K-Swiss

Probably not good to start a blog on an equity that has not worked for me. Oh well. In some ways I would rather write about failures more than successes because that is what I learn from.

Many of you have asked about K-Swiss recently and I have finally gotten a chance to listen to the latest call and look through the numbers and get an opinion on it. Obviously at this point I can proudly proclaim that my thesis has been wrong, at least looking at a timing perspective. It has been a little over a year and the stock is down 20%. Fun fun. So the question becomes what do I do now? Double down, lick my wounds and sell redeploying the capital somewhere else, or do nothing. I have heard it said many times that what separates the average investor from the great ones is how one reacts when your stock pick is down 20%. Well unfortunately I have the opportunity to see how I react on several names, can anybody spell USG? (Thank goodness I am short a lot of stuff in the financial world) So looking at the basics. It looks cheap at around a 10% free cash flow yield, 6 to 7X EBITDA, 2X book and a massive war chest of nearly 300 million in cash with no debt or representing a little over $7 bucks a share. (Also on a DCF basis it looks cheap as well) Great woo hoo but let me be intellectually honest here. I could have spouted off the same numbers a year ago when the enterprise value was $800 million instead of the current $500 million. So the multiples have stayed the same while the underlying numbers have deteriorated. So your immediate thought should be value trap. Can anyone spell Eastman Kodak? This is a real possibility.

So lets recap. There should have been no doubt in anyone's mind that the domestic U.S. business in 2007 was going to be horrible and I do mean horrible and sure enough it hasn't disappointed. U.S. sales will be down 30% plus. What has caused the huge drop in stock price in the past few weeks is that international sales are slowing or "plateauing." International sales have been growing at 50% for several years now. To put this perspective 5 years ago 90%+ of the entire companies sales were U.S. sales. Now about 52% of sales are U.S. sales. Anyway U.S. sales are continuing to decline and the European sales growth are slowing which is the worst of both worlds.

When I bought this stock I knew they were going into a downturn. That has not surprised me at all. What has surprised me is the apparent length of this downturn. It looks like now second half of '08 is the earliest I can hope for in a true rebound assuming their first effort to reinvigorate their customer base actually works. If you have heard me talk about this stock you know K Swiss has done this a couple of times. The last time in 99 when the stock went from 15 to 3 in about six months. Overall revenue was down 50% (remember almost all revenue was U.S. revenue). K-Swiss reinvented (reposition is probably a better word) themselves and it went from 3 to 30 over the next few years. To continue to play the stock you have to believe the company is on the right path to reposition their brand and do the right things by controlling the supply side of the equation.

Of the people who have the most to lose primarily among them is Steven Nichols Chairman and CEO. He owns over 20% of the company and he operates it as an owner, forgoing short term pops in business performance for longer term intrinsic value creation. About 12 months ago he embarked upon a K-Swiss brand shake up. So part of my bet is on Mr. Nichols, I do like being in partnership with him in owning K-Swiss.

I am typically willing to give a company 2 to 3 years to work out their plan and we are in the midst of year 2. To sell now seems to be imprudent though I have to realize that there is the potential for a value trap as mentioned. At the same time things do not appear to be changing in the time frame I thought or hoped they would. So taking a big swing and really adding to my position doesn't necessarily seem wise either. So I have been pondering the wisest choice of action. Of course the wisest choice may be to do nothing but this could also be a great buying opportunity so the way I think I am going to move forward is sell covered calls on what I own to fund buying other calls. So I would sell Jan 08 $30 calls which are around $.35 a call and buy Jan $22.5 calls which are remarkable cheap at around $2.40. This to me does a couple of things. I can stay in the game and pay a little for the possibility to take a big swing in six months at today's prices. Gives the chance to lock in a price of $22.50 so not miss out if this turns out to be a huge buying opportunity while funding some of this through selling calls at $30 (a full 40% higher than current prices). If things really get worse in the next six months I do not lose much. In this way I am not totally being passive and just sitting there but since the picture is not anymore clear I do not have to risk throwing very much good money after bad. Am I getting to cute in all this financial engineering? Something I have thought about but because the calls are so cheap right now after this huge sell off I think it makes sense. My gut is telling me it will probably get worse before it gets better but with a massive war chest of cash they can do a lot of things to create value and with Nichols owning the majority of stock and acting like an owner with shareholder capital I am not to worried about them doing something stupid with company capital. He has quoted Buffett on the earnings call several times in talking about deworsification – doing something just to do it and being worse off because of it. Nichols has talked several times about acquisitions and I wouldn't be surprised to see something in the next six months. I wouldn't be surprised to see that have a positive reaction on the stock because it eliminates the uncertainty of what they will do with all their cash and help smooth out their financial performance lowering stupidly enough perceived risk (many of you know the problems I have with how Wall Street looks at risk and won't elaborate here) . Anyway I have many more thoughts that I can talk about if anyone has interest but that is where I think I am with this company. As I said fun times.