Collective Brands (PSS) is a major player in the footwear and accessories market and owns such brands as Payless ShoeSource, Saucony, Sperry Top-Sider, Stride-Rite, and Keds. Each of PSS’s brands serves a targeted market and serves those markets well. The company’s primary target consumer is lower income but still fashion conscious consumers.
Overall, PSS has fantastic management, in my opinion, and highly efficient and effective processes. Combine these traits with a penchant for innovation and strong cash generation capabilities, even through the recession, and you have the makings of a formidable company.
Opportunity Presented by Uncertainty
We first analyzed this company last December but felt at the time that the margin of safety at the then-current stock price of roughly $20/share was not sufficient for us to enter the stock. Fortunately for us, the market’s general fear of near-term uncertainty has worked in our favor. This stock fell 12% immediately following the Q1 fiscal year 2012 earnings release last week, and has declined roughly 30% since we originally passed on the investment. The recent drop in stock price was caused by the Q1 fiscal year 2012 results, which were viewed negatively by the market. Naturally, being long-term investors, we sensed a great opportunity.
The fear that triggered the drop in stock price following the Q1 earnings release is centered mainly around the primary target consumer I mentioned above. Q1 results were negatively affected by higher gas and food prices as well as bad weather. The vast majority of the sales decline was limited to the flagship Payless ShoeSource domestic business as the company continued to deliver on its initiatives throughout the rest of the business.
The drop in Q1 sales relative to Q1 of last year can be traced primarily to the Easter holiday season. Easter normally serves as an earnings boost for Payless Domestic, as many of its target consumers normally purchase “Easter” shoes in droves. This year proved to be the perfect storm, unfortunately. Easter was later this year than it had been in 70 years and happened to coincide with rising food and fuel prices as well as some nasty weather. Had Easter occurred earlier in the year, the company’s Q1 results likely would have looked a lot better.
The market was already weary of the strength of PSS’s target consumer after the recession and continued high unemployment. Regardless, the poor short-term results and near-term uncertainty do not concern us because we feel confident that PSS will be a very successful company over the long haul and will continue to generate solid cash even during the bad times. We have factored in a weak short-term into our valuation and still believe the company to be significantly undervalued.
Collective Brands is comprised of three lines of business: Payless ShoeSource, Collective Brands Performance & Lifestyle Group, and Collective Licensing. The company began as just Payless ShoeSource in 1956. It made no material acquisitions until 2007, when it bought Collective Licensing in March and The Stride Rite Corporation in August of that year. Those two acquisitions gave them new brands and new brand development capabilities.
Collective Licensing is a brand development and licensing company that specializes in building, launching, licensing and growing brands focused on the youth lifestyle market, including Airwalk, Above the Rim, Vision Street Wear, Sims and Lamar. This new company is used to support Payless ShoeSource and the other new acquisition, Stride Rite. Stride Rite came with four premium brands: Saucony, Sperry Top-Sider, Keds and Stride Rite. Stride Rite was reformed as the Performance & Lifestyle Group. Stride Rite also came with a chain of retail stores -- also called Stride Rite -- that carried the four brands, as well as a wholesale business where the brands were sold to other retailers.
So, to bring it all together, after starting with Payless and then buying Stride Rite for its chain of stores, brand names, and wholesale business and buying Collective Licensing to support Payless and eventually Stride Rite, we have the company in its current form. It subsequently renamed itself Collective Brands and organized it into four segments, each of which is managed separately.
The four segments of the company are (including percent of total revenue over the trailing 12 months):
- Payless Domestic (59.7%): Mature business but a cash cow that helps fund the growth of the rest of company as well as contributing to other uses of capital
- Payless International (13.6%): New to the company in terms of broader focus, relatively small compared to Domestic, and potentially a powerful growth engine. Realizes the highest operating margins.
- Performance & Lifestyle Group – Wholesale (19.8%): Profitable segment with solid margins and now a growth engine in the hands of PSS’s management.
- Performance & Lifesyle Group – Retail (6.9%): Perpetual money loser that the company is focused on making profitable; relatively small so losses do not endanger rest of the business.
Payless Domestic is a fully mature business. It is one of the largest footwear retailers in the Western Hemisphere and has over 4,000 stores nationwide. This segment also includes Collective Brands' sourcing unit as well as Collective Licensing.
