I believe that Heelys' (NASDAQ:HLYS) business is unsustainable. I would recommend shorting their stock as Heelys shoes are a passing fad and the company is built around a single shoe product that is heavily reliant on the tastes of 6-10 year olds.
As Heelys were a popular gift for children this holiday season, it's not too surprising to see the company post 4th quarter earnings that beat Wall Street numbers handily. Net income for the fourth quarter of 2007 increased 700 percent to $11.5 million from $1.4 million the prior year, while earnings per share increased to 44 cents per share from 6 cents per share in the prior year period. The Street was looking for earnings of 28 cents per share.
The Short Case: Analyst’s estimates of growth are overly optimistic. According to Capital IQ, growth for this year is forecasted at 20.7% for this year and 22.5% for the next 5 years. Heelys is expected to have earnings per share of $1.67, with around 83% of their earnings coming from 4th quarter holiday sales in 2007. This leaves little room for error, and it is questionable if Heelys was creating shareholder value to begin with. Cash flow from operations in 2006 was -$2,180,000.00, and Free cash flow for 2006 was -$2,573,475.00.
Nor is Heelys business model anything to write home about. In their recent 10-k, management commented that they “depend primarily upon sales from a single product line and the absence of continued demand for our products would have a material adverse effect on our net sales and results of operation.” Management also is worried about not being able to enforce their patents on Heelys shoes, as they should be. It is not exactly a proprietary or revolutionary idea to attach a wheel to a shoe. This isn’t exactly like manufacturing the next breakthrough in nanotechnology, and I believe that roller skates and roller blades beat Heelys to this idea by three or four decades.
The company has struggled to get patent protection abroad, in Japan and Taiwan. Management brilliantly tell us in the risk factors section of their 10-k that “if consumer interest in HEELYS-wheeled footwear or wheeled sports activity products in general declines, we would likely experience a significant loss of sales and may be forced to liquidate excess inventories at a discount, which would have a material adverse impact on our business and operations."
Around 95%-98% of all of Heelys sales come from a single product. Retailers also seem to have little confidence in Heelys. Heelys retail customers purchase merchandise on a per order basis and have no long term contracts with Heelys. Retailers may also cancel their contract with Heelys with little notice and without penalty. In the coming quarters, it will be important to watch for revenue build up as a clue to how Heelys is doing.
The risks mentioned above becoming a reality seem highly probable, for the simple reason that the tastes of 6-10 year old consumers changes as the wind blows. It is unlikely that the same kids who asked for Heelys this year for the holidays will want Heelys again next year. It would be equivalent to asking for and getting a Tickle-Me-Elmo two holiday seasons in a row. This age group will quickly move on to the next hot product, whatever that may be. From a historical perspective, anyone who has followed fads in the United States knows that fad items don’t remain hot for too long. Does anyone remember Pet Rocks, Reebok Pumps, LA Gears, fanny packs, POGS, Power Rangers, the Macarena, Beanie Babies, Tomagachi, Pokemon Cards, Razor Scooters, and the Rachel hair cut? All were hugely popular items that sold well for a while, but eventually the novelty of these products wore off and the rapid growth in sales fell sharply.
The Bottom Line: With a business model that is built upon a single product that is marketed to a group that isn’t old enough to see PG-13 movies, Heelys' sales will suffer if this group has a change in tastes, which seems inevitable. Because of the weak business model and inability to generate cash flow, I don’t foresee Heelys looking attractive enough to get a buyout bid if its stock becomes extremely cheap.
For a rough estimate of the intrinsic value of Heelys stock, as I don't see Heelys remaining a going concern, I will use the amount of net tangible assets on their balance sheet, which is $93, 292,000.00 and divide this by the number of common shares outstanding of 27,005,000. This gives us a price target of $3.45 per share.
Disclosure: Author has a short position in HLYS
HLYS 3-mo chart