George Schultze Likes Footstar -- But We Have Our Doubts (FTAR)

Due to SEC regulations requiring disclosure, investors can take peeks at the holdings of many large money managers. Rarely though do investors get to hear why managers are buying specific stocks.

George J. Schultze of Schultze Asset Management is an exception here. In an April 5, 2006 13-D filing which lists him as a 6.4% owner of shoe retailer Footstar, Inc. (FTAR), he explains exactly why he’s interested in the company’s shares.

The filing reads:

Schultze Asset Management, LLC is a long-term shareholder of the Company. The Reporting Persons may hold discussions with management, the board of directors of the Company and other shareholders of the Company concerning ways of maximizing shareholder value. Although the Company's business plan as outlined in its plan of reorganization disclosure statement is not without risk, the Reporting Persons believe that the Company's stock is substantially undervalued.

By using two customary valuation ratio measures - (1) enterprise value to last twelve months EBITDA (earnings before interest, taxes, depreciation and amortization), and (2) enterprise value to last twelve months sales – and comparing these measures for the Company with comparable public footwear companies, it is clear that the Company's common stock trades at substantially less value than other public footwear companies.

Based on the ratio of the Company's enterprise value of $64.2 million to the Company's last twelve months' EBITDA of $41.9 million, the Company's common stock trades at only 1.5x EBITDA while comparable public footwear companies including Payless Shoes, Ross Stores, Foot Locker, Brown Shoe Co., Finish Line, Shoe Carnival, and Rocky Shoes) trade at an average of 7.8x their last twelve months' EBITDA.

Similarly, based on the ratio of the Company's enterprise value of $64.2 million to the Company's last twelve months' sales of $715.1 million, the Company's common stock trades at only 0.09x sales while comparable public footwear companies (including Payless Shoes, Ross Stores, Foot Locker, Brown Shoe Co., Finish Line, Shoe Carnival, and Rocky Shoes) trade at an average of 0.64x last twelve months' sales.

Neither of the above two valuation measures ascribe any value to the Company's net operating loss carryforward ("NOL") asset. The Company's NOL is approximately $156.1 million based on the Company's latest Annual Report on Form 10-K for the fiscal year ended December 31, 2005. Since the Company's NOL will likely reduce the Company's cash income taxes for the foreseeable future, it is a significant valuable asset that should be reflected in overall enterprise valuation.

Footstar is one cheap stock. The current multiples on Yahoo Finance are 4.13 times trailing earnings, 0.13 times sales, and 1.27 times book value.

As you might have surmised, the company is cheap for a reason. Footstar sells family footwear, primarily through a license which allows it to run the shoe departments of over 1400 Kmart stores. The catch is that the company’s agreement with Kmart expires at the end of 2008 at which time Kmart is obligated to purchase the FTAR’s inventory (but not its brands which include Thom McAn) at book value.

Schultze is right that Footstar is cheap, but the investment case is unusual here so it’s probably not so helpful to compare the company’s multiples to those of other public footwear retailers as he does. It might make more sense to think of valuation in terms of what a 2008 liquidation would fetch. You can also add the value of the NOL’s to that amount, and place odds on the chance of Kmart renewing the Footstar relationship. For a valuation along these lines, see Whitney Tilson’s piece.

Two other things to be aware of: Footstar is recently out of Chapter 11, and the company announced in February that it received a Wells notice from the SEC. It’s not typically fun to see companies you own have the phrases “Chapter 11” and “Wells notice” in their filings, but if you can make the case that these phrases plus the 2008 Kmart agreement expiration are driving a valuation that’s cheap on both an ongoing and liquidation basis, maybe the stock’s a buy.

FTAR year to date chart: