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K-Swiss: A Margins Success Story

by Louis Corrigan (TMF Seymor)

Atlanta, GA. (Feb. 9, 1999) -- Before looking for new blood on this week's Rising Margins screen, I'll revisit some previous candidates that are reappearing. The point of these success stories (both rose 80% in the last three months) is not to toot my own horn but to reinforce the fact that this screen can be remarkably useful in hunting for investment candidates.

In my November 10 column, I profiled Resmed <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: RESM)") else Response.Write("(Nasdaq: RESM)") end if %>, a leading manufacturer of products for diagnosing and managing respiratory and sleep disorders. The stock had soared $6 1/2 to $57 1/2 after its Q1 earnings report, but still looked like a "viable research candidate" thanks to its highly profitable and fast-growing business. By January 26, it traded for $52. That was after a 2-for-1 stock split. So it had risen 82% in less than 3 months!

But perhaps the stock had gotten ahead of the company. Since Resmed reported Q2 results last week, the stock has slumped from $50 to $38 1/2 (it's still up 34% since I discussed it). Sales rose 33% while EPS increased 67% to $0.25, three cents ahead of estimates. That was good, but investors are worried about some of the details. Net income soared 71%, but operating income increased just 27% -- in other words, less than sales. That's in contrast to the first quarter, when sales rose 38% and operating income shot up 104%

The problem is that gross margins were flat at 68% for the quarter. Selling, general and administrative expenses rose by 37%, or faster than sales, thus crimping operating margins. Net income got a big boost from reduced foreign currency hedging losses, which cut "other expenses" by over 80%. That's good for Resmed, but it doesn't offset the falling operating margins. Also, accounts receivable are up 44% while inventories are 39% higher on a year-over-year basis. Though neither number is way out of whack with the sales growth, you prefer to see these numbers rising less than sales. So that's another concern.

Only with a small company will you see the "other expenses" line have such a dramatic impact on EPS. Though I think it's right to key off of EPS for our margins screen, we have to make a realistic evaluation of the business, discounting radical changes in taxes or other non-operating items. While Resmed technically makes our rising margins screen, a little digging into its income statement should disqualify it. Resmed is still a very profitable little company, but following the margins theorem, you would have sold it last Tuesday in the high $40s.

Another repeater that won't show up on our screen until next week is tennis shoe company K-Swiss <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: KSWS)") else Response.Write("(Nasdaq: KSWS)") end if %>. On November 3, with the stock around $24, I wrote, "This one definitely deserves further research. Either it's dirt cheap and has simply been ignored because of its tiny float and small market cap, or there's something else to the story." Two weeks later, after investors did a little due diligence, old Swissy was up to $30, and I repeated, "It still looks like a potential bargain."

Well... I was right. Today the stock shot up more than $9 a share to an intraday high of $43 3/4 thanks to a strong Q4 earnings report. Sales soared 68% to $40 million as domestic revenue rose by 95%, offsetting a 34% decline in international sales. EPS did even better, speeding ahead 195% to $0.66 from $0.22 a year ago and handily beating the $0.53 per share estimate, despite a much higher tax rate. For the year, sales increased 39% to $162 million, pumping EPS up 214% to $2.20 from $0.70 in FY97.

The balance sheet continues to look good. Inventories are up 23% year over year (way below the sales growth rate) and accounts receivable are up 69%, high, but consistent with the sales growth. K-Swiss ended the year with $6.54 per share in cash. That's down from last year, but the company spent $5.4 million during 1998 to buy back 257,000 shares of stock, meaning the board paid $20 a share. Pretty smart. Subtracting the cash from the current price, we see the stock is really trading at about $37 for a P/E of 16.8.

That's despite growing sales at 39% and EPS by 214% last year. In addition, the domestic order backlog for the first six months of the year is $131 million, up 134% from last year. K-Swiss is also seeing some pick-up in international sales after a weak 1997. So the near future looks great.

The board obviously agrees. It today announced a 2-for-1 stock split and boosted its quarterly dividend by 50%. Goldman Sachs upgraded the stock to "trading buy" from "market outperform." The athletic shoe business is prone to fashion trends, so there's definitely less margin of safety today in K-Swiss shares than there was three months ago. But the good story looks intact. Using a multiple of 20 on even the stale $2.90 per share earnings estimate for FY99 (it's sure to be jacked up) and adding the cash gets us a target price of $64.50, or another 50% gain from here. So it's not too late to take a closer look at K-Swiss.

Next up, Cache <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CACH)") else Response.Write("(Nasdaq: CACH)") end if %>, a small mall-based retailer of women's apparel. Its 172 Cache stores offer casual clothing to women 25 years old and up while its new expansion vehicle, the 12-store Lillie Rubin chain, targets women 40 years old and up. This thinly traded stock has soared 60% in the last week after a strong Q4 earnings report and yesterday's news of aggressive growth plans.

For the quarter, sales increased 17% to $48 million on 6% same-store sales growth. That pushed EPS up 43% to $0.33 versus $0.23 last year. For the year, sales increased 8.2% and EPS 65% to $0.43 from $0.26. Q4 results benefited from higher gross margins (37.3% vs. 35.2%), only a slight uptick in expenses relative to sales, and a hefty gain in interest income from its cash hoard of $1.50 per share. The balance sheet is otherwise in good shape, too.

On Monday, Cache said that over the next five years it plans to open 100 new Lillie Rubin stores and 50 Cache stores. It's brought in Gayle Wyroba, a top AnnTaylor <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ANN)") else Response.Write("(NYSE: ANN)") end if %> merchandise manager, as new VP of sportswear for Cache stores. That should improve Cache's performance and free up management talent. The company plans to introduce a new Lillie Rubin prototype with a less intimidating boutique format. These stores will be rolled out starting this fall, mainly in malls where the company already has a Cache store, which should help keep expenses low.

While Cache has greatly improved its profitability, the net profit margin was still a razor thin 2.68% in FY98 versus just 1.74% in FY97. A fashion miscue or an economic downturn and the profits might simply disappear. Still, backing out cash net of long-term liabilities (about $10 million), we get an enterprise value of $63.4 million. With $147 million in sales, the stock trades at a modest 0.43 price-to-sales ratio. Making the same adjustments, it sports a P/E of about 16, or substantially below the recent earnings growth rate.

Low-margin, small-cap women's apparel retailers aren't exactly Wall Street favorites, so Cache may remain undiscovered for a while yet. But some further investigation might be in order, especially if the stock sees some profit-taking in the next few weeks. It's worth noting, too, that insider buying, though often early, is usually a good sign. Director Joseph Saul was a big buyer in the $3 range 18 months ago.

Lots of others to choose from this week on the margins list, but that's all we have time for.

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