Description

 Thesis

DECK is currently trading at less than 4.1x EBITDA, 11x Free cash flow, and 9x P/E despite having superior growth opportunities, high returns on capital and no debt.  Since new management took over in 2005, DECK has transformed itself from just a seller of shoes to a manager of lifestyle brands.  The Ugg brand is the primary driver of the business and is still in its nascent growth phase as it expands into other product categories and increases distribution both international and domestically.  For a company growing its topline double digits, the company should trade at a minimum of 8x ebitda, 15x FCF, or 15x P/E, which is over 50% upside from here.  Looking out a few years, they should end this year with close to $24/share and two years from now close to $40/share in cash.  Should growth continue at its current trajectory, DECK would be trading at approximately 2.8x FCF after subtracting out $40/share in cash (stock currently at $67.40/share).

Business Description

Deckers Outdoor Corporation engages in the design, production, and brand management of footwear for outdoor activities and casual lifestyle use. It offers casual open-toe and closed-toe footwear, including adventure travel shoes, outdoor multi-sport shoes, trail running shoes, amphibious footwear, light hiking shoes and boots, sheepskin boots and slippers, rugged closed-toe footwear, sneakers, sustainable footwear, and sandals under various styles for men, women, and kids.  The company also offers various accessories, including handbags, headwear, packs, and outerwear.  It markets its products under the Teva, UGG, Simple, TSUBO and Ahnu brand names.  For now, the vast majority of sales are to women (90% for Ugg) but the kids and men's businesses are growing rapidly.

Through the wholesale channel, the company sells its products primarily to specialty retailers, department stores (Nordstrom's is a 10% customer), outdoor retailers, sporting goods retailers, shoe stores, and online retailers.  The growth in this channel is coming from: 1) adding new wholesale accounts internationally; 2) increasing shelf space for Ugg products within it current distribution footprint by expanding categories by gender, age, and season; 3) adding shop within shops which is mostly in specialty retail (e.g. 90 new stores this year on top of 69 last year).

Through the direct channel, Deckers sells its products through its Web sites, catalogs, and full-priced retail and outlet stores. It has joint venture with Stella International Holdings Limited for the opening of retail stores and wholesale distribution for the UGG brand in China.  The company has 12 stores now primarily in major metropolitan areas and will have 18 by the end of year.  These stores are comping over 25% even in this environment.  The company will have 30 stores in the US and 100 internationally.

One of the key reasons to the company's success has been through tight distribution and inventory management.  The company will not sell to demand but rather keep stock limited across the channel and within accounts.  This "limited" distribution strategy ensures the products remain fresh at all times.

 Investment Highlights

 Strong and Experienced Management Team

Angel Martinez, joined Deckers in 2005 as CEO, after spending 21 years at Reebok.  He is known for turning around the Rockport division and diversifying the company's product offering by introducing the aerobic shoe, tennis shoes, walking shoes, and basketball shoes, as well as creating the Reebok "Classic" line of footwear and apparel.  He was the third employee at Reebok and spent a lot of time on brand building and marketing.  He was sought to eventually takeover as CEO but had resigned to be closer to his family back to California.  He then co-founded Keen Footwear in 2003 and grew it to be a formidable competitor to Teva in just 2 years.  He left Keen in 2005 to take the CEO position at Deckers.  Since he joined in 2005, the company has been on a rapid growth trajectory driven by the Ugg brand.  He has intentionally limited distribution of the product to maintain its wide spread appeal and has diversified the extended the brand into other product categories similar to what he did at Reebok.  Given his strength in brand building and marketing, Angel has built Ugg to be the premier brand for accessible luxury and comfort, which is why other categories (e.g. apparel, accessories, etc.) and other shoe products (e.g. sandals, slippers, boots, etc.) have been selling well.

 Numerous growth opportunities still exist for Ugg

Despite growing the Ugg brand from $24MM in sales in 2002 to $582MM by 2008, Ugg is gaining momentum as a high quality luxury brand known for comfort and affordability with core products selling for $140-$150. 

 The company projects sales for Ugg to be $750MM by 2012 (note: total sales are expected to reach $1bn) and this could prove conservative given the opportunity set:

 Significant opportunity for brand extensions:

• Previously UGG was known only for its sheep-skin lined boots and Teva for its outdoor sandals. DECK has extended each of the brands to be more year-around. For example, UGG has more selections w/ limited sheepskin and include sandals and flip flops, in addition to slippers. UGG has also increased its selection of men's and kid's footwear.
• DECK manages its inventory in each retailer such that the retailer must accept some of the new items. Retailers will be not allocated just the products that they want to sell. This ensures that the brand extensions have an opportunity to be marketed and sold.
• Channel checks of new products have been doing extremely well at retailers

Retail Opportunity

• Retail stores give DECK an opportunity to present its full selection of merchandise - which makes it easier to sell to its wholesale customers and can be another marketing vehicle for the company. The stores will showcase 100 styles versus 40 styles to a typical account. These stores are comping over 20% indicating the strength of the brand across product categories

International

• DECK currently only has limited international exposure with only $100MM (17% of total Ugg sales) in sales as of then end of 2008. The plan is to grow this to 30% of the business in the next few years. They are underpenetrated in mature markets like Germany and Japan and have significant potential in China, which they have entered through a JV with Stella International

Other Brand Optionality

Given the strength of this management team in brand building and marketing, there is optionality in their ability to profitably grow the Teva, Simple, TSUBO and Ahnu brands.  The company believes they should achieve sales for Teva of $110MM, Simple of $80MM, TSUBO of $40MM and Ahnu of $20MM by 2012.

