Heelys (HLYS) is an interesting stock to look at, though it doesn't fit my usual criteria for quality. The company sells those "wheeled sneakers" that were hot with the Bart Simpson crowd a few years ago. You could call it a busted fad. The bad news is that sales fell from $188.2 million in fiscal 2006 to $30.4 million in fiscal 2010. The good news is that the company still has a lot of the cash that it earned in the good years and raised in its IPO. In fact, the company is one of the few that has a negative enterprise value. Based on the latest balance sheet dated March 31st, 2011, HLYS has $62.6 million in cash and short-term investments. As an aside, HLYS has been redeploying cash into relatively safe short-term investments in recent quarters, which has resulted in the reduction in cash on recent cash flow statements looking more alarming than it actually is. Back to this issue of a negative enterprise value, if they paid off the $700,000 in negotiated liabilities, Heely's would still have $61.9 million left over, versus a market capitalization of $60.66 million (HLYS's balance sheet does not show any preferred equity or minority interest).
We can divide Heelys into two parts: A pile of net cash worth $61.9 million, and a money-losing novelty shoe business. The shoe business has $12.4 million in tangible capital - $11.6 million in spontaneous net working capital plus $0.7 million in plant and equipment. Is HLYS worth more dead or alive? In liquidation, any proceeds from liquidating tangible capital and the firms' patents would represent excess value relative to the current share price, given that net cash is roughly equal to the market cap. The only reason not to liquidate the money losing shoe business is that there is some chance that it could move from the red to the black. Putting up the extra cash required to keep a money losing business alive is similar to exercising a call option (its actually like exercising a perpetual compound call option, but that level of detail is not necessary here). In my opinion, it is often illuminating to think of some financial decisions in terms of options, but in this case the important thing is that you understand that in most circumstances it is wrong to value a money losing segment in a multi-segment firm at zero or less than zero. If at any stage the value of the option to keep the business alive falls below liquidation value plus the amount cash that you have to put in (the "exercise price" or "strike price" in options parlance), the firm can liquidate and bring the losses to an end.
This is where it gets interesting. Assume that the option to continue to invest in the shoe business has a very low value, well below liquidation value. I suspect that this is the case now, though I don't know that for a fact. There is always the hope that another Heel's fad could sweep through some part of the world. The majority of the company's sales are overseas, though sales appear to have already peaked in some foreign markets. Regardless, even if the shoe business should be liquidated, the problem is that there is little incentive for management to liquidate it. If I interpret the NASDAQ data and the proxy statement correctly, management's stock holdings are not large relative to salary. While by all indications Heely's management consists of ethical and responsible individuals, I tend to emphasize incentives when trying to predict how management will behave. And it is always plausible in a situation like this that management may act both ethically and in manner consistent with their own economic incentives, if they perceive that their incentives are aligned with shareholder's incentives. It is well known that corporate managers are often overconfident about the prospects of their own business. If HLYS were to liquidate the shoe business, it would be difficult for management to argue against simply liquidating the entire company and distributing the excess cash to the shareholders. That leads us to a conclusion that contradicts the assertion that I made above about how the presence of a money losing segment in a multi-segment firm shouldn't decrease the value of the entire firm. One likely outcome for Heelys is that management will continue to exercise the far out of the money option to keep the shoe business alive indefinitely, while meanwhile enjoying the nice compensation package and prestige associated with being an officer of a public company.
Outside of a resurrection of the shoe business or a liquidation, are there any other possible positive outcomes for HLYS? Generally, using the firm's cash for an acquisition is not considered a favorable outcome for shareholders, as there is a strong tendency for management to overpay. In this case, however, an acquisition might free up management to close the shoe business, because their services would still be needed to run the newly acquired business. If Heelys could avoid overpaying by too much, an acquisition might actually increase value by aligning shareholder and management incentives. It would not surprise me in the least for HLYS to acquire a small private toy or sporting goods related company in the near future.
While I find the HLYS' situation interesting right now, I don't see enough value at the current price to make HLYS a buy. I'm not an expert on the business, but I find the cash burn resulting from the buildup in inventories and receivables in the first quarter of 2011 worrisome, especially given that sales declined both quarter on quarter and versus the first quarter of 2010. The buildup in receivables after the Christmas season is of particular concern because receivables fell sharply following the 2009 holiday season (from Q4 2009 to Q1 2010). We'll learn more when the company reports second quarter results on August 11th.
