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Is Payless Worth More?

Payless ShoeSource's (NYSE: PSS  ) stock got plenty of mileage yesterday after the company released its second-quarter report. The stock surged ahead 14.7% to $12.58 before pulling back to $11.37, closing up 3.7% on about 3.5 times the normal volume. I find it very interesting to see the value of a company shoot up only to fall back down, so I'll offer an opinion on what happened.

The company reported on "a series of strategic initiatives as a part of an ongoing process to build long-term shareholder value." Translation -- we've got to do some things to get the company turned around. The term "strategic initiatives" is used way too often, considering it often doesn't really mean anything.

So, why all the excitement yesterday?

By definition, the value of a business is the sum of all of the future cash flows discounted back to the present at some rate. Using this basic equation, we can come up with four basic ways to increase value:

  1. Increase the cash flows from the assets in place.
  2. Increase the expected growth rate.
  3. Lengthen the period of high growth.
  4. Reduce the cost of financing (refers to the cost of capital, a pet peeve of mine that we will not get into here).

Payless plans to sell all of its 181 Parade stores, jettison its operations in Chile and Peru, close 260 stores in addition to the 230 already scheduled for closing (it operates 5,072 stores), and reduce the amount of wholesale business it does. By stopping the flow of cash to underperforming assets, management is focusing on creating value in area 1. Management estimated it would cost between $40 million to $60 million to do the job. Payless would receive $116 million, the net present value of the savings from not having to make lease payments for those closed stores. Not bad, but certainly not worth the $110 million increase in market cap when the company rose to $12.58 per share.

The company stayed in area 1 as it spent less on promotions and kept prices higher. The results were flat sales, higher gross margins, and decreased units sold, which caused increased inventory. Unfortunately, that is cash out to the tune of about $11 million, as estimated from the $22 million of inventory increase over the six months shown in the cash flow statement.

The company is still opening stores. It opened 68 during the second quarter. That's playing in area 2, an area likely to yield higher value. Unfortunately, 68 stores translates into only 1.3% growth. I didn't see any references to increased brand building, and that resides in area 3, which is longer-term and has created lots of value for companies such as Coca-Cola (NYSE: KO  ) and Nike (NYSE: NKE  ) . But management is clearly not focused there right now given the pressure from discount retailers such as Wal-Mart (NYSE: WMT  ) and Target (NYSE: TGT  ) to cut costs.

So, the press release gave us a benefit of $116 million in cost savings, $60 million in potential cost for those savings, and $29 million less cash generated than the previous six months of operation. The math: $116 million minus $60 million minus $29 million equals $27 million in net value added. With 68 million shares outstanding and a $0.41 increase in per share price today, $28 million of business value was added. Coincidence? Not really. If you believe that sophisticated investors who look at cash flows lead the markets, then the value created was overestimated early in the day and corrected back to a fairer estimation.

Unfortunately, like other retailers stuck in the no-man's-land, Payless will have to decide what strategy it wants to take to compete in the future -- a branded strategy or a low-cost strategy. Both have challenges that, until solved, do not make the stock a buying opportunity, especially since I calculate its EV/FCF to be around 17.

Fool contributor David Meier is no stranger to Payless. His wife buys shoes there for the family. He owns shares of Nike but of no other company mentioned.

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