By David Sterman
Momentum investing can lead to powerful gains. That's why some investors suggest you should always "let your winners ride," presumably to even higher prices. This was my logic when I recommended shares of Crocs (Nasdaq: CROX) last August.
The footwear maker's stock had already surged 1,200% in just 15 months, and shares still looked reasonably valued. Since then, they've risen another 85%, now trading at about $26 a share. However, letting this winner keep riding may prove risky -- shares are valued well above the peer group and investor expectations about future operating performance are quite high.
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But we live in a different reality now. After a strong two-year run for the major indexes, a cautious tone has set in and momentum investing has become an unsafe strategy. Instead, it's time to play defense and seek out names that will hold up in down markets, while still posting upside in rising markets. Looking at the peer group for Crocs, I can't help but notice the stunning valuation for rival Collective Brands (NYSE: PSS).
Through its 4,833 Payless ShoeSource stores around the globe, the company designs and sells footwear and related accessories under many widely known brands, including Sperry Top-Sider, Stride-Rite, Keds and Airwalk. It's not a high-growth business, but it's wildly profitable and shares are quite cheap, having fallen by a third since late April. Shares now trade right at book value, which makes the stock a compelling value play.
Why the selloff? For starters, the flagship Payless stores have seen a slowdown in traffic in recent months because its lower-income demographic is still feeling the lingering effects of the recession and persistently high unemployment. Rising gas prices also affect consumer spending, since many people have to cut back in other areas of their budget to cope. So when gas spikes to $4 a gallon, footwear sales inevitably take a hit. Because of this, investors are assuming sales will remain weak for at least the next few quarters. In addition, feeling the heat of this slowdown, the company's CEO, Matthew Rubel, recently resigned.
However, the beauty of this business is in its long-term consistency. Footwear purchases can be delayed, but not avoided altogether -- shoes invariably wear out from use. Smooth out the annual gyrations, and Collective Brands manages to boost sales 3% to 4% every year, with earnings before interest, taxes, depreciation and amortization (EBITDA) growing at twice this pace.
Ironically, the recently-departed Rubel had begun to put Collective Brands on an even better trajectory, boosting the wholesale distribution of shoes to other retailers (which currently represent 20% of sales) and pursuing international expansion (representing 14% of sales).
From fiscal (January) 2007 to 2009, the company generated $45 million in annual free cash flow. This figure shot up to $204 million in 2010 and slightly declined to $174 million in 2011. The robust cash flow is helping the stock in several ways. First, Collective Brands has begun to repurchase shares more aggressively -- it bought back 53,000 of its own shares for $1.1 million during the first quarter of the year. Second, the company pared $100 million from long-term debt in the past year, which now totals roughly $658 million. If current cash flow trends persist, then Collective Brands can maintain both of these trends.
To rebuild the stock price, the board will need to appoint a CEO with vision. The new leader will have to implement needed corrective actions -- perhaps accelerating the international store expansion or taking a fresh look at merchandising efforts. Another bold move would be to cull the weakest 10% of stores from the company's 4,800 store base (current plans call for a net reduction of just 30 stores). At a minimum, renegotiating lower lease rates while mall operators are in a weakened state may help boost margins.
To be sure, the loss of a CEO and a same-store sales drop warrant a pullback in a stock's price. But at $14 a share, this stock is too cheap to ignore.
If the market tanks or the company fails to boost results, then shares could simply languish at current levels (receiving support from the $14.42 book value and EBITDA multiple of 4). However, in a brighter scenario of a rising market, improving consumer sentiment or a well-regarded new CEO hire, this stock could quickly move back to the low $20s, where it stood this spring. That's 50% upside, with minimal downside.