K Swiss: Funny for everyone but investors?

This K Swiss/Kenny Powers video is nothing short of hilarious:

The comments section are filled with "K Swiss is awesome!  I'm buying a pair of these shoes."  Is this bankable scuttlebutt?  No.  Eastbound and Down, the HBO comedy series that created the Kenny Powers persona is going to be a cult classic for years to come.  K Swiss is a different story.  While I don't think there is much value in the stock, there is value in looking back at what was once a turnaround situation with what I might have thought was once a margin of safety.

In late 2008, when the shares were around the same price, the company had 75% of it market cap in net cash, $327m in sales, and $24m in profits for Fiscal 2008.  In 2010, the company did $217m in sales and lost $68m and currently 25% of its market cap in net cash.  The CEO owns a big slug of stock and has grown the company over the past few decades, so by that traditional indicator of aligned interest, shareholders are in decent hands.  The situation has changed, but the stock price is about the same (using year end 2008 prices).  The company has tripled sales of its Palladium brand in the past 3 years from $11m to $31m, but the K Swiss brand has seen a 40% contraction in sales despite the release of new products and the Kenny Powers centric ad campaign from $315m to $185m.  The recent video might be the funniest of them all, but it is not a brand new branding approach - Kenny Powers K Swiss commercials are about a year old).

One reason for the losses is that the company hasn't righted the ship in terms of expenses.  Instead of bringing its costs in line with revenue, it has continually sought to find ways to force its revenue to justify its costs.  In 2006 with $489m in revenue, the company had $130m in selling, general and administrative costs, but fast forward to 2010 and the company had $217m in revenue and $142m in SG&A.    The lowest SG&A has been in the past 5 years was $118m in 2009, before the company started pumping money into an aggressive ad campaign.  Even if the company wants to hide behind a long-term view approach to their SG&A, the past 5 years of >50% sales decline has not seen the cost structure budge to be remotely in line with sales.  At the same time, it is hard to envision reviving a consumer brand without an aggressive advertising campaign.  

I could very well be wrong that costs need to come in line with revenue, because the inversion would be that revenue will come in line with costs.  The Kenny Powers-centric ad campaign, as well as several other micro-viral campaigns centered around other personalities, has been around for the past year.  In the 2010 Annual Report, management touted the reception of these investments which are being put through the SG&A line item in the financial statements:

"The first spokesperson was the fictional Kenny Powers from the HBO TV show, “Eastbound & Down,” that featured our Tubes training shoes on Kenny and NFL athletes Jeremy Shockey and Patrick Willis, along with mixed martial arts fighter Urijah Faber. These spots were well received even before their official launch. Online sites, social media, outdoors in New York and Los Angeles and a special Tubes micro site featuring Kenny Powers preceded the official launch. We generated great attention for the brand and strong sales for Tubes at retail and at kswiss.com. By late in the year, Footwear News had ranked us as number one on their list of brands with the biggest jump in buzz while our Facebook fans increased 22-fold and our Twitter followers were up 300%"

These are all nice metrics in that they show some kind of growth.  But how is the business doing?  I'm about to use a limited data set since only one quarters worth of financial statements are available to compare pre and post edgy ad campaign.  Next quarter's earnings have the potential to clear things up, but there are indications that celebration might be premature.  What is the right amount of time to judge traction gained in an ad campaign?  I don't know.  Maybe it is more than 9-10 months, but I'll work with what I have.  The CEO recently said “We are seeing the first fruits of 2010’s investments with sizable year-over-year increases in both our domestic and international futures orders and sequential improvement in revenues."  I think when you peel back the numbers and look at the increase in future orders and revenue improvements in relation to metrics such as gross margins, accounts receivable, and inventory, the growth in terms of quality is overstated.

On one hand, the CEO can claim that the ad campaign has gained traction as there has been a YoY growth in revenue of 10%.  People are buying more of their products.  That is a fact.  How and at what price are they purchasing them though?  While revenue grew 10%, accounts receivable grew 22% indicating that they are offering merchants better payment terms.  The deterioration in gross margin indicates that they are lowering their prices as well.  

From the most recent 10-Q explaining the year over year 420 basis point deterioration in gross margin: "The decrease was the result of an increase in inventory and royalty reserves and greater discounts given to customers due to production delays by our factories for the three months ended March 31, 2011 compared to the three months ended March 31, 2010."  To what extent each individual reason is responsible is hard to tell.  Their guidance for 2011 is that gross margin remains at 39%, so I find it difficult to reconcile their own words with their own words.  I didn't include it in the above chart, but gross margins in later quarters of 2010 had 40%+ gross margins, while the full year margins came in at 39%.  Full year gross margins should iron out any issues in the quarterly numbers, so that things like production delays necessitating greater discounts should not be the sole cause of a huge drop in gross margins.  It could also be that gross margins were abnormally high in the first quarter of 2010.  

The combination of higher growth in inventory and account receivable relative to revenue growth can indicate a lot of things.  The cynic in me wants to say that the Twitter followers and Facebook friends aren't translating into sales.  As a result, management is having to cut prices and give merchants better payment terms in order to drive sales.  At the same time, one could look at the inventory and claim that management is very confident in their ad campaign is beginning to gain traction and wants to be able to respond to the increased sales growth.  Perhaps even a halo effect has emerged and people are beginning to look beyond the growth in K Swiss Tubes sales.  The company's backlog also increased 45% yoy, but this is lower growth than the inventory by a wide margin.  My cynicism and the company's growing backlog can contribute to the higher inventory at the same time though.

Late 2008 had the benefit of a large net cash position and strong trailing earnings over a multi year period.  At the same time the forward looking environment was not as kind.  Luckily, despite what I would consider a weakening financial profile, the share price hasn't really dropped much.  Is the opposite true now?  Is a smaller cash position and trailing losses obscuring a business in revival?  It's hard to tell, although it seems like management's claims that its ad campaign had traction hasn't played out in the first quarter of 2011.  This will play out in the next few quarters, but the margin of safety isn't there if a negative scenario plays out - and I don't think that the financials indicate this is six sigma probability event.  It's also worth noting that had you invested based on a turnaround in late 2008, you would not have lost money including the $2 special dividend as the price is pretty much unchanged since then.  While vindicating the concept of investing in turnaround with a margin of safety, such a scenario doesn't exist for investors today.