Its concept has always been to provide a unique need in the marketplace. The segment offers products that look really expensive but are not. This is mostly important to what it calls its "Expressive" consumer, particularly women. Expressive consumers want affordable fashion, which to PSS are shoes that look like they come from Dillards (DDS) or Steve Madden but cost as though they come from Wal-Mart (WMT).
The company’s goal is to get trendy fashion to its stores at the same time as the more expensive stores and before mass-market discount retailers. It appears to be succeeding in this goal, based on the make-up of the company’s typical consumer. For example, according to the company, while 26% of all women in the United States value more fashion over less and value price over quality, 37% of Payless’ female shoppers fall into this category.
Payless also measures well on quality. Women who value quality over price while still valuing fashion make up 37% of all women while comprising 39% of Payless’ female shoppers. Conversely, the company tends to lose the shoppers who do not value fashion, according to the statistics provided by the company. To give you a further idea of its customer base, 55% of Payless' shoppers have household incomes of less than $50K and 51% of its shoppers have households of four or more.
Payless fits the need of a certain demographic very well -- a demographic that is very large. As you might imagine, this demographic was hurt more by the recession, thus hurting recent sales for Payless. The continued weakness of this customer through the first part of this year has spooked the market as discussed above, thus providing a buying opportunity for long-term minded investors. The reduction in the unemployment rate therefore serves as a future catalyst for the company.
However, the company is not sitting idly by waiting for the economy to improve. On the sales side, Payless has rolled out accessories, which are doing very well. Accessories as a percentage of total segment sales have increased from ~7% in 2008 to 10% in 2010. The company has also continued to develop its existing brands while also rolling out new brands, aided significantly by its new subsidiary, Collective Licensing.
Payless is also focused on a very effective marketing strategy through both the traditional channels and newer channels, such as social media. In addition, the company is remodeling select stores with its new "Hot Zones" model, which makes the front of the store more appealing, primarily with accessories.
So far, the company has rolled it out to less than 20% of total stores, as its strategy is to take everything slowly and manage it carefully. The company has also rolled out a new focus on children's shoes, including a partnership with Disney (DIS). Finally, the company has rolled out a new customer service training program called SMILES. The goal is to increase the enjoyment of the shopping experience and customer conversion. An enhanced focus on customer service is rarely a bad thing. Since the roll out, customer service related-statistics have increased across the board.
On the cost side, Payless has started putting store managers over multiple stores, which has been a good cost saver without sacrificing operational quality. Also, the company has made the stores more energy efficient, thereby reducing energy-related costs by 30%. Finally, the company has started aggressively renegotiating leases. Every year, 20% of leases come up for renewal, and the company has taken advantage of the current economic situation to aggressively force its lessors to reduce rates. This strategy has been successful so far as the company continues to implement it.
The company has also rolled out new price optimization software and improved its Global Sourcing to further improve sales while reducing costs. This is universal to all segments, though, so I will discuss this only at the end after I have discussed each segment.
Revenue for this segment has declined 2% to 6% annually in the past couple of years using trailing 12 month numbers, while operating margins have fluctuated between 1.5% and 5.0%. The company believes that the decline has leveled off and expects relatively flat sales going forward. I assume a continued decline in sales and operating margins in this segment for at least one more year before leveling off.
This segment is relatively small and surprisingly a new focus for the company. By far the largest base is in Canada, where the company has ~300 stores and where it receives 42% of this segment's revenue. Since 2005, annualized growth has been 5% despite the economic recession, and there is still a lot of opportunity on the horizon, particularly in the form of franchising. The company has an established base in Puerto Rico and Central America (outside Mexico) as well as two countries in South America. Canada and Puerto Rico, similar to the US, represent mature markets with strong cash flow. For these two areas, the company is focused primarily on maintaining sales with moderate growth while driving down costs to improve margins.
Payless International has materially higher operating margins compared to US Domestic, partially due to lower costs in Latin America as well as the fact that some of the sales are from Franchising and JVs, a growing portion of sales. The strategy for Latin America is focusing on high brand awareness while filling the same role as the company fills in the US. These areas are very open to US brands and the niche customer the company serves abound in these areas. For example, in Colombia, the company opened its first store in 2008 and already has 63% brand awareness and 64 stores there.
