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Thursday, December 18, 1997

Converse, Inc.
(NYSE: CVE)
Phone: 978-664-1100
Website: http://www.converse.com
Price (12/17/97): $6


HOW DID IT FIND TROUBLE?

Athletic shoe maker Converse delivered a slam dunk for investors who started the fast break at $4 in June 1996 and drove the lane to the February 1997 high of $28. But the company's hoop dreams have been rejected since then. An industry slowdown and sluggish sales of its Dennis Rodman shoes revealed the company's turnaround jumper to be flat.

Converse stock began the year running, continuing its market-leading fourth quarter price appreciation as word got around that former Fidelity fund manager Jeffrey Vinik was a serious buyer. Next came a favorable court ruling (good for an $8 million after-tax gain) and excitement over its new basketball shoes. As orders poured in, pumping first quarter sales up better than 50%, the stock soared to its 52-week high.

But at 56 times forward earnings estimates, the stock reflected the kind of expectations Chicago Bulls fans have for the NBA's would-be leading rebounder Dennis Rodman. Like Rodman, Converse has failed to deliver.

The stock began dropping in March on word of a proposed 4.5 million share secondary offering. A schizo April saw the stock pummeled on retailer Footstar's (NYSE: FTS) prediction of a second half slowdown in athletic shoe sales only to recover somewhat on news that first quarter earnings beat estimates by 24%. By May, the stock rallied further as it floated $80 million in 7% notes convertible at $21.83, a nifty move that decreased interest payments on its sizable debt.

But by mid-July, the $85 Rodman "All Star 91" shoe was bombing and athletic shoes in general were seeing the predicted sluggish sales. The company missed its second quarter earnings number by 29% and warned that "profits from continuing operations in the second half of the year will be lower than originally anticipated." Analyst downgrades were followed by third quarter earnings of a penny per share, which missed estimates by 50%.

If all that wasn't bad enough, then came the anti-heroics of Converse ad-man Latrell Sprewell.

BUSINESS DESCRIPTION

Converse is a second-tier athletic shoe manufacturer best known for its timeless Chuck Taylor canvas All-Stars. It offers a full-line of basketball, athletic/leisure, children's, and cross training shoes and derives additional revenues from licensing the Converse brand to third-party merchandisers of apparel and sports accessories.

Converse products are distributed in 90 countries by 9,000 retail outlets. Last year 44% of sales came from international markets, including 12% from Japan. About 70% of its products are made in Pacific Rim countries.

The company competes against industry gorilla Nike (NYSE: NKNKE), and other strong players such as Reebok (NYSE: RBK), June Daily Trouble Fila (NYSE: FLH), and Adidas. Slowing sales have crushed the entire industry this year.

Apollo Capital Management owns 65% of the company.

FINANCIAL FACTS

Income Statement*
12-month sales: $430.8 million
12-month income: $4.4 million*
12-month EPS: $0.22*
Profit Margin: 1.0%*
Market Cap: $106.4 million
(*Includes one-time gain and charges)

Balance Sheet
Cash: $7.2 million
Current Assets: $207 million
Current Liabilities: $166.4 million
Long-Term Debt: $80 million

Ratios
Price-to-earnings: 27.3
Price-to-sales: 0.25

HOW COULD YOU HAVE SEEN IT COMING?

Back in February, I wrote a skeptical Daily Double on Converse wondering whether a best-case turnaround scenario was already built into the price. Though the stock rallied 33% from there, the Fool message folder on AOL was stuffed with good reasons for gaping astonishment at the stock's valuation. As it turns out, the bears were right.

Analysts had simply grown way too enthusiastic in boosting 1997 earnings estimates to $0.50 a share. Although Converse has made some real progress in improving operations and paying down and refinancing its debt, its new shoes didn't live up to the hype. Any industry slowdown promised to punish the smaller competitors. The July warning about weak second half sales should have definitively wrecked the investment thesis on this turnaround.

WHERE TO FROM HERE?

Discounting a one-time windfall, Converse has made just $0.32 per share for the first nine months of '97. Analysts surveyed by First Call are looking for a fourth quarter loss. Lowball estimates call for $0.01 per share in earnings this year and $0.25 per share next year, the latter down from a consensus $1.16 just 60 days ago. That puts the stock at 24 times next year's conservative number. Based on potentially optimistic long-term growth estimates of 25%, YPEG fair value would be somewhere between $6 1/4 and $8 3/4.

Gross margin improvements earlier in the year have been reversed due to the strong dollar's affect on overseas sales. On the other hand, selling, general and administrative expenses have improved year-over-year in the last few quarters. With stronger sales, operating income rose 63% in the third quarter to $5 million, which means operating income is now nicely ahead of reduced interest expenses.

Still, the important basketball shoe category has gone from triple-digit growth earlier in the year to a third quarter crash of 2.5%, with orders falling by 25%. Leisure is Converse's only category showing accelerating growth, thanks to strong sales of cool new All-Star brands at the Gap (NYSE: GPS) and to resurgent interest in the indomitable Chuck Taylors.

Though athletic shoe makers ought to see labor cost savings from the collapsing Asian currencies, Converse may not benefit that much given that still-strong China is its major overseas source and the company's "athleisure" shoes are actually made in North Carolina. Plus, its strongest overseas market has been Japan, where the fallout from the Asian contagion has been bad.

Then there's the negative shareholder equity of $29.6 million and the likelihood that the strongest players, like a Nike, will lead any athletic shoe recovery while Converse and others lag behind.

One could argue that Converse's brand name, if properly managed, is worth more than the current enterprise value of $179 million. In fact, the Chuck Taylor brand alone ought to be a little gold mine: these shoes cost next to nothing to make and even less to market. Plus, they require no R&D.

Investors who think this failed turnaround could turn back around should spend some time at local shoe retailers checking the channel that's supposed to be overloaded with inventory. In the meantime, the tax-loss selling seems likely to grind this shoemaker a little deeper into the ground.

-- Louis Corrigan
(TMFSeymor@aol.com)


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