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Payless Walks the Line

Its stores are set for a makeover but the stock could be left behind.
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Payless ShoeSource


looks poised to become a much better place to shop, but that doesn't necessarily mean the company's stock price will keep going up.

If there's one trend in discretionary spending that can survive a downturn in the economy, it might be women's desire to go out and buy a new pair of shoes. The Payless chain, with its dowdy storefronts and disheveled sales floors, has never been a favored destination for such women, but the company's new CEO, Matthew Rubel, aims to change that. Since he comes from


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stylish and successful Cole Haan unit, his plan has some credibility.

Rubel plans to give Payless a makeover, transforming the chain from a quick stop for people looking to save money on footwear to a chic destination for affordable fashions. Rubel has said he wants the brand to garner an "emotional attachment" from customers, particularly shoe-hungry women. The only problem for investors is that the stock price is trading too high now, especially given the cost of the makeover and the competition that lies in wait.

"Payless deserves a higher multiple than other shoe retailers, but at these levels, it's gone above and beyond," says Ron Bookbinder, an analyst with Sterne, Agee & Leach who recently downgraded the stock to neutral. "We think the stock has shifted from a value story to a sales-driven story, and that's a much tougher proposition in a business like shoe retailing."

Bookbinder does not own shares of Payless, and his firm has no investment banking relationship with the company.

Shares of Payless more than doubled last year as the company reshuffled management, and cost-cutting measures resulted in what is expected to be a 127% year-over-year increase in profit. Sales growth, meanwhile, has been negligible, up just 0.3% for 2005, while sales at stores open at least a year rose 2.5%.

The stock price rose in short bursts over the course of the year, peaking at $21 in July as Rubel took over the top spot, dipping in the teens throughout the fall and surging to a 52-week high of $25.74 in the week after Christmas.

Currently around $24, Payless is trading at more than 18 times its earnings estimates through 2006. Other lower-cost shoe store chains, like

Shoe Carnival

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, operator of Famous Footwear, normally trade closer to 13 times earnings.

Payless, meanwhile, has typically traded at a premium closer to 15 times earnings in recent years because of its healthy balance sheet, strong cash flows and its inclination to return cash to shareholders. Since 1999, the company has repurchased more than $500 million of its outstanding stock.

The retailer's high stock price now has much to do with Wall Street's excitement about what Rubel might do with the chain, but the profit gains in 2005 that supported the rally can more accurately be attributed to former CEO Steven Douglass.

"It's the previous regime that really set up what they benefited from in 2005," Bookbinder says. "They cut the SG&A (selling, general and administration costs) to the bone. They brought the inventory down and improved the merchandising right before Steven left."

Back in August of 2004, when profits were down and market share was dwindling, Payless launched a plan under Douglass to trim $12 million from its annual spending. It sold off its Parade chain, closed 260 Payless stores and shed operations in Chile and Peru.

The cutbacks worked, boosting gross margins to a record 35.1% by the first quarter of 2005, up from 31.3% in the year-earlier period. Most of the gain came from a $24.7 million decline in selling costs. Profits were up 114%, even though sales grew only 0.4% for the period. The same trend continued through the next two quarters.

Now, with its gross margin as good as the company is likely to get it, only sales growth is likely to support the stock at current levels.

"We believe it will take a 7% comp

a year-over-year gain in sales open at least a year in 2006 to warrant today's share price," Bookbinder says. "That would be quite a feat, because the shoe retailing business is a very tough business. You need everything to cooperate with you, from the weather to the economy. It's not the sort of thing you want to bet much money on."

Shoe retailing is notoriously tricky, and in recent years, the competition has grown. In addition to the many private shoe stores thriving throughout the country, discount superstores like


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have become a potent force.

"We expect the low-priced footwear industry to remain highly promotional for the foreseeable future as competitors add more stores and mass merchandisers increase their footwear product offerings," says Morningstar analyst Brady Lemos. "In our opinion, Payless has no economic moat to defend itself from these external threats and will struggle to produce consistent profitability."

Payless' December same-store sales, a key barometer of retail health, fell 1.5% from the previous year. The company has been more consistent with its monthly sales of late, but the unexpected decline in the holiday season suggests it remains a market share target for competitors. That's where the new CEO comes in.

To come to Payless, Rubel gave up a job presiding over the transformation of an obscure shoemaker into a hot brand for stylish shoes and handbags. At Cole Haan, Rubel was elbowing the likes of



in the accessible luxuries market, selling shoes for more than $200. Now, he'll be selling shoes that are often priced closer to $18.

Despite the transition, investors still think Rubel can spruce up Payless ShoeSource. That sprucing, however, will cost money, and that process could create an atmosphere for a falling share price.

"It's only natural that Rubel will want to make some big changes to assert himself in his new job and make some impressions," Bookbinder says. "He's going to do a big store-remodel. He's going to change the storefronts to something more attractive, and all that will increase the selling costs again."

If selling costs rise, then the burden will be on Payless to increase sales even further to maintain the margins that led to its spurt of profitability in 2005. Some people think Rubel can return Payless to its heyday in 2000 when its operating margins hit 8%. In 2004, they had fallen to 2%, and now they're at 4%.

"To reach operating margins of 8%, we calculate you would need something like a mid-teen comp in 2006, and that's assuming that selling costs stay where they are," Bookbinder says. "Neither scenario seems very likely."

Using a discounted cash flow model, Morningstar's Lemos puts Payless' shares fair value at $12, just over half today's market price. He also expects Payless to earn an average return on invested capital below its cost of capital over the next five years.

"This is not the type of stock we would recommend for long-term investors," he says.