Management is rolling out Payless in other areas of the world judiciously. Instead of making significant capital investments, the company is using franchises and JVs with local partners. The company only recently signed franchise agreements for the Middle East, Russia, Turkey, Israel, Singapore, Malaysia, Philippines, Indonesia, and Mexico. Management notes that there is an opportunity for over 700 franchised stores within five years. The company already has 80 stores set to open in 2011 and a total of 1,235 possible stores under existing agreements. The market in these areas is largely fragmented, undeveloped competition that has lower local costs. And consumers in these areas still value fashion and price, Payless' specialty.
Sales in this segment are expected to grow in the mid-single digits, but, due to the franchising model, earnings should grow even faster. Sales increases have been in the 3% to 5% range each of the past two years, while operating margins have been solid at 9.0% to over 11.0%. I expect revenue to continue increasing at a steady pace of roughly 5% and for operating margins to remain consistently above 9.0%.
Performance & Lifestyle Group (P&LG)
P&LG-Wholesale and Retail segments are discussed as one because the key here is brand development. P&LG has four primary brands: Saucony, Keds, Sperry Top-Sider, and Stride Rite. Each of these brands has its own president, its own vision and mission statement, and its own unique, carefully tailored strategy.
The keys here are fashion, marketing, uniqueness via technology (Saucony and Sperry Top-Sider) or other (kids shoes up to size 6 instead of industry standard 4 and 1/2), product category expansion or contraction, key partnerships, geographical focus, appropriate price points, and appropriate distribution channels. These may sound like normal items every similar company should consider, but Collective Brands takes it to the next level. The company thinks very carefully about every single aspect of every brand, and every action is driven by the company’s core values (discussed below).
The proof is in the pudding. When it took over this business and these brands, which have each been around for a long-time (one since 1916), the company was told that the brands were fully matured, that there was no growth left. So far, the company has proved the naysayers wrong. Since 2008 (first full year with new brands), the company has grown some brands and at a minimum made the others stronger.
- Sperry Top-Sider: Realized 12.5% annualized growth rate since 2008 despite recession. The goal is to be the #1 boat shoe and also to expand beyond boat shoes, which the company has done successfully so far.
- Keds: Eliminated some products that were unprofitable, so growth's not as applicable here yet. The company is effectively turning this brand around by focusing on a core product and expanding appropriately from there. Previous product variety and distributions channels were not consistent with brand image.
- Stride Rite: #3 position in children's footwear segment and #1 in baby footwear. Sales are down here as the company has closed unprofitable stores. The company is bringing operational excellence and lessons learned with Payless stores to these stores as well as developing new key partnerships here (Star Wars) and rolling out new brand launches within Stride Rite.
- Saucony: 22.4% annualized growth rate since 2008 despite the recession. The goal is to be the #1 running shoe. The traditional core is athletic running shoes, but the company is expanding into "minimalism/natural movement" shoes and outdoor/trail running shoes. The company is also expanding into apparel, which has been successful so far. This brand already has the #1 compression technology in the industry.
The Wholesale side of this business is very profitable margin-wise. It has the best margins in the entire company. The retail side, however, is still not profitable, though management is working on it. I think this will become profitable over time, but the company is not focused on heavily growing this segment. Further, making the retail stores for this segment profitable is not crucial for long-term success. My valuation even assumes that the retail stores will remain unprofitable for the indefinite future.
The company has realized impressive growth on the wholesale side with a solid 24% growth over the trailing 12 months while realizing an impressive 9.5% operating margin. The company expects to continue growing wholesale in the mid-teens. I expect the company to be conservatively accurate while still maintaining high operating margins.
The retail side is not as impressive, as growth has been in the 1% to 5% range the past couple of years while operating margins have actually been negative. I expect revenue to remain flat going forward while margins remain negative. P&LG Retail is the smallest segment at 6.9% of revenue over the trailing 12 months, so continued negative margins, while undesirable, are not disastrous to the company as a whole.
Global Supply Chain
This is the lifeblood of Payless' operations. The global supply chain is the fuel that keeps the engine running efficiently. It is run by its own president and services the entire company. As the president of this segment said, the goal is to get the right product to the right store at the right time as efficiently and cheaply as possible. The company goes into a lot of detail in its various presentations, but the key is the focus on speed, quality, and cost, all of which the company manages effectively.
