Description

DECK manages a portfolio of footwear and accessories brands, most notably UGG (85% of revs), Teva (9% of revs), and Sanuk (5% of revs).  Slowing sales, compressed margins, and an inventory overbuild starting in Q411 led DECK to be a very popular and successful (down ~68% from Q411 highs) short throughout 2012. 

However, the short thesis has run its course, margins will normalize with time, and a patient investor will eventually see the value of a portfolio of emerging fashion/lifestyle brands overcome the short term problems that have plagued the stock.

A few important points:

-       I claim no special insight into fashion trends, nor do I believe that anyone is capable of predicting fashion longer term.

-       To paraphrase our benefactor’s sister, noted retail investor Linda Greenblatt, [retail is especially ill suited for sell side analysis because the sell side focuses on 12 month targets, and inventory problems often take 18-24 months to work themselves out].

-       Shareholder base is in transition as the growth crowd has headed for the exits (10 years of consecutive 10+% revenue growth is expected to end FY12) and the value crowd has not yet stepped in.  However, the brand remains strong, inventory levels will normalize, and margins will expand as capex on new stores and a corporate HQ is reduced.

-       The majority of the page one holders bought their stock within the last year, and the stock has massively underperformed making it a prime candidate for tax loss selling.

-       It is emotionally difficult to stand against ~45% short interest, but this is not a debt heavy/accounting irregularity/broken model/ potential zero type short investment.  As such, the short interest adds downside protection as shorts become buyers.  Additionally, short interest began to rapidly grow in Q1 2012, meaning some shorts are likely rapidly approaching long term hold status on their short, making it more attractive to cover their position.

-       “face up to two unpleasant facts: The future is never clear, [and] you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values” Warren Buffet.

In the interest of brevity for background on the company, the management, the various brands, and the growth initiatives that admittedly got a bit extended I recommend reading the VIC long recommendation that was written in june of 2009.  The story played out almost exactly as the author (skca74) predicted before skidding as margins compressed and growth slowed.  Additionally, in the interest of brevity the majority of this writeup will focus on the UGG brand.  Suffice it to say that Teva and Sanuk are at worst neutral and at best incrementally positive to the story.

Margin Compression:

-       Over the last several quarters profit margins have compressed from over 15% to FY12 estimated 8.9% as a result of:

-       Costs associated with building out the infrastructure necessary to transition foreign operations from a distributor model to a wholesale operation (note that skca74 predicted this).  This is a temporary condition and should ultimately lead to wider margins as the middle man is eliminated overseas.

-       Costs associated with building out UGG retail stores (including costs associated with buying out the 49% of a JV formed to build and operate retail stores in China that the company did not control .)There are presently 68 retail stores, and the company has set 150 stores by 2015 as their goal.  The cost of a new store is somewhere between $1-2M – more for larger footprint stores in the North America and Europe and less for smaller footprint stores in Asia.   This obviously increases capex, but is ultimately necessary to help transition UGG from a one trick pony (the traditional boot) to a marketing driven lifestyle brand.  When store count matures, capex will  drop and margins will expand. 

-       An ~80% increase in sheep skin prices since 2010.  The real driver here is increased demand for red meat, concurrent with a decline in the popularity of lamb/mutton for consumption, not demand for sheep skin.  It is difficult to predict future prices, but ultimately this is a cyclical issue.  Furthermore it is a safe assumption that long term demand for lamb/mutton for consumption will outstrip demand for sheep skin for fashion which will lead to excess supply of sheep skin, and thus lower prices.  Additional benefit will come from diversification away from sheep skin based products.  Prices for fall 2013 have been locked in 11% lower than fall 2012 which management estimates will have a positive margin impact of 150 bps versus a 500 bps drag in 2012.  Also of note, on the Q312 conference call management said, “we’ve taken a significant step in mitigating one of the largest risk factors in the business, i.e. the volatility of sheep” and indicated that details of a new process rollout for 2013 will be detailed next year. 

-       Construction of a global headquarters.  The company plans to  spend ~$36M on this.  While I believe this may be a waste of shareholder’s money, it is a one time item.

-       Increased advertising and legal spend.  A necessary evil.  While the rise in popularity of the original UGG boot was largely organic, broadening the brand platform requires marketing effort, and protecting the brand requires trademark protection etc.

-       Pricing power.  This is obviously the most difficult to predict piece of the margin story even long term, and most recently the major concern has been tied to inventory concerns, which I will address in the next section.

