The Consumer Stock Network

Yesterday, Collective Brands (NYSE: PSS) - formerly Payless ShoeSource - announced that a federal court in Oregon had ruled against the company in a lawsuit with adidas AG. As a result, the court ordered Collective Brands to pay $305M in damages. Collective Brands' management believes the verdict was "excessive and unjustified," and will ask the the court to set aside the verdict or overturn it.

The verdict is the result of December 2001 lawsuit in which adidas accused Payless of "trademark and trade dress infringement, unfair competition, deceptive trade practices and breach of contract" for selling unauthorized footwear featuring its trademarked "three-stripe" logo.

Legal battles are always challenging from the perspective of financial analysis. If the verdict stands as ruled, the $305M penalty is a serious blow to a company that already took on significant debt to finance the acquisition of Stride Rite last year. Considering the company has $232M in cash, $936M of debt, and $702M of equity on its balance sheet, a payment of this magnitude materially changes its capital structure and its valuation. That said, the penalty does seem excessive ($305M is almost 10% of consolidated 2007 revenues of $3.0B), and there is a chance that the verdict will be overturned or settled for a reduced penalty payment

Another concern is that this ruling will set precedent. A quick review of the "Legal Proceeding" section of Collective Brand's 10-K filing indicates that K-Swiss (NASDAQ: KSWS) has filed a similar trademark lawsuit in California. We would expect K-Swiss' legal team to use the findings from this case to augment their own complaint.

It is virtually impossible to predict how legal matter like these will be resolved, but they are always expensive and will certainly weigh on the company's bottom-line. Collective Brands does not break out legal expenses in its filings, so it is difficult to tell how much of an impact an increase in legal activity will have. However, the company expenses legal costs as incurred, suggesting that there could be additional margin pressures in the upcoming quarters.

Investment recommendation: Following yesterday's pull-back, Collective Brands' stock is now trading at just 9.3x the consensus 2008 (fiscal 2009) EPS estimate of $1.12, a ten-year low (though historical multiples are less relevant here due to the Stride Rite acquisition). Though we are intrigued by the potential earnings power that the Payless/Stride Rite/Collective Licensing "hybrid" platform can have, including synergy opportunities and cost saving measures, we view the integration of the three businesses as a long-term project. The adidas penalty and the possibility of other unfavorable legal rulings further clouds the situation. A investment case could be made for deep value investors at current levels, but given the challenging footwear environment, we would advise individual investors to take more of a "wait-and-see" approach until there is better visibility.

Update: There are a handful of websites/blogs that go into more depth regarding the legal aspects of the case. We have linked to them below:

• It might cost Payless more to pay less [43(B)log]
• adidas wins $305 million trademark case against Payless [Playbooks & Profits]