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<DAILY TROUBLE>
Friday, May 21, 1999

K2 Inc.
(NYSE: KTO)
Website: www.k2sports.com
Phone:  323-724-2800
Price  (5/20/99): $10

HOW DID IT FIND TROUBLE?

Once a hit with extreme sports enthusiasts looking for mountain bikes or comfy in-line skates, K2 has become such a dog that it might need to change its name to K9.

The stock was trading above $20 per share last August before the company reported dismal Q3 earnings of just $0.09 per share. That missed estimates of $0.13 a share and sent the stock speeding over a cliff. Demand for K2's high-end full-suspension bikes "abruptly declined," according to the company. As lower-priced models from competitors hit the market, K2 was forced to slash prices. The firm took an after-tax charge for reserves of $9.4 million, or $0.57 per share for the period.

Since K2's in-line skate business hit the skids just a year earlier, the company was hoping for a very white Christmas to drive its ski business. But beyond a few blizzards, the winter weather was unseasonably warm and, thus, unusually cool for K2. Fourth quarter earnings of $0.10 per share were half the prior-year results and 50% shy of estimates, according to Zacks.

The stock's slalom course since last fall has included some peaks. Still, it's looking like K2 needs some new equipment to surmount the recent trading range.

BUSINESS DESCRIPTION

Based in Los Angeles, K2 primarily makes high-end, performance-oriented recreational products. It designs and markets alpine skis, snowboards, roller blades, and mountain bikes under the K2 brand. It also designs and markets Olin snow skis, Stearns flotation devices, BMX bikes, Shakespeare fishing rods, and Hilton active apparel.

For FY98, sporting goods accounted for $404.9 million in sales (70.5% of total sales), down 1.4% from FY97. Other recreational products, such as Hilton and Planet Earth apparel, accounted for $43.7 million in revenue (7.6% of the total), up 27.8%.

K2's industrial products division did $125.9 million in sales (21.9%), up 10.4%. This division makes composite utility poles and fiberglass radio antennas, but it benefited especially from sales of nylon and polyester monofilament line used by paper producers.

Insiders own 6.7% of the stock.

FINANCIAL FACTS

12-month sales:       $586.5 million 
12-month income:       $13.7 million
12-month EPS:           $0.83
Profit Margin:           2.3% 
Market Cap:           $165.7 million 
Enterprise Value:     $272.1 million
(*Income and EPS from continuing
operations excluding one-time charges.)

Balance Sheet
Cash:                   $3.8 million
Current Assets:       $324.7 million
Current Liabilities:  $120.3 million 
Long-term Debt:       $110.2 million     

Ratios
Price-to-earnings:    12
Price-to-sales:          0.3
EV-to-sales:             0.46

HOW COULD YOU HAVE SEEN IT COMING?

Had you known that I was hankering to get some K2 soft in-line skates for Christmas 1997, you might have known K2 was in trouble. That's because I tend to pick up on fads as they're sputtering out.

Back in 1994, K2 introduced an innovative soft boot design. These "roller blades" feel like a hiking boot with wheels rather than a bunch of clunky plastic. Over a four-year period, the company's skate sales soared from $10 million to $117 million, bringing K2's stock along for the ride. However, price cuts by competitors and what K2 called the "substantial decline of the worldwide 'aggressive' skate market" led to a disastrous third quarter in fiscal 1997. That proved the beginning of a long downhill run.

With this major growth engine hobbled, K2 was suddenly very dependent on its bikes and snow skiing/boarding businesses. And a quick look around each of these industries would have suggested similar competitive trends. Companies like Ride (Nasdaq: RIDE) and Rockshox (Nasdaq: RSHX) were bumping along as fierce competition squeezed prices, making it tough for high-tech, high-end products to win the premiums manufacturers were expecting.

WHERE TO FROM HERE?

Overall, shipments of K2's high-end, full-suspension mountain bikes plunged 47% last year, while in-line skate sales were flat -- thanks only to gains in the children's market. Snowboard sales increased due to K2's new Clicker step-in binding product. Yet, the company actually shut down its ski and snowboard production plants late in Q1 to reduce inventory. And on April 21 CEO Richard Rodstein said, "Pre-season orders for our core winter sports products suggest that sales of these products will be off from the prior year."

There has been some good news. First quarter sporting goods revenues rose 13.2% thanks to a 37% jump in skate sales. Overall revenues ran up 8% to $163 million. Earnings from continuing operations of $0.19 per share bested estimates calling for $0.16. Moreover, the company recently acquired the Morrow brand from the financially distressed Morrow Snowboards.

On March 31, the company also won a preliminary injunction against French sporting goods firm Salomon, S.A. -- a unit of adidas-Salomon AG -- which prevents that firm from selling soft-style in-line skates because it may infringe on K2's patent. In addition, K2 has already introduced a line of mid-priced full-suspension and single-suspension mountain bikes as part of its new segmentation strategy. If that move doesn't work, K2 could exit the bike biz, according to a report earlier this year in Sporting Goods Business.

For his part, CEO Rodstein admitted in April that the global sporting goods market remains "challenging." That's usually code for "don't get your hopes up."

Looking at the Q1 balance sheet, inventories actually fell 15% versus the year-ago period, to $163.9 million. However, accounts receivable increased 10% to $138.6 million, and that was after factoring $50 million in receivables. So, inventories in the sales channel probably remain quite high for certain products. The company also has a significant amount of long-term debt.

The current consensus earnings estimate calls for K2 to earn $0.94 per share this year and $1.06 in FY 2000, putting the forward P/E at a reasonable 10.5. As a very satisfied K2 customer, I know the company has the technological prowess to produce great gear. Whether the company can really regain momentum, though, is an open question. While first quarter skate sales were impressive, the bike and ski markets remain as clouds hanging over the stock.

-- Louis Corrigan

The Fool is hiring. Answer the call.

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