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Footstar (OTC:FTAR) is a liquidation play with tangible equity of $82.1 million ($3.84 per share) and an expected liquidation value of at least $96 million ($4.5 per share). This compares to the current stock price of $2.8. I see a very low chance of getting less then the current stock price, with the upside being a 40% return in less then a year.

Footstar runs the footwear departments in 1,383 Kmart and 833 Rite Aid (NYSE:RAD) stores. In March 2004, due to poor acquisitions, accounting problems and then liquidity issues, Footstar went into bankruptcy. In February 2006, the company emerged and paid creditors in full. While in bankruptcy in 2005, after years of litigation, the contract with Kmart was amended. Originally set to expire on December 31, 2012, the contract now expires on December 31, 2008. After the contract expires, Footstar will liquidate.

Liquidation

On April 30th, 2008, Footstar paid a $5 taxable dividend. On April 3rd, 2008, Footstar sold substantially all of its intellectual property to Kmart for $13 million. On June 30th 2008 Footstar paid a further $1 dividend.

When the contract expires at the end of the year, Kmart will purchase the inventory related to its stores, excluding unsalable or damaged inventory for book value. Any seasonal (four months past season) will be purchased for 40% of cost. Footstar has already reserved $2.4 million for seasonal inventory. Any unsalable or damaged inventory will not be purchased.

The other asset remaining is Footstar’s headquarters building located in Mahwah, NJ which is listed for $19.5 million. Mike Lynch told me that they have had interest in the property but nothing has materialized.

K-mart agreed to hire substantially all store and district managers. Footstar eliminated three executive positions and notified 218 employees of termination. The severance cost related to these employees is $8.5 million plus $2 million in benefit costs, with $3.6 million already accrued, $6.9 million in remaining severance is not yet expensed. It is my understanding that this accounts for all of the severance. I spoke to Mike Lynch whose is CFO. This is what he said:

All employees are accounted for at this juncture, but it is possible that additional severance/retention measures could still be put in place depending upon the circumstances.

The last item that needs to be accounted for is Footstar’s second half 08 operating earnings. Considering income taxes is virtually nil due to deferred tax assets, operating earnings is the best metric to use. Operating income was $28.4 million for the first half. But this includes a gain of $22.3 million for the reduced severance after Kmart agreed to hire all store and district managers. A charge of $2.4 million for the seasonal inventory and $3.6 million in severence related to the portion that has already been expensed.

Neting out these items gives operating earnings of $12.1 million compared to $21.5 million or the first half last year. The factors effecting second half earnings will be lower operating expenses due to lower headcount and weaker retail environment. In the first half, Kmart recorded same store sales declines of 6% compared to Footstar’s decline of 10.6%. Sears stated that they are modeling flat to a modest decline in same store sales for the second half. Operating earnings declined 40% in the first half. Operating earnings was $32 million in the 2nd half of 07. My best case and worse case 2nd half 08 operating earnings estimate is $19-$25 million.

Here is a chart showing the balance sheet at June 28, 2008 adjusted to the expected liquidation value:

click to enlarge


Risks

The largest risk is that management will not liquidate in an expedient manner. Footstar will file a plan of liquidation in early 09. But the sale of the headquarters building could delay the liquidation. Also, some have raised the issue that the last two dividends were not tax efficient and that they should have been set as liquidating dividends and not taxable. The OutPoint Group waged a proxy fight earlier this year attempting to name two candidates to the board. The Outpoint group owns 3% of the company. They raised such issues as the excessive compensation for the top executives - the CEO’s total compensation was $3.5 million last year and the CFO made $700,00. Directors are paid between $110-$160 thousand a year. Footstar reimbursed the chairman $160,000 for his failed bid for the company in 2006.

My estimate of second half cash flow could prove to be way off, especially given the current situation in the economy. My estimate is fairly conservative but the results remain yet to be seen. But keep in mind that even without the 2nd half cash flow, tangible equity is $82 million compared to a market cap of $60 million.

Source: What Liquidation Will Look Like for Footstar, Kmart