Collective Brands: Trademark Infringement Case Update and Stock Assessment

Collective Brands (NYSE: PSS) CEO Matt Rubel responded to last week's unfavorable federal court ruling in which the company was found guilty of trademark infringement and ordered to pay $305M in damages to adidas AG. In a letter to shareholders, Rubel discussed why he believes that the jury's ruling was "unjustified and excessive," and disclosed that the company will file motions asking the court to set aside the verdict, enter a judgment in its favor, order a new trial, or greatly reduce the jury's award.

Two key points from Rubel's letter:

• The total award of $305M (including $137M of Payless profits and $137M in punitive damages) is ten times the amount of actual damages found ($30.6M) and exceeds the profits that Payless ShoeSource made on its two- and four-stripe shoe styles by 15 times. Though our scope of patent and trademark infringement case is limited, we don't ever recall seeing a jury award of this magnitude.
• If the decision stands as ruled, it may also give adidas exclusive rights to all two- and four-stripe footwear designs. Payless is by no means the only footwear retailer with a private label that resembles adidas' three-stripe design (look around the footwear department at any mass merchant retailer). A ruling like this could potentially give adidas a monopoly on all striped shoe styles, which would have grave consequences across the industry as a whole.

As we discussed last week, the final outcome of legal disputes like these are virtually impossible to predict. Even though management provided compelling evidence as to why the jury award should be reduced, investors should not assume this will happen when forming an investment thesis or valuation assumptions. The only certainty in this matter is that the company will incur additional litigation expenses, leading to additional margin pressures in coming quarters. There is also the matter of the ongoing K-Swiss (NASDAQ: KSWS) trademark battle taking place in California. We anticipate the K-Swiss legal team will use findings from the adidas case to augment its own arguments, likely requiring additional litigation costs on the part of Collective Brands.

On a positive note, Rubel reported that the company is set to announce 1Q08 sales of $932M (a decline of 2.5% y/y) and EPS of $0.61-$0.67, beating current consensus analyst estimates. Management also expects EBITDA to exceed $100M - almost 11% of sales - which is a solid figure given the current challenges facing the footwear industry. While the 1Q08 results are encouraging, they do come with a grain of salt. The 1Q08 results do not include the impact of additional litigation expenses (the 1Q08 impact should be minimal - it is future quarters we are more concerned with) and an $0.08 tax benefit stemming from earnings generated in lower-tax international jurisdictions (largely South America). Excluding the positive tax effect, 1Q08 earnings would come in roughly equivalent to the analyst consensus of $0.54 per share.

Investment recommendation: The stock was up almost 12% in Monday's trading session to $11.50 [ed: it closed at $11.82], due largely to the better-than-expected 1Q08 earnings results. Using the previous consensus calendar 2008 (fiscal 2009) EPS estimate of $1.12 plus the $0.10 upside from the 1Q08 results (comparing the midpoint of the $0.61-$0.67 range to the previous consensus of $0.54), the stock is now trading at 9.5x times forward earnings, roughly in-line with long-term earnings growth expectations. We remain upbeat on the prospects for the combined Payless/Stride Rite/Collective Licensing platform, and admire the merchandising creativity that Rubel has assembled under the Collective Brands umbrella. However, we still characterize Collective Brands as a long-term investment that will require patience on the part of the investor. Even longer-horizon value investors may want to wait until after the 1Q08 conference call (June 4th, 5;00 pm EST) to build or add to positions - there is a chance that negative commentary regarding the overall state of the footwear industry or ongoing litigation could bring the stock price downward.

Disclosure: No positions

Comments

[Paul Price]

Looks like a 'shoe thing'.