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4 comments | by: Brandon Smithson June 19, 2007 | about: KSWS, NKE

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Nike (NKE) has long enjoyed a well-recognized brand name, quality products, cutting edge
athletic technology, and a sound management team. Long time stockholders have been well
rewarded over the past decade, having been the beneficiaries of increased stock buy backs,
regular dividends, and most recently this spring, a two for one stock split.

Nike forges ahead each season by introducing hot new styles, and they always seem to have a
product that is flying off shelves and causing traffic at the local sporting goods or shoe store.
  

 
   
 

  

Nike has always ruled the athletic apparel business with new styles and affordable
performance gear. With the introduction of dri-fit several years ago, they created the market
for a type of specialty sweat resistant sportswear that enhanced performance. Not far on its
heels was Under Armour (UA), who has since perfected the technology Nike first introduced,
and is signing deals with collegiate and professional teams, left and right. However, as long
as Nike is first to market with these new product introductions, it will continue to enjoy the
prestige and profits associated with an industry leader.

Industry leadership has always been expected at the footwear business of Nike, the
cornerstone of the company. However, in recent years, several specialty footwear companies
are gaining momentum, and that should be of major concern to the Nike footwear business:
Crocs, INC (Cë
), and Heelys (HLYS). Both of these companies have created a new
market, which in the past had been Nike¶s game.

Crocs are a casual sandal made of plastic, and you have probably seen elementary age kids
zip around the mall on their new Heely¶s shoes. While still in their infancy, these two
companies have already started to turn a generation of shoe purchasers away from the
traditional athletic shoe, towards affordable sporty fashion statements, which is a market
which Nike used to own.

Nike has several options as it tries to set its strategy in response this change in demographics
and consumer preferences. Its first option would be to funnel the boatloads of cash it
generates from years and years of frugal operations back into the business. In the past, Nike
has used its cash flow from operations to fund stock buybacks and dividend payments (just
under $1B in µ06), as well as short term investments ($0.9M in ¶06).

While investors cheer when cash is returned to them, one really has to wonder why Nike
would tie up almost a billion dollars in cash for short term investment purposes. Wouldn¶t
this money be better suited on market research, new manufacturing facilities, or a new
development lab? ½erhaps this symptom of caution is a theme which will continue to play
itself out on in the board rooms of Beaverton, until the footwear giant we know as Nike has
lost its grip on the industry.

n the other hand, instead of treating that cash as an anchor on the company, Nike should
take a big swing and acquire one of these specialty shoe companies. With the excellence in
manufacturing and supply chain that Nike has learned, it could buy a company for both the
breath of fresh air and talent, as well as leveraging its operational rigor to squeeze better
profits from the new acquisition.

According to recent filings, Nike has over $2B in cash in the vault waiting to be used. After a
quick comparison of other publicly traded apparel companies, there are multiple options for
acquisitions that Nike could afford. The companies I looked at include K-Swiss (KSWS),
Timberland (TBL), Skechers (SK
), Stride ëite (Sëë) and Lacrosse (B T). The results of
this analysis are in the table below:

The clear favorite here is K-Swiss. There are multiple synergies here that Nike could take
advantage of, and this deal would make a lot of sense to both companies. A fellow West-
Coast shoe company, K-Swiss is famous for its simple, yet recognizable, style of striped
shoe. Sales have declined in the last year, as the main product line is not gaining the revenue
traction in the U.S. market that management expected. International sales look quite robust,
but this has not excited Wall Street. However, margins have continued to increase, which
show a clear effort to deliver, despite the top line miss.

K-Swiss is funded without any debt, and is currently trading at only 14 times earnings,
perhaps because of its conservative management, and use of capital. The recent concerns over
the viability of a company based on a very limited product line have chipped off about 30%
of the market capitalization (now just under $1B), and suddenly this company looks very
very affordable for Nike. The beauty of this deal is that when Nike plugs K-Swiss into its
existing distribution channels, Nike not only gets the benefit of a turnaround sales story at K-
Swiss, but it also enjoys the profit margins which are currently almost double that of Nike¶s.
Cost savings and revenue expansions are a great formula for acquisitions.

There is no telling how long this deal will wait for Nike. With the amount of private equity in
the markets these days, an operation like K-Swiss with healthy margins, a depressed stock
price, and a pristine balance sheet shouldn¶t have to wait very long to be gobbled up. The
interesting thing will be to see if Nike will step up to the plate and open up the cash vault to
make a deal, or be content to sit on it while the rest of the footwear and athletic apparel
industry catches up to them.