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Long/Short Position in Heelys, Inc. [HLYS: Asdaqgm]

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Long/Short Position in Heelys, Inc. [HLYS: Asdaqgm] McIntire Investment Institute Investment Proposal – Long/Short Position in Heelys, Inc. [HLYS: asdaqGM] April 23, 2007 Dmitri Adler, Analyst Key Statistics Price – $32.32 Market Cap – $865.74M P/E, ttm – 27.52 PEG Ratio – 1.05 Profit Margin – 15.5% Operating Margin – 24.2% ROA – 48.73% ROE – 56.75% Revenue – $188.21M Gross Profit – $65.64M EBITDA ttm - $46.52M EPS – $1.16 Total Cash – $54.18M Debt/Equity – 0.002 Current Ratio – 8.362 Heelys currently has a healthy financial position. The PEG ratio is well below the commonly accepted limit of two, which means that the recent growth of the company is not overvalued, partially because analysts realize the “fad” nature of the product. The P/E ratio of 27.52 is high for retail, which usually trades at around 20, but this valuation is consistent for a growth company with prospects for future development. Because of Heelys unique style of outsourcing almost all functions except for design, development, and marketing its costs are low and its margins are some of the best in the industry. It has very little debt, most of which was paid off with the IPO proceeds, and is in no threat of financial distress. The company has a relatively large amount of cash, given its size, that it is planning on investing into the company in order to increase growth. A market cap of $865 million makes this company small enough where MII can get an edge on the market through VAR by continually tracking consumer demand in stores. Heelys financials are stable, which makes the company potentially investment grade if all other criteria are satisfied. Business Overview Heelys is a 41 person company founded in 2000 in order to design, market, and distribute shoes that contain one or two retractable wheels in the heel. The company went public in 2006 and has had rapidly rising sales that have propelled its price from $21 at its IPO to the current price of $32.32. Most of the $58.8 million of net proceeds from the IPO will go towards infrastructure improvement of IT systems, new hires, and marketing and advertising. Heelys out sources all manufacturing to 11 facilities, 7 in China, 2 in Indonesia, and 2 in South Korea with a total output capability of 1.4 million pairs per month. All the manufacturing contracts are short-term, which allows great flexibility of the company. At the same time, Heelys also has no long term contracts with retailers, which adds risk to its distribution capability if its sales do not achieve required levels. Heelys fills shoe orders in 3-4 months and all items are shipped directly from manufacturers to the retail chains, which eliminates needs for warehousing and decreases net working capital. Heelys “no order cancellation” policy appears to not have caused significant difficulty in attracting new distributors. Ninety eight percent of Heelys revenue comes from sales of wheeled foot wear and the other 2% comes from accessories such as replacement wheels, helmets, and other protective gear. Heelys shoes cost from $59.99 to $99.99, which is a very competitive price compared to roller-skates and other athletic footwear. The company distributes its merchandise through The Sports Authority, Modell’s, Dick’s Sporting Goods, Journeys, The Finish Line, Nordstrom, Mervyn’s, and certain online stores such as Zappos.com. These retailers operate a little over 7,400 of which only about 5000 currently carry Heelys. A large part of the company’s strategy is to expand its sales by having more store outlets carry Heelys products. Heelys uses a network of 19 independent sales representatives to source new retail clients. These sales reps are considered as independent contractors and sell products of other companies in addition to Heelys. This strategy increases Heelys’ flexibility but potentially decreases the efficiency of its expansion efforts. Heelys targets 6-14 year old boys and girls that comprised 36.4 million individuals in 2005 and are projected to reach 38.2 million individuals by 2015. The relatively slow growth of this population segment indicates that Heelys will have a limited market size for its products for the foreseeable future. The company holds more than 80 patents and has additional patents pending in 25 countries, which should significantly broaden its market base. Not all of Heelys patents are universally upheld however – Heelys patents have been successfully challenged in lower courts in Japan and the case is pending in the court of appeals and a similar law suit is pending in Indonesia. While Asian sales are not a significant percentage of Heelys sales, the company has experienced problems with copycats that sell identical products under different brand names. Thesis Points My research suggests that Heelys has strong prospects for growth for at least the next two quarters. I believe if MII is to make a play on Heelys at all, then it should invest on the stock as a long for the short term, the next several quarters, and short the stock towards the end of 2007 or beginning of 2008 when expectations for the company are still high but the popularity of its products begins to decline. I think that this company is a risky bet because of the fickle consumer demand for fads. 1. Sales are strong in stores across the country as “Heeling” gains popularity. 