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Core biz hit bottom, new biz ramping while R&D rolling and product costs out of Asia are down. New CEO at FL is big call option. Until then, $11 stock with $5 is cash. Not bad when I’m modeling a 40% 2-yr growth acceleration and 25 point boost in mgns.

It’s pretty darn rare for me to warm up to a story when sales are down 35% and inventories are flat. That kind of trajectory and its implication for margins is just outright scary. But K Swiss is proving to be the exception. I think we’re at an inflection point here. It will initially be a ‘results are trending less bad’ story, but I have many reasons to believe that fundamentals will turn positive within 12 months.

Here’s the ‘Then vs. Now.’

Then… (2007-Today)

1)      K Swiss has had a fashion trend going against it for the past 2-3 years (weakness in ‘classics’), which hit revenue by 50%.  Some companies would retrench and pull back in every spending area imaginable when under such top line pressure. But KSWS invested in two new technologies – Tubes and miSoul in order to grow around the core fashion category.

2)      At the same time, we were looking at the tightest capacity strain out of Asia that we’ve seen in over 10 years. Not a pleasant margin event for anyone in this industry – especially a small player like KSWS.

3)      Foot Locker was a massive drain on KSWS’ top line. I’d characterize FL as one of the worst managed companies in retail over the past ten years – up there with Sears. As FL struggled with its US business, it cut KSWS orders meaningfully. FL went from a peak of 29% to less than 10% today. Being held hostage to a bad retailer is, well…bad.

4)      At the same time, the company was also dealing with its failed Royal Elastics division, which was losing money and distracting management.

Going Forward

1)      The new running line is ramping up at the same time the R&D related to the technology is rolling over. In addition, a new line is always lowest margin when it starts – i.e. now. Each incremental pair that sells gets more profitable due to amortization of tooling and molds.

2)      I feel pretty comfortable in banking on KSWS’ ‘classics’ business being close to the bottom. It’s now sub-$200mm globally. The math there on both door penetration and pair per door is pathetic.

3)      We don’t need to assume any growth in the core, and with the addition of running, Palladium (its new boot business) and skate, we’re looking at over 40% growth in revenue over 2-years.

4)      With costs out of China coming down near double digits for footwear as capacity reopens from 6,000 factories up to a number closer to 10,000 in the Pearl River Delta, there is a meaningful COGS tailwind.

5)      Let’s not forget the Foot Locker factor. Next week, the new CEO starts his job – Ken Hicks, formerly President and head merchant at JC Penney. Think about it…If you come from a company where you flat-out own every vendor that tries to sell to you, and you end up at a retailer where one brand is half of your sales (Nike), what will your first move be? Probably to sit down with smaller, but profitable, brands that can be better partners to Foot Locker under its new leadership. Keep in mind that a K Swiss classic shoe is one of the most profitable sales for FL. I don’t have anything in my model for a major change in this relationship.

6)      Did I mention that KSWS has over $5 in cash on its balance sheet? With the stock at $11, and near a buck in EPS power, this is tough to ignore.

What concerns me…

1)      Time… You could have made the ‘great balance sheet’ call in each of the past 3 years. You’d have gotten smoked. There’s nice support here, but it might take time to get paid.

2)      I can’t shake the possibility that this management team goes out and does a stupid deal to ‘get more connected with the youth consumer.’  C’mon guys… Fix your current business, pull the levers you can, and get on with it. You’ve proven that your deal prowess isn’t anything to write home about. In fact, you have yet to make one work.

3)      I want to make sure that these guys are allocating enough capital to growing these new businesses. If it turns out that I need to take up SG&A in my model north of 10% to get the product to resonate w consumers, then it’s tough to find any earnings.

KSWS: Warming to a Dog - KSWS miSOUL

KSWS: Warming to a Dog - KSWS Palladium 2

KSWS: Warming to a Dog - KSWS Tubes