The company outsources 100% of its manufacturing. In 2008, 95% of the manufacturing was done in China. However, the company saw the writing on the wall there in terms of rising costs and started to shift some of that manufacturing to other Asian countries as well as westward within China (away from the coasts), which is cheaper. By 2012, the company expects over 25% of its manufacturing to be done outside of China versus just 5% in 2008. There is large demand for outsourcing manufacturing in Asia, as you might imagine. But PSS is the type of company manufacturers want to do business with. PSS pays and has a lot of volume, thereby keeping the factories busy. PSS is preferred to the point that manufacturers the company uses in China are building capacity in the countries where PSS is moving to continue servicing PSS. PSS also demands that its manufacturers purchase a certain quality of raw materials, which is clout many companies do not have with these manufacturers.
Another key item is its distribution centers. The company has built out space while consolidating locations to improve its efficiency. All of its efforts have helped to reduce lead time by 20 days from order placement-to-store while also reducing costs.
Another big factor is re-ordering. The company has to be able to replace inventory for peak items in-season on time and cost effectively. The company has continued to improve in this category over time. This is one aspect that Payless brought to the table to significantly improve the additional brands they purchased in 2007.
Another key item is overall inventory management. The company has just recently implemented a new price optimization tool that allows the company to know exactly when and how to mark-down products to maximize revenue based on sales performance within a certain period of time.
I believe that the company’s highly efficient and effective global supply chain function provides it with a unique advantage in doing business world-wide and keeping down costs in keeping with offering inexpensive products.
This company's greatest strength is its management. The CEO even noted that his primary job is to develop talent. He must be doing a great job because Collective Brands seems to have a deep talent pool for management. While I normally prefer a CEO promoted from within, PSS’s CEO, an external hire in 2005, has a great pedigree in the retail industry and is highly capable. The company appears to have a fairly decentralized operating structure, and the CEO seems to give his managers a lot of leeway.
Management clearly thinks very carefully about every single aspect of the business. No stone internally goes unturned. This very close attention to detail coupled with management’s strong understanding of how it all works effectively together has resulted in a wonderful operation. I like to equate it to turning a bunch of intuitive MIT engineers loose on the footwear and apparel industry.
The company has four key core values that I believe everyone in the company buys into fully, based on my listening to the four-hour investor conference during which numerous managers talked, and based on the strategies they have outlined for every single part of the business.
Those core values are:
- Consumer connections: The consumer is key. Give them what they want.
- Powerful brands and innovative products: There is definitely a culture of quality, reputation, and innovation that simply permeated the investor conference and shows up in the company’s diverse product line and financial results.
- Operational excellence: I have touched on this throughout. The CEO noted that the company has had a reputation for years for being operationally excellent.
- Dynamic growth: Officially, international expansion, wider variety of shoes, expanding product categories and possibly acquisitions. Essentially, though, this drives a culture that is not happy with the status quo. I do not expect the company to make a lot of acquisitions, but I get the sense that the new CEO awakened a sleeping dragon. It's no coincidence that he became CEO in 2005 and by 2007 the company made two strategic acquisitions that are proving to be great growth engines.
Further proof of management's excellence is the pay structure. Throughout the organization, a large percentage of compensation (and often times the vast majority) is pay-for-performance. I am a huge fan of this type of pay structure in any organization, especially for the CEO. 16% of the CEO’s total salary is from his base salary, and the rest is pay-for-performance, including a good chunk that is based on the company's performance over a three-year period. For the 2007-09 period, despite having good performance all things considered, the company failed to meet its internally developed targets. Therefore, the company issued no incentive compensation for this period. I always respect a company that sets lofty goals and does what it says it will do when those goals are not met. Many companies simply move the finish line so that they can cross it.
Balance Sheet Risks
I do not believe there are any significant risks on the balance sheet. The leverage ratio (total assets/net equity) is a little high at 3.0, but that is due primarily to the 2007 acquisitions. The company has been aggressively been paying down that debt each year. The underfunded pension and other post-retirement plan status are not material. The company has a significant amount of cash and uses it to pay down debt, pay for capex, and make stock buybacks.
The biggest off-balance sheet risk is operating leases, but 20% of these come up for renewal every year and, as noted above, the company is aggressively reducing these lease rates lately.
I valued the company using an upside model and a downside model. The upside model includes all of the positives discussed above and the downside model includes all the negatives which I believe have been baked into the price due to the Q1 ’12 results. My upside price target is $25.01 which in my opinion is still conservative by around $3 or $4. My downside price target is $11.64 and includes what I believe to be highly unlikely events. Overall, I calculate a potential upside of at least 60% and a potential downside of at most 26%, representing a favorable reward to risk ratio in my view.