Guest Columns

By Max Olson

In this article I would like to examine a few aspects of capital allocation. Instead of just explaining them, I think it's useful to use K-Swiss (KSWS) as a case study. I choose KSWS because it is a company I have looked at in the past and it provides some interesting examples. As this article is not specifically about the company, I won't go into any business details other than to say that KSWS is a niche footwear company whose competitive advantages lay in cost structure and local dominance of its product space.

K-Swiss has an amazing return on invested capital. It makes a lot of money without having to plow that cash back into hard assets in order to keep earnings up.

Here's the problem: K-Swiss makes too much money. Too much money you say? How can that be? Well, in and of itself it's not a bad thing; but, it becomes a problem when there is no place to put the cash but the bank. This is the capital allocation process at work.

Some businesses keep cash for a reason. They need that money to ward off competition or to weather a cyclical downturn in their industry. Microsoft (MSFT) is a shining example of using this to their advantage. At the moment, Berkshire Hathaway (BRK.B) has too much cash for its own good (Buffett has stated that they need only about $10B). But, Buffett is in his own world and he has earned my patience – as I know that cash will be put to good use at some point.

I don't believe this is the case at K-Swiss. Do they really need almost $200M in cash earning four percent a year? Let's say that out of the $190M in cash they have, $40M is needed for running the day-to-day business (I think this is very conservative, considering their low capital requirements & high cash generation). This leaves $150M in cash. The athletic shoe industry and KSWS (historically) do have some cyclicality. So, let's say they keep another $50M for a rainy day (or in this case, a rainy few years). That still leaves $100M, and in 2005, after share buybacks and such they added about $50M.

Cash Flow Statement

Taking a look at the cash flow statement for '05, depreciation approximates cap-ex which is most likely 99% used for maintenance and not growth. K-Swiss prefers to grow sales with advertising and other intangible assets; that's why they have such a high ROIC. In 2005, K-Swiss decreased working capital (as it had in 2004) and paid out $6M in dividends.

So now, with the retained earnings plus the decrease in working capital, what did they do with the money? They paid down some debt incurred in 2004, and bought back $26M in stock. After all this, there was still $53M that wasn't spent and went right into a money market account.

When you subtract excess cash when calculating ROIC, you have to assume management is going to reinvest earnings at those same returns in the future; otherwise, you might as well leave that cash in the equation.

I like to think of the cash flow statement as the "capital allocation" statement. This is where you get to see how much money came into the business, and where management is putting that cash to use. Profitable growth? Unprofitable growth? De-leveraging? Share buybacks? Dividends?

What Can K-Swiss Do With Its Excess Cash?

There are a few options:

1) Buy back more stock, or do one large tender offer

2) Pay out a larger dividend (I'm not a fan of this option)

3) Reinvest in the core business through invested capital or more advertising

For any business that has barriers to entry and returns on capital in KSWS's range, the third option is my favorite choice by a large margin. But with KSWS, that might (I'm no expert here) do more harm than good. One advantage of KSWS is that it has (for the most part) stayed out of the range of bigger players like Nike and Adidas/Reebok.

Getting bigger and bigger might make sense to grow earnings in the short-term; but, in the long-term, doing so would lead to direct competition with the big players. This leads to lower margins/lower volumes, and hence a lower ROIC. All of this essentially means that K-Swiss has reached the limits of their franchise. As a result, their returns on incremental capital are completely different from the ROIC of their core shoe business.

Assuming that the stock is still cheap, the best option would be to buy back more stock or to invest more in the European business (the latter choice is preferable only if K-Swiss can create the same competitive advantages it enjoys in North America). Investing in other ventures like Royal Elastics could also be a good option if they can get the same returns.

Worst case scenario: if management cannot find high return investments within their competency range, and shares are not significantly undervalued, then returning capital to shareholders with a large one-time dividend becomes the only reasonable option.

Max Olson runs an investment partnership that follows a deep value approach to investing. His articles focus on general principles of value investing as well as specific applications of those principles. Max can be reached at max@maxcapitalcorp.com.

Posted by Geoff Gannon at 02:14 AM | Permalink | Comments (0) | TrackBacks (0)

By Steven Rosales

I am a new investor. What does that mean? Simply that I do not have much experience investing. While I had read books about investing and was aware of the stock market, I had never given much thought to investing.

I saw the stock market as a competition where I was at a disadvantage; investing involved too much risk for the potential reward. Therefore, as of January 1, 2006, I had never purchased a stock. But that has changed. It changed because I reached a point in life where I had funds to invest and needed to make some decisions on how to invest them.

Now many people think that the best way to invest is to place your money with a mutual fund. I was one of those people up until November 2005 when I read John Bogle's book on mutual funds. Two things about this book stood out to me. The first was that whether the fund increases or decreases my investment, the people who are running it get paid, and that these “fees” impact my investment results (if I am up 10% on the year, and I have to pay a total expense fee of 1.5%, I have actually only made 8.5%).

The second point that stood out to me was the fact that the vast majority of money managers do not outperform the stock market. In his book, Bogle points out that most people would be better off just buying the market in an index fund. These are funds where essentially every stock is part of the fund and your return is guaranteed to match what the whole stock market does, good or bad.

When I read this I realized there were actually two distinct risks in mutual funds. First, that I only had a 15% chance of picking a mutual fund that would do better than the market as a whole, and second, that this mutual fund would then have to do a lot better than the market as a whole to outperform index funds after all the mutual fund's fees and expenses had reduced its performance. For example, if the market goes up 10% and it costs me 2% to be in a mutual fund, than the mutual fund has to earn 12% just to stay up with the market.

So with this sobering thought I began to ask myself whether there might be a better way for me to invest my money than just handing it off to a mutual fund. Could I find a way to participate in the stock market and avoid having to do it through mutual funds, and at the same time not increase (in fact, hopefully decrease) the risk associated with investing in a mutual fund?

The answer to those questions is what this series of articles is all about. As a new investor I have set off on a journey to discover if a reasonably intelligent individual who is willing to devote a sensible amount of time can learn to successfully invest in the stock market.

Steven Rosales began investing about a year ago. His goals are simple: preserve capital, grow capital, and invest with a margin of safety. Steven is the author of Value Blog Review, a website devoted to presenting and discussing the best blogs, websites, and books for new investors.

Posted by Geoff Gannon at 02:01 AM | Permalink | Comments (1) | TrackBacks (0)