Why We’re Still Bullish on Collective Brands

As followers of Valuentum know, Collective Brands (PSS) was one of the first positions in our best ideas portfolio. Unfortunately, the timing could not have been worse, as the market collapsed upon itself, sending down Collective shares by over 30%. Since bottoming out at around $9, Collective has rallied nearly 50%, with the shares trading between $13 and $14. Given the announcement of “strategic initiatives” and its tremendous short-term out performance, we revisited our position and think that with or without a buyout, Collective remains one of our top picks.

DCF Valuation: $24

At Valuentum, we ultimately think a crucial part of the investment process is applying a discounted cash flow model to arrive at a fair value estimate. This gives a sense of the intrinsic value of a business and allows us to determine the true value of a company without the often incorrect price the market may assign to it.

Under our full range of possibilities, we think Collective Brands is worth between $17 and $31 per share. Our base case scenario leaves us with a fair value of $24, which implies 32x our 2011 earnings forecast and 17x our 2012 estimate.

Although the company is struggling with its core, low-end Payless Shoes customer, most stores remain cash-flow positive. Furthermore, PLG wholesale, which includes, Keds, Sperry, and Saucony, is generating plenty of cash from its growing revenues and 11% operating margin.

However, it appears the sum of the parts is greater than the whole.

Although Valuentum is not an investment bank by any means, we’ve simplified our sum of the part to illustrate what an acquirer may pay for the business, which is more valuable broken into two than as one.

First, we honestly don’t see any strategic fits in the public arena. VF Corp (VFC), which has looked to expand their footwear offerings, recently acquired Timberland. The deal cost them $2.3 billion, at a 16x 2010 EBIT multiple. Though they were able to finance the deal via 3.5% short dated notes, we don’t expect management to start piling up debt on an acquisition spree.

How about Deckers (DECK)? Though UGG is on its way to becoming an iconic American brand, it seems odd that they would try to enter running via Saucony. However, we think the Sperry and Keds brand do make a lot of sense, and that the company could leverage some of its fashion know-how into continued growth. That being said, we’re not sure if management really wants to make any acquisitions or if they want to tap into their growing cash position given the uncertain macroeconomic conditions.

Nike? Not a chance. They acquired Converse several years ago, but the deal was dirt cheap and paid for itself almost immediately. Given its past acquisitions, including Starter, Bauer, Cole Haan, and Umbro, we think Nike would prefer a beaten down iconic brand rather than paying up for growth and some overlap (Nike/Saucony; Cole Haan/Sperry).

Regardless, we think this wholesale business is extremely valuable, and could be acquired by a private equity firm. Based on EBIT multiples, we think there’s several ways the business may be valued:

We looked at recent consumer cyclical private equity deals, and noticed that most companies fetched EBIT multiples between 8 and 15. Based on a 12x our 2011 EBIT estimate, the wholesale business is worth over $800 million, or $13.82/share. Collective Brands closed at $13.86, so at this price, investors are potentially getting $2 billion in sales, $128 million in 2010 operating profit and Payless International for four cents! Even in a weighted average of outcomes, Collective Brands net of PLG whole sale still only costs fifty cents. We think that’s a pretty great deal for investors.

What if the bankers don’t break it up?

Even if the bankers decide not to break-up the company, Collective we still receive a premium to its current share price.

Based on commonly used M&A metrics like EBITA and book value, given the current market landscape, the company could fetch a bid between $17 and $32 per share. This is noticeably similar to our fair value estimate, so we find these numbers realistic. The company still looks undervalued at current levels, and we will continue to hold the company in our best ideas portfolio.