2. Strong sales will prompt new stores to carry Heelys which will help boost sales to the projected 20% annual growth. 3. New marketing campaign for the spring and summer will boost demand. The only previous marketing campaign in 2005 has dramatically increased awareness of the company and is mostly responsible for the more than 400% increase in sales for 2006. 4. VAR suggests that kids are very excited about Heelys, which ensures the company’s survival and growth in the near future. Sales Overview In the past year Heelys has increased sales by over 400% to $188,208,000 mostly due to a large marketing campaign that significantly increased awareness of the product and sparked demand. Heelys is about to launch another marketing campaign that should raise sales by about 20-25%, from the 6.2 million pairs sold last year. The company’s newly increased capacity to produce up to 1.4 million pairs of shoes per month is prepared to fill the necessary orders if demand will increase above the predicted levels. Heelys has 3 different shoe models in addition to the accessories and safety gear it sells. However, 89.1% if its net 2006 sales came from one particular model of the shoe. This highlights the significant risk of the company because its entire fortune rests on a singly type of a one-of-a-kind product. Most of Heelys sales are from different types of retail stores, as the graph below shows. Dept. Online Sporting Stores 10% Goods 7% Retailers 45% Specialty and Indep. Retailers 38% In order to boost their largest source of revenue Heelys supplies its customers with lots of in-store marketing materials, free POP merchandise displays, and extensive salesperson training clinics. According to analyst reports this makes Heelys a very convenient supplier for the stores, especially because of the demos that the company puts on where professional skaters perform stunts in Heelys shoes around malls, which brings attention to the merchandise but also the store. In order to create a brand identity Heelys asks retailers to locate all Heelys merchandise together close to the shoe department so that customers can identify Heelys as a distinct brand and not simply a type of shoe, as was the case with the failed company Rollerblade. According to consumer reviews on zappos.com, boys and girls are equally satisfied with their purchases. Out of more than 1,300 positive reviews, 55% were male customer s and 45% were females, respectively. This shows that the product is well targeted towards the age group which allows the company to have a larger customer base. The shoe is a large marketing success as it quickly captured market share in the skateboard footwear niche as the graph below shows. Top Ten U.S. Skateboard Footwear Brand Market Share ─ Athletic Sporting Goods Skechers NSS Puma Dukes 1% Airwalk 2% DC Shoe 4% 1% 1% 7% Adidas Etnies 37% 11% Vans 14% Heelys 22% Although Heelys sells its merchandise throughout the world patent infringements and a lack of popularity of the skateboarding culture prevents repid expansion of sales. In 2006, 85.7% of sales came from the United States, and as the graph below shows, more than half of 14.3% of international sales came from Canada. Heelys’ International Sales Breakdown by Country Brazil/Chile/ Argentina All Other Portugal 3% 7% 5% Ireland 11% Canada 58% UK 16% Trends and Parallels Heelys is seen as a fad by most analysts and it has all the ominous characteristics of fads such as Rollerblade and L.A. Gear, both of which have lost the prominence they had at their primes. Rollerblade has been in business since 1980 and in the early nineties controlled over 50% of the market share. However, poor branding and insufficient patents allowed many competitors to enter the market and commoditize the product. As the popularity of inline skating decreased in the late 1990’s the market size shrank and remains modest now. Very similar fates befell L.A. Gear and the exercise fad and the razor scooters. At the peak of their popularity, there were more than 30 million domestic inline skaters and over 15 million scooter riders, far more than the 6.2 million pairs of Heelys sold last year.
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