Boring Name, Interesting Restructuring
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Brown Shoe (NYSE: BWS) is a small-cap retailer and wholesaler of shoes. Despite being listed since at least the late 1970s, at least, Brown Shoe is still trading at roughly the same level as it was in the early 1980s. It has three divisions: Famous Footwear a 1,000+ shoe retailer with a growing online presence, Speciality Retail which has a larger online presence as well as 234 stores under assorted names, and Wholesale which designs, sources, and markets shoes (Brown acts as both a licensee and a licensor of designs). The shoe business is tough as the history of Brown Shoe's share price and financials attest; since 1984 the company's ROE has averaged ~6%, however, management has really altered the direction of the company.
No longer directly involved in manufacturing but sourcing shoes from third-party independents mostly in China, This new model requires less capital, utilizes Brown Shoe's scale in sourcing and distribution, and allows the company to focus on retailing and trying to create and utilize "brands." Over the past ten years (exc. extraordinary charges), Brown Shoe's return on equity has been double the 1984 average. However, this route has involved new costs too.
Brown Shoe has made $390m of acquisitions since 2006 ($340m net of disposals). The $150m impairment to goodwill in FY/09 clearly highlights the potential hazards of this new strategy. If the company does not build brands, it has to license them or buy them in as it did late last year with American Sporting Goods Corp.
Looking at the historical performance of the company we find that Famous Footwear has really led performance at Brown Shoe over the past five years. The number of stores has been somewhat flat so the majority of top-line growth for Famous Footwear has been achieved with increasing sales per store. E-commerce sales are also becoming important for Famous Footwear, without them the FY/12 decline in stores would have hit the top-line far harder. The performance in Wholesale has been more volatile through the recession but sales have bounced back hard from the FY/10 trough. Unfortunately, operating margins have gone the opposite way nearly halving since FY/10 and leading to a 30% fall in recurring operating profit. Specialty Retail has kept losing money, at 10% of total revenue and a FY/12 operating loss of $7.6m the problems here are perhaps less urgent than at Wholesale, but they are still a lag on overall performance. FY/12 did see some improvement both in e-commerce and retail stores however, the stores are not at a profitable level yet.
The company has responded to this underperformance in Wholesale and Specialty with it's "Portfolio Realignment" program. In short, this will attempt to exit from unprofitable and non-core lines of business. The first stage of this was the sale of AND1, a company acquired as part of the American Sporting Goods acquisition. The company registered a pre-tax gain of ~$20m which is clearly great news for shareholders. Other stages included exiting certain lines and closing distribution centers, a Chinese factory (seemingly acquired with ASG), and closing unprofitable stores. The key question when companies pursue these programs is whether these cuts are going to disrupt the company's core business? In this case, we can could suppose there is a lot of room here. Speciality Retail clearly needs a big overhaul and the problem with Wholesale has clearly been it has pursued growth in some presumably unprofitable areas. As we will see later, the first quarter for Brown Shoe was very strong, but implementing this restructuring may cause disruption. At the very least we can highlight that selling AND1 is clearly a fairly unobtrusive beginning to the program.
Returning to the first quarter again, this strong showing has been the main reason for the YTD strength of the share price. I think the main reason for the favorable reaction to Q1 was figures from Famous Footwear, which registered 2.6% same-store sales growth, a fairly respectable figure in a very mixed retail environment. The results from Wholesale and Specialty Retail were certainly far less impressive. Wholesale registered continued top-line growth; however, inventory markdowns led to weak profit. Gross margins were down 120bps year-on-year. Specialty Retail continued to lose money.
In retrospect, it is clear that at $8.50/share (where the company was before reporting Q1) and, therefore, a market cap of about $360m, Brown Shoe looked fairly cheap. At that price it was selling well under book and if you stripped out all the one-time stuff, the earnings multiple was maybe around 10x. There are a few question marks such as poor cash conversion and growing working capital requirements but neither of the issues suggest real danger. Likewise with debt, the company is moving towards a situation that could be problematic but, at the moment, has enough room for investors to feel comfortable. Moreover, if the restructuring is successful, the upside could be very significant particularly with wholesale which sounds like it could be a very decent business. Indeed, to justify an $8/share price one would have to reckon that Famous Footwear store numbers could never grow in the future, something that while possible, in some situations, overall seems unlikely. However, it is difficult to say what changed after Q1.
The company now trades around $13.50, a market cap of ~$570m, a forward earnings ratio of ~15x. Other footwear retailers, such as Shoe Carnival (NASDAQ: SCVL), Finish Line (NASDAQ: FINL), and Foot Locker (NYSE: FL) are trading broadly in line with this valuation. Shoe Carnival is the most expensive at roughly 13x forward earnings and Finish Line is the cheapest at just over 10.5x forward earnings estimates. Therefore, Brown Shoe does not seem especially cheap. What is more, although trading at Famous Footwear was strong, what we are really looking for is indication that the restructuring is going well. However, the upside to the restructuring is large. Operating earnings could grow to around $100m if the restructuring is even modestly successful. This could be achieved on top of solid growth in store numbers and online at Famous Footwear. Although Brown Shoe trades at a slight premium to competitors, it is easy to see how this could be justified given the potential gains from restructuring.
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