Historically management has been conscious about restricting distribution in order to maintain exclusivity and pricing power and I see no reason why that would not continue to be the case when the recent inventory problems are worked through.  Additionally, sell side criticism has focused on knockoff risk as cheap imitations of the classic UGG boot hit the market.  Simply stated, knockoff risk is a risk that all branded retail faces.  However, I think that this risk for UGG is mitigated by two factors.  First, UGG boot popularity is as much tied to their comfort level as their fashion level, if not more.  Conversely an item like an expensive handbag is valued on fashion only, not comfort, making it easier to fake.   It is unlikely that a cheap imitation will come close to the comfort level of a true UGG boot.  Second, at the ~$200 level UGG boots are significantly cheaper than the most frequently knocked off products like purses and watches.  This makes consumers more likely to pay full price for the real thing. 

This of course all assumes constant demand which is far from certain, and the short crowd is quick to identify the classic UGG boot as a fad that has faded.  It is entirely possible that we have seen the peak in classic UGG popularity, but I suspect the short crowd that thinks classic UGGs will completely disappear from the landscape is the same crowd that predicted Crocs would disappear.  If a fad based on an ugly rubber sandal/clog hybrid can evolve into a company that continues to grow sales through a broader product offering I see no reason why the UGG brand can't do the same. 

Additionally while  a grain of salt may be necessary, a management funded marketing surveys cited on the Q312 conference call indicate positive trends in terms of consumer opinion of the brand and likelihood to buy in the coming months. 

In sum, most of the above are temporary evils and with time margins will mean revert.  It is also worth noting that the Teva and Sanuk brand are largely higher margin open toed brands, and UGG is diversifying into higher margin non sheep skin dependent products as well.

Inventory Concerns:

-       In recent history it is undeniable management was overly aggressive in their growth assumptions and accumulated too much inventory which led to product showing up on discount dealer websites.  This problem is mitigated by:

-       Weather.  While I dislike the “weather” excuse as much as the next analyst, it is worth noting that the extremely cold and snowy 2010 winter made for exceptionally difficult comps in the extremely mild 2011 winter for a company whose main product is a cold weather boot.  As such management’s over aggressive assumptions can be somewhat justified. 

-       The reality is that inventory mistakes are a fact of life in retail.  However, assuming a reasonably capable management team inventory overbuild is a temporary problem.

-       Transition to a wholesale model from a distributor model overseas.  Inventory remains on DECK’s books rather than being offloaded to a distributor.  In exchange margins are improved by cutting out the middle man.  A good long term trade in my opinion, and it is worth noting that this will show up on the top line.

-       Build out of retail store network requires higher inventory levels.  A good long term trade in my opinion.

-       Broadening of the product offering to more “fashion” items.  More skus = more inventory.  It is worth noting that the fashion items are at higher risk of write down / discounting than the traditional UGG boots which have a longer shelf life than fashion items.

In sum, recent inventory problems are temporary, and I don’t believe that the limited discounting which has taken place is anywhere near enough to permanently impair the UGG brand. 

Future Growth Opportunities:

Again I would refer you to the previous VIC write up which gives more detail, but in short DECK has ample growth opportunities in retail, men’s, children’s, and fashion areas.  Additionally, less than a third of sales come from outside the US at this point. 

In sum, I put no value on growth, but I believe future growth is likely.

Valuation:

Consensus estimates for 2012 put profit margins at 8.88%.  However, with management indentifying 500 bps of gross margin compression tied to higher sheep skin costs in recent years and 200 bps of gross margin compression tied to higher close out sales etc b/c of the inventory overbuild, it is not difficult to see gross margins expanding.  Additionally, building the new headquarters and opening new stores leads to somewhere around 350 bps of operating margin compression which will roll off within a few years.  Combining the above and factoring in changing sales mix to higher margin items I believe a return to ~13 -15% net margins is conservative.

With net margins of 13% and a hurdle rate of 10%, the company would be appropriately valued at 1.3x sales ( ~ $50/share) assuming no growth.  At the current level of less than 1x sales and without accounting for future reduced share count there is a 43% margin of safety at today’s prices.  With net margins at 15% and the company valued at 1.5x sales (~ $58/share) there is a 65% margin of safety.  This is before accounting for reduced share count going forward.

On an earnings basis, DECK trades at ~7x FY11 earnings.  FY earnings were likely a high mark that won’t be matched for a few years, however, if FY11 earnings were cut in half, implying that DECK traded at 14x, it would still be significantly cheaper than other luxury brands (COH 16x, RL 21x, BRBY 21x) and other shoe/accessory makers (WWW 18