PSS: The Decision Tree

This is 2008 all over again, where three words in a press release make all the difference in the stock – Reviewing Strategic Alternatives (or Hiring Goldman Sachs).

The quarter was definitely upbeat – especially in light of the weak numbers we saw today out of Brown Shoe – and was better than our expectations. What really surprised us there is that this was the quarter for them to take every charge, build every reserve, and find every possible area to front-load costs in the wake of Rubel’s departure. They did  this to some degree, but not as much as we thought.

There were two options for the management team heading into this event. A) Saying and doing nothing about its strategy, or B) taking the bull by the horns and showing that it is in control of its destiny. We definitely got #2, or at least the appearance of #2.

On one hand, they said that they were going to Review Strategic Alternatives – which could be complete smoke in mirrors. Perhaps they split the company up, but on the flip side, they said that they’re going full bore in closing 475 (~10% of total) stores – most of which are by year-end – and are on a very active hunt for a CEO. We can’t imagine that they’d hire, or attract, a high-quality CEO when there is an asset rationalization and Strategic Review Plan already in place.

At this point, there are essentially three outcomes for investors:

1. An all out sale of the company.
2. A sale of some part of the company.
3. No sale at all. Instead, the company names a new CEO and gets to work on closing stores, or whatever the new strategy will be.

The first two outcomes have been on the table since ex-CEO Rubel’s departure, but the third and most likely outcome just got considerably more favorable. Here are our thoughts on each:

1) An all out sale of the company:

• This is the least likely of the three scenarios given the disparate characteristics of two business that would ultimately attract different buyers.
• The high fixed cost and real estate intensive nature of the domestic Payless business is best suited for a financial buyer. One with a Ron Johnson-like 7-year duration that can take control, absorb losses, and slowly but surely take the store count meaningfully.
• Another possibility is a large property owner like a strip-mall REIT that is better equipped to utilize the company’s store base and either take out/take down the leases, or flip them to a more profitable concept. But these companies are hardly cash-rich right now.
• Based on our breakup analysis, we get to a valuation of $3-$6 per share for the ‘core’ payless business (both domestic and international) taking debt into account and $9-$11 per share for the PLG business on our bear case assumptions. $3-6 + $9-11 = $12-$17. Using less than heroic assumptions, we can get a valuation for the PLG business in the mid-teens to low-20s alone.

2) A sale of some part of the company:

• This is a distinct possibility, but the company is less likely to sell off PLG in its entirety as the company’s key growth engine.
• Saucony and Sperry are the most likely candidates and both could see interest from both financial and strategic buyers.
• Re Saucony:
• VFC could buy it in a heartbeat. It’s small enough that they can do this side by side Timberland.
• Adidas makes sense. They’ll do anything to get into the technical running market. They’d rather buy Asics, but if the price is right it can happen.
• Why not Li&Fung? Li Ning? Yue Yuen? Li&Fung has stated flat out that it wants to buy brands to leverage its scale. Yue Yuen has diversified into retail. Moving into the content side of the equation would definitely leverage its manufacturing base.
• New Balance, Asics, and Under Armour are all out.
• Nike wouldn’t touch it with a twenty foot pole. The irony is that Nike does not do well at all in the technical running category – despite the fact that it views its birthright to be rooted in running (watch the movie ‘Without Limits’ or ‘Pre’). An interesting angle on Nike’s running share… it has about 35% share in the running space. But count the number of swooshes on the feet of the first 20 finishers of the Chicago marathon. You’ll see far fewer than 35%. Nonetheless, the factoid here is that as long as Nike THINKS it can dominate this category (which it does) it won’t buy anyone else. It’s a strategy that has paid off for shareholders, by the way.
• Re Sperry:
• A financial buyer is more likely. This brand is strong enough to be a stand-alone company – and even a public one.
• On the strategic side, there’s everyone from VFC, to JNY, to the same Asian acquirers that we think are going to make their way into this market.
• We’ve already hit on the valuations above, however in breaking out PLG further, Stride Rite and Keds are worth $1-$2 per share with Saucony and Sperry valued at $9-11 with slightly more than half of the value attributed to Saucony at $5-$6.
• There are no structural impediments that would prohibit a carve out of PLG from happening. However, carving out a single brand within PLG would be a bit more difficult in terms of integrated back office functions. Consider the following…
• It took the company a very very long time to integrate some of the back-end infrastructure (consolidated 2DCs and a manufacturing facility) and pulled roughly $25mm of SG&A out, but the PLG brands still operate independently to a large extent.
• The entire PLG team still operates out of their own HQs in Lexington, MA.  
• It wasn’t until Q2 that only some of the PLG stores were hooked into the same PeopleSoft financial systems that the core domestic Payless business uses and in a similar fashion, the retail systems that count traffic/store metrics are also still largely independent from one another.

