It's common knowledge that a diet high in fatty foods will ultimately lead to hardening of the arteries. One featuring a high concentration of sodium will cause hypertension. And a company that tries to digest too many acquisitions will experience the corporate equivalent of indigestion. Sporting goods manufacturer K2 (NYSE:KTO) seems to be in need of some antacid tablets right about now.
The manufacturer of such well-known sporting good labels as Rawlings, Worth, Ride, Brass Eagle, Ex Officio, and its eponymous K2 skis, K2 found that its end-of-year acquisitions of ski equipment and clothing companies Volkl, Marker, and Marmot Mountain are indeed causing the drain in earnings that it projected at the end of the fourth quarter in March. It was that guidance that KO'd the stock with analysts who had been much more buoyant about its prospects when those acquisitions were first announced.
The second quarter is typically slow for ski equipment sales, but the downturn in paintball equipment sales, which had previously been strong for a growing extreme sport, caused action sports revenues to drop by more than 6% to $65.1 million from last year. The decline was accentuated by the acquisitions and more than offset the respectable, if not downright healthy, increases in the other three segments into which K2 has divided its business. Over the same period last year, K2's team sports division was up 11%; marine and outdoor was up 21%; and apparel and footwear was up 209%.
As a result, earnings per diluted share came in at $0.03, well below the $0.16 per share the company earned in the second quarter of 2004. What hasn't declined is the company's dilution of shareholder value. From June '04 to June '05, K2 increased the number of outstanding shares by 31%, or 46 million shares, to finance its acquisition spree, and its debt levels have doubled to just under $400 million.
Still, for the coming year, management maintains it will be able to achieve its pro forma adjusted guidance of $0.87 to $0.91 a share based on 55 million outstanding shares. With another 20% dilution in the cards, investors just might expect to see another acquisition. But it's going to take some exceptionally strong sales growth to offset the drain to shareholder value and hit the mark the company has set for itself. Certainly it's good to raise the bar, but maybe they shouldn't be setting the hurdle quite so high.
Consider that the second half of the year accounts for slightly more than half the sales K2 will realize for the full year. With some $619 million in sales already in the bank, K2 will more than likely realize only another $675 million in sales over the next six months, even with the acquisition triumvirate performing up to par. Margins will have to improve markedly, even more than they have been doing, to generate enough profits to meet their goal. It doesn't seem possible, certainly not without taking on more debt to fund an acquisition, and certainly not without even more dilution.
Like a diner at a smorgasbord, it takes a strong stomach and a clear head to be able to take what you want, but eat what you take -- without bringing on the indigestion. It's a lesson K2 still has to learn.
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Fool contributor Rich Duprey owns shares in K2. The Motley Fool has a disclosure policy.