 Teva

• Over the last five years, the brand had been relatively flat with $83MM in sales in 2004 and $87MM in sales in 2008. This dismal performance was due to a lack of innovation and relevance at many of their retailers and driven by the core assortment of low-end flip-flop products. The company has invested in innovation and marketing to redevelop the brand and image. It has developed non-weather dependent footwear and is making inroads in the women's outdoor performance sandal category. Previously, the brand was very dependent on warm, spring weather. Even at the $80MM sales level, the brand generates positive $14MM in operating income and is not a drag on cash flows

 Simple

• The management team has the greatest aspirations for the Simple brand given that sales were only $17MM in 2008. This brand is the company's platform for selling environmentally friendly footwear and expanding into other product lines (e.g. Simple kids sells "green" backpacks ). The company believes EcoSneaks', at $55-$60/pair", could take off given the price point. The comparison has been made to a Converse Chuck Taylor, which has sold millions of pairs around the world.

 TSUBO

• This was a recent acquisition (May 2008) for the company designed by a former Reebok designer. It is a premium lifestyle comfort brand with higher price points that Ugg selling a full line of sport and dress casuals, boots, sandals and heels. The company believes they can leverage their current distribution, design and marketing capabilities to meaningfully grow the brand. Tsubo has sales of under $10MM and operates close to free cash flow breakeven

 Ahnu

• This was also a small recent acquisition (March 2009) by the company to help Teva grow its market share in the outdoor footwear space. Ahnu focuses on women's outdoor lifestyles through color and comfort but plans to grow in men's and kids

Margin expansion opportunity

The company already has maintained gross margins in the 43-45% range but should improve that over time due to growth of the retail and internet businesses.  Additionally, international gross margins are lower due to the fact that they have to go through distributors.  Internationally, as markets get to a certain size, the company will drop the distributor and take over distribution thus capturing the incremental margins.  Note that SG&A would be higher initially to create the infrastructure but over time as the brand grows, operating margins should grow.  Historically, the company operated SG&A at 22-23% of sales while the company's guidance for 2009 is 25% of sales.  Some of this is due to the growth of its retail store base but as sales grows, the company should be able to get SG&A leverage and get back to 22-23% longer term. 

 Cheap Valuation

At $67.40/share, with 13.2MM diluted shares, the market cap is $890MM and with $230MM in cash and no debt, the EV is $659MM.  The company has about $17.50/share in cash and will another $6.50/share by the end of the year to end the year with $24/share in cash.  Assuming the company can generate another $200MM in free cash flow over the following 2 years, the company will have just under $40/share by the end of 2011.  At that point in time, excluding the $40/share in cash you have company trading at $27.40/share with a forward multiple of under 2.7x FCF.  This should trade for a minimum of 15x 2012 FCF which is 175% upside from here.

Market's View

The market is concerned that the Ugg brand is not a brand that espouses comfort and affordable luxury but just a one hit wonder that will eventually die off.  We are comforted by a few observations: 1) Angel has done this before in his career with Reebok in terms of developing and diversifying a brand; 2) Our channel checks at the department stores, specialty stores and the retail outlets have been consistent with increasing demand for all Ugg products; 3) the shop in shops and retail outlets showcase the brand in many more categories outside of just the famous sheepskin boots and are comping over 25%.  Additionally, the market is concerned that the CFO, Thomas Hillebrandt, recently resigned after less than a year of being hired.  We have spoken with management about his departure and are comfortable that it had nothing to do with the company's performance or financial credibility but rather fit and culture.  Finally, the market is concerned about the macro environment and in particular consumer spending for luxury goods.  The good news is the fall product line is already presold and the brand is given significant support at retail because it is a traffic driver.  What gives us comfort is that the company is not going after the ultra luxury category but rather affordable luxury and is focused on comfort.

 Catalysts

• The company has recently reiterated guidance and provided a long-term 2012 outlook. The stock is extremely cheap if they hit the targets but even these targets could prove conservative
• A combination of strong earnings with a relatively high short interest may provide further catalyst to the upside
• Share buyback was recently announced ($50MM authorization) but this should be an ongoing activity given the free cash flow generation of the business

 Risks

- Risk to Visibility/Backlog

• DECK is pleased w/ the current backlog for fall product. The risk is that sales are less than expected and DECK is faced w/ cancelled orders.

- Fashion Risk

• While UGG has proven itself to be more than a fad, there remains fashion risk as it expands from boots into other styles. Similarly Teva and Simple face fashion risk as they aim to become more year round businesses.

- Dependence on select large customers

• DECK's tight control of distributor also leaves it susceptible to reliance on a few large customers such as JWN. JWN represented 17% of sales in 2007 (mostly for UGG). This leaves DECK at risk in the vent the retailer wishes to deemphasize DECK merchandise.
• Top five customers were 30.4% of net sales

- Inventory risk in other brands

• In an effort to make the Simple and Teva brands more year-round, DECK is increasing inventory which could be risk if there is poor sell through.

Catalyst

• The company has recently reiterated guidance and provided a long-term 2012 outlook. The stock is extremely cheap if they hit the targets but even these targets could prove conservative
• A combination of strong earnings with a relatively high short interest may provide further catalyst to the upside
• Share buyback was recently announced ($50MM authorization) but this should be an ongoing activity given the free cash flow generation of the business