the rent let alone the SG&A expenses.

Additionally, even though the landlords are paying for a significant amount of the construction costs, Vans' capital expenditures are still around $2-3 million per park, which certainly isn't an insignificant amount.

The company originally planned to have around 20-25 parks by now; the current count is soon to be 11. Only one skatepark is currently being planned (Sacramento, California) and it isn't expected until 2004. This park will be a little smaller than the average at around 40,000 sqft.

Liquidity and Free cash flow

This is where Vans gets interesting. Working capital less inventory less deferred tax asset less total debt stands at $3.54 per share, roughly at par with the share price. Cash is $3 per share. Tangible book value is $8.19 per share.

What gets my attention is that management has slashed the CapEx budget drastically until they get their sales woes straightened out. As a result, even with the huge skatepark losses, the business can still be expected to generate cash, albeit only marginally above breakeven. Current EPS guidance is for around $0.04, and management has already modelled negative mid single digit retails comps into this number.

Annual depreciation should come in around 8-9 million. CapEx going forward, on the other hand, should come in around 6-7 million. Included in this figure I am modelling around 5 new stores annually @ 300k per store, and 10 remodels @ 200k per store, which is in line with what Vans has historically paid. As you can see, even with earnings coming in around breakeven, there should still be a little cash flow provided by the spread in CapEx and depreciation going forward.

The turnaround according to management

Vans management has some ideas about how to turnaround the business, but I'm not optimistic about many of their plans.

For the parks they intend to:
1) Simplify the pricing structure to make the parks more attractive to skaters.
2) Negotiate better leasing terms with the landlords.

I think #1 is a waste of time, but hey, I'll let them give it a shot. Changing the pricing structure would be an effort to appeal to the more value-conscious customers. The problem with this is that their main competition is FREE. If anyone is leaving a Vans park because of the price, a drop from $11 to $9 isn't going to tear them away from a free park. When you are competing against free you have to differentiate based on service and customer experience; trying to offer a better 'value' is a waste.

#2 is simply begging, and as I mentioned previously, I doubt the company gets very far with this strategy.

As for turning around the rest of the retail business, the company has a few other ideas:

1) Getting Vans product into stores where their key customer shops, whether that is skate/surf speciality stores or PacSun or wherever.
2) Increase targeting of 10-20 year old female customer.

I don't know why management keeps parroting #1 lately given that this has been a big part of their strategy for a while now. It sounds clever though and I guess that's why they keep repeating it to the analyst community.

#2 at least sounds like a viable strategy, but your guess is as good as mine as to whether it will lead to increased comps.

The turnaround as I see it happening

Within the next 24-30 months I see margins returning to the 4-5% range on roughly flat sales. How do we get there?

1) The company is not planning any major skatepark decisions for at least the next six months. After this time, however, I expect to see them plan the gradual closure of 3 or 4 additional parks. As I explained earlier, closing these parks should yield $1 million in pre-tax earnings a piece.

2) Retail sales comped down -9.3% in the second quarter, and they were even worse prior to this. The weak comps for the past few quarters are being caused partially by general weak consumer spending, and partially by Vans' having underinventoried stores (they were 17% lower y-o-y in Q2, and 12% lower in Q1 – on a per store basis the decline is even more significant). The inventory situation is a management gaff that is clearly fixable. Retail spending will pick up again eventually, and when this happens I don't see any reason why Vans won't benefit. The company spends a lot of money promoting and building its brand. If Vans didn't do this I might be a little concerned about the ability of sales to rebound with consumer spending, but this isn't the case. The company also has several initiatives in place to improve comps, but I don't place particular faith in any of them driving comps.

3) Marketing and promotion will return to regular levels, which will save 2-3 margin points over last FY from this alone.

From the few years before 2002, marketing and promotion was typically 7% of sales. After reaching over 10% last year, the first two quarters are already running around 1-1.5% lower at 8.9% of sales. In the past few quarters the company has been actively decreasing marketing and promotional expenses as part of their restructuring plan. While marketing came in around $34 million last year, I think it is reasonable to expect $25-$30 million annually going forward. The company has been taking the steps necessary to make this happen. Also, any pick up in retail comps will provide some additional leverage to make the 7% a more realistic goal.

4) General and administrative expenses have been inflated recently by several one-time charges that will eventually disappear. They are still digesting the Mosa acquisition. They also have some ongoing litigation costs. For the first half of this FY these have resulted in around $2 million in G&A charges that are one-time in nature, IMO.

Valuation

Within the next 24-30 months I expect to see around $340 million in sales with 4-5% margins, or around $0.85 EPS. Giving this a multiple of 7x and adding $4 in cash (my guess) we arrive at around $10. With a current share price of $3.57, that would provide for a gain of around 3X in the event of a successful turnaround.

In the event that margins don't turn around, I would expect management to keep the CapEx budget low. As a result, the company probably wouldn't start bleeding any cash unless retail sales completely fall apart or if the skatepark loss widens further and the company is unable to get out of any of its leases. This last scenario is highly improbable IMO, and the more likely negative scenario is the one that sees the company stagnating at breakeven free cash flow for the next few years, thus creating a dead investment.

The probability of the turnaround happening, and the anticipated return associated with this event, more than offset the risk IMO of the negative outcomes that I have outlined above.

Additional details that may be of interest:

Stock options

Stock options have been reasonable at Vans. Cancellation rate has also likely been high given the stock performance over the last couple of years. Grants for the last few years as a percentage of OS are:
      Grants   % of OS
2002 205,000 1.1%
2001 813,000 4.7%
2000 307,000 2.2%
1999 529,000 4.0%
1998 243,000 1.8%
1997 465,000 3.5%
1996 425,751 3.4%

Currency risk

There is currency risk here due to Vans' strong international presence. They are exiting the South American market at least, but they have been negatively affected in the past by a weak Euro.

Returns on Invested Capital

Vans' ROIC is pretty weak. In a good year the company can get around 15%, but over time this figure averages out to around 10%. In comparison, Nike's ROIC is consistently around 20%. A weak ROIC is naturally going to inhibit the rate of future growth, but this isn't important to my investment thesis. I'm not looking for any sales growth here, and I don't intend on holding the shares for more than two years. I am only looking for the turnaround that I described above.

Catalysts

1) Improving comps once the company works through its underinventoried situation, and when the retail landscape improves.

2) Margin improvements driven by:
- a planned decrease in marketing expenses
- shutting down a few additional skateparks
- the removal of one-time G&A expenses, specifically the ones associated with the Mosa acquisition.

3) Any positive free cash flow will add to the cash balance and raise the floor on the stock. I don't see the company trading below cash unless the business falls apart.

4) A stock buyback; however, I am not expecting to see one that is large enough to be meaningful. With over $3 per share in cash and no debt, the company would appear to be liquid enough. A repurchase program was announced previously, however, the company did not execute on it during Q2.
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