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I am an individual investor who occasionally shares opinions about investments and other matters on the internet. I am not a registered investment adviser or investment adviser representative. I did pass the series 65 exam in 2011, but I have never been registered as an investment adviser or investment adviser representative in any jurisdiction. I will not respond to any inquiries about investment management services. Nothing posted on this blog should be interpreted as actionable investment advice, financial planning advice, tax advice, or legal advice. I do not derive or seek to derive any income from my blogging activities. This blog is intended solely for the entertainment of the reader, and the author.
We can divide Heelys into two parts: A pile of net cash worth $61.9 million, and a money-losing novelty shoe business. The shoe business has $12.4 million in tangible capital - $11.6 million in spontaneous net working capital plus $0.7 million in plant and equipment. Is HLYS worth more dead or alive? In liquidation, any proceeds from liquidating tangible capital and the firms' patents would represent excess value relative to the current share price, given that net cash is roughly equal to the market cap. The only reason not to liquidate the money losing shoe business is that there is some chance that it could move from the red to the black. Putting up the extra cash required to keep a money losing business alive is similar to exercising a call option (its actually like exercising a perpetual compound call option, but that level of detail is not necessary here). In my opinion, it is often illuminating to think of some financial decisions in terms of options, but in this case the important thing is that you understand that in most circumstances it is wrong to value a money losing segment in a multi-segment firm at zero or less than zero. If at any stage the value of the option to keep the business alive falls below liquidation value plus the amount cash that you have to put in (the "exercise price" or "strike price" in options parlance), the firm can liquidate and bring the losses to an end.
This is where it gets interesting. Assume that the option to continue to invest in the shoe business has a very low value, well below liquidation value. I suspect that this is the case now, though I don't know that for a fact. There is always the hope that another Heel's fad could sweep through some part of the world. The majority of the company's sales are overseas, though sales appear to have already peaked in some foreign markets. Regardless, even if the shoe business should be liquidated, the problem is that there is little incentive for management to liquidate it. If I interpret the NASDAQ data and the proxy statement correctly, management's stock holdings are not large relative to salary. While by all indications Heely's management consists of ethical and responsible individuals, I tend to emphasize incentives when trying to predict how management will behave. And it is always plausible in a situation like this that management may act both ethically and in manner consistent with their own economic incentives, if they perceive that their incentives are aligned with shareholder's incentives. It is well known that corporate managers are often overconfident about the prospects of their own business. If HLYS were to liquidate the shoe business, it would be difficult for management to argue against simply liquidating the entire company and distributing the excess cash to the shareholders. That leads us to a conclusion that contradicts the assertion that I made above about how the presence of a money losing segment in a multi-segment firm shouldn't decrease the value of the entire firm. One likely outcome for Heelys is that management will continue to exercise the far out of the money option to keep the shoe business alive indefinitely, while meanwhile enjoying the nice compensation package and prestige associated with being an officer of a public company.
Outside of a resurrection of the shoe business or a liquidation, are there any other possible positive outcomes for HLYS? Generally, using the firm's cash for an acquisition is not considered a favorable outcome for shareholders, as there is a strong tendency for management to overpay. In this case, however, an acquisition might free up management to close the shoe business, because their services would still be needed to run the newly acquired business. If Heelys could avoid overpaying by too much, an acquisition might actually increase value by aligning shareholder and management incentives. It would not surprise me in the least for HLYS to acquire a small private toy or sporting goods related company in the near future.
While I find the HLYS' situation interesting right now, I don't see enough value at the current price to make HLYS a buy. I'm not an expert on the business, but I find the cash burn resulting from the buildup in inventories and receivables in the first quarter of 2011 worrisome, especially given that sales declined both quarter on quarter and versus the first quarter of 2010. The buildup in receivables after the Christmas season is of particular concern because receivables fell sharply following the 2009 holiday season (from Q4 2009 to Q1 2010). We'll learn more when the company reports second quarter results on August 11th.
******************************************************************************************************************
I am an individual investor who occasionally shares opinions about investments and other matters on the internet. I am not a registered investment adviser or investment adviser representative. I did pass the series 65 exam in 2011, but I have never been registered as an investment adviser or investment adviser representative in any jurisdiction. I will not respond to any inquiries about investment management services. Nothing posted on this blog should be interpreted as actionable investment advice, financial planning advice, tax advice, or legal advice. I do not derive or seek to derive any income from my blogging activities. This blog is intended solely for the entertainment of the reader, and the author.
