PSS: Draconian

 

 

The bottom line is that the liklihood for this company to look materially different -- in 6-12 months -- perhaps smaller, but more profitable and less levered, is quite high. Though we still have lease accretion/dilution math to crunch, in looking through the decision tree, we don't see how the recent turn of events can be viewed as anything but positive. 

 

After the last quarter, we expected draconian change at PSS. We simply did not think that Matt Rubel leaving would be it.

 

The circumstances were pretty clear to us. Matt has his plan, and wanted to make certain moves in the wake of the company's performance over the past year. But the Board felt differently. Our sense is that the Board was looking for more draconian change, rather than tweaks to the strategy. 

 

The last thing that Matt wants, or needs, is being at odds with the Board of his Company. Let's face it...he's a pretty strong personality.

 

We've been pretty adamant that at his age (53) he has at least another job left in him. We thought that he'd capitalize on that AFTER a meaningful rebound in the stock. But with a $10mm peck on the cheek on the way out, it definitely helps ease the pain.

 

Our strong sense is that he'll relax for a few months, and will be picked off to run a company that is not so limited in growth potential.

 

One thing we'll give the Board credit for is not sitting idle while the stock so grossly underperformed. We were not privy to the the precise discussions behind closed doors, but at least the Board asked the right questions. The result is clear. This happened after only 6 quarters of meaningful underperformance. Maybe I was numbed by the pain of seeing Boards like Liz Claiborne sit there with blinders on through 17 quarters of Chinese water torture.

 

So what does all of this mean for PSS?

  1. Yes, this is a game changer to any investment thesis. The interim CEO is a lawyer, who will bide time until either a) someone is brought in to really move the needle with changing this business model (think Crocs), or a) the company is bought by a financial buyer.
  2. Why a financial buyer today and not yesterday? The reality is that any buyer would need complete buy-in from Matt as well as the team he assembled -- who is loyal to him. That's a risky proposition given the culture that Matt instilled in this company. But with the Board doing the dirty work, the risk profile goes down for a financial buyer to come in and either break it up (think Fortune Brands) or keep PSS intact yet grossly cut the store base
  3. Some hypothetical math...
    • let’s do some simple math. Core Payless accounts for $2.5bn in revs, with PLG at about $1bn. But PLG accounts for about $70-$75mm in EBIT. Yes, that means that core Payless stores are currently churning out about $70mm/year based on our model. $70mm on $2.5bn in sales? That’s a 2.8% margin business, which is simply awful for a model with relatively low operating asset turns.
    • The Hypothetical… So, if we’ve got 4,800 stores running at an average margin of 2.8%, do you think they’re all running at that rate? No. In fact, one of the most poorly understood parts of retail (due to GAAP reporting standards) is the massive gap that exists between a given company’s better vs. poorer performing stores. Our sense is that about a third of Payless stores are dilutive to the P&L, and upwards of half that number are cash-flow dilutive. If we assume that these stores have sales productivity that are 2/3 that of the average PSS store, and that 800 are taken out, it gets us to about $275mm in revenue lost, but $25-$30mm in EBIT gained. Our math might not be spot on, but we think it’s directionally accurate. In this situation, we think the Street would look right through a special charge – even if it’s all cash.
    • Most people would argue that this math is a bit extreme, as its clearly many times what management has referred to in the past as % of stores that are cash flow negative. But we think this is the new normal -- and we think that Board is inclined to agree -- or at least seriously consider the possibilities. A consistent low growth, high inflation environment is a game changer for evaluating the quality and consistency of a portfolio.
    • We noted after the last (disastrous) quarter that this kind of math is useless if the CEO and the Board ignore it. We did not think it would be ignored at PSS. But perhaps not acted upon so soon.
  4. With a $10mm charge in the quarter, and the high probability that the company will sweep everything under the carpet this quarter certainly does not bode well for 2Q earnings. But the reality is that since the last miss, the amount of call volume I had on this name has been close to nil. Am I suggesting that this is the kind of event where Matt Rubel leaving will be a stock-popping event (ie Bill McComb at LIZ)? No. But in going through cash flow scenarios, I question how this could really be bad for shareholders unless the Board brings in someone who tries to follow Matt's plan and the shoes simply don't fit.

The bottom line is that the liklihood for this company to look materially different -- in 6-12 months -- perhaps smaller, but more profitable and less levered, is quite high. I cannot envision that with such poor sentiment on this name that this won't play out as a positive. 

 

We already get to meaningful support for the stock in the high-single digits for Saucony and Sperry alone. The next -- and very important -- question is 1) how many stores should be closed, 2) how many CAN be closed, 3) what is the financial cost to get out, and 4) will that be accretive or dilutive after netting it against the improved cash flow. This is not a 'back of the envelope' analysis. Stay tuned...we'll be back with more details.