3) No sale at all. Instead, the company names a new CEO and gets to work on closing stores:

• Business as usual is probably the most likely outcome as the company completes its strategic review process.
• Assuming an asset sale does not occur, who PSS hires as the new CEO will be the most important near-term catalyst. (positive or negative)
• The board wasted no time in getting a plan in place to aggressively reduce underperforming stores, which is the most significant positive development to come out of Q2 results.
• In total, the company expects to close approximately 475 stores (~400 Payless & ~75 Stride Rite) over the next 3-years with 300 closings by year-end with most coming after the holidays.
• We are modeling approximately 60 store closures in Q3 and another 255 at the end of Q4.
• With roughly $110mm in revenues associated with these stores, we expect closures to impact revenues by $5mm in Q3 and ~$15mm in Q4. The greatest hit to revenues will come in F12 (~$75mm) given the timing of closures in F11.
• Additionally, there are $25-$35mm in costs (lease terminations, severance, etc.) associated with these closings, the bulk of which are expected to be realized in the 2H F11. Of course, the Street will strip these costs out as being non-recurring – even though they represent real cash going out the door, and PSS making up for poor decisions made in years past. Nonetheless, on an ‘adjusted’ basis, we’re likely to see far better comparision starting in 1Q12.
• Lastly, the net benefit of these actions are expected to improve EBIT by $18-$22mm once all closures are completed. We’re modeling in an incremental $0.15 in F12 EPS as a result of these actions.
• Gross margins came in worse than expected in Q2. Given continued pricing adjustments in the 2H along with 13% product cost increases, we’ve lowered our gross margin assumptions in the 2H to down -325bps and -100bps in Q3 and Q4 respectively.
• Assuming PSS continues to operate as it exists today (incl store closures), we are shaking out at $0.75 for F11 EPS and $1.44 for F12 EPS.

Of course the biggest question is not being asked at all. And that is whether Payless has even earned the right to exist at all.

1. It has underperformed in strong consumer environments, and underperformed in ‘trade down’ climates.
2. It underperformed by having too much exposure to third party buyers/designers, so it took those functions incrementally in house. Then it overshot and underperformed, and realized that it needed to shift back closer to the original model (where it underperformed).
3. It went in with more aggressive opening price points in the fall of 2009, and that did not work. So then they went in with higher prices in 2010 – which didn’t work. Now they’re ‘sharpening’ opening price points again.
4. Should this be a 4,500 store chain? Why not 3,000? Why not 1,000?

It’s not clear if the Board is asking this at all.

So…what to do with the stock with the monsterous pop it is having today? Definitely don’t chase it – though that’s likely a foregone conclusion. When all is said and done, we’ll be interested to see how much of the day’s volume is short-covering. This stock typically trades at ~10x EPS and 5-7x EBITDA, which suggests a value about where it is now. We think that a break-up value is a good 25% higher, but we need better confidence that this beast will, in fact be broken up, or that a new CEO will raise the bar to take our estimates meaningfully higher before we get back involved…