VFC BUYING ZQK’S DC SHOE?

Despite my initial gut, it makes a ton of sense. If my price math is right, the big winner is ZQK as it mitigates balance sheet risk. VFC buys eps leaving Nike as the stand alone candidate for TBL.

I didn’t see this one coming… The buzz out of ASR (Action Sports Retailer trade expo) is that VF Corp is buying DC Shoes from Quiksilver. There are two things to consider. 1) Does the deal fit strategically for VFC, 2) why in the world would ZQK sell its fastest-growing business, and 3) what does this mean for the investment case for each.

1) Does The Deal Fit? At first glance, my sense would be ‘No’ given what appears to be meaningful overlap between DC Shoes and VFC’s Vans. But the reality is that distribution is radically different, with Vans geared disproportionately toward company-owned stores, National Chains, and Shoe Chains, and DC geared towards athletic specialty and department stores – and at a 30% premium to Vans. VFC gives DC a platform to grow in Europe – a region where skate is a solid market, but one where DC has largely failed to grow under Quiksilver’s leadership.

Another consideration is that with VF Corp growing Vans, Reef, and The North Face footwear, it increasingly needs scale as the Asian factories gain leverage in this new reality where factories are closing, and pushing costs to US brands and retailers that are losing leverage on the margin. This would help VFC in that regard.

Another factor to keep in mind is that VFC was one of two likely buyers for Timberland. If this deal goes through, it’s basically up to Nike to step in and buy Timberland.

2) What is ZQK Thinking? Why sell its fastest-growing division? This is a function of ‘want vs. need.’ Does the company want to divest DC? I know for certain that the answer is No. But with the stock just over a bone, and with the EBITDA multiple well above the earnings multiple – it’s clear that the balance sheet matters far more than just about anything business-related.

So what would ZQK look like ex-DC? It’s impossible to tell for sure given that lack of any price disclosure. ZQK bought DC for about $100mm in 2004 when DC was at $100mm in revs and 9x EBITDA. On one hand, multiples have been crushed – which is stating the obvious. In addition, DC has failed to realize any scale benefits, and margins are still sitting near 10%. On the flip side, ZQK has grown DC from $100mm to about $475mm. If I assume 10% EBIT margins, 3% D&A, and a 5x cash flow multiple – then it suggests about $300mm in cash to ZQK. That’s not to mention divesting ZQK’s biggest working capital drag (footwear is the biggest drag after the now-divested hardgoods business). Based on those assumptions, my math is that this divestiture would be accretive.

Backing this business out of ZQK, my math leaves me with about $0.35-$0.40 per share in earnings. Not bad for a $1.50 stock whose debt/EBITDA goes from 5x to 4.2x with such a deal (and from over 8x with hardgoods). That’s not to mention that this would leave ZQK with a core apparel business (Quik and Roxy) where it could refocus on getting margins back into the double digits – something I thing is very much within reach.

3) What Does this Mean for the Stocks?
• ZQK: If this deal happens in the ballpark of the numbers I discussed, my math suggests a value today for ZQK at least 2x where it went out on Friday. A year out (if the co can realize margin goals) then we’re talking much higher.

• VFC: This would conveniently come at a time when VFC’s base business is fizzing out, and earnings expectations are way too high for 2009. The purchase price in question will not break VFC’s bank, and will help the company grow earnings – even if not organically. Again, this is all price-dependant, but at face value this is a positive for VFC.

• TBL: Bad for TBL. There were two likely suitors. VFC and NKE. A field of one would not help TBL’s bidding dynamics.

• Other bidders? Nike would not touch DC, in my humble opinion. Not because it does not like the category. Quite the opposite, actually. Mark Parker (CEO) is very much in tune with the relevance of the skate consumer. But that is why Nike has developed its own skate brand over the past 5 years. Keep in mind that Nike bought Hurley to better understand the skate consumer. Now Nike skate (6.0, etc…) eclipses Hurley in size. Nike’s motto is ‘why buy another brand when we can beat them organically with our own?’ Regardless of whether or not they can win, as long as they believe it, then they’ll deploy the capital internally as opposed to externally – and likely get a higher ROI. I’d be surprised to see other bidders here unless the announced price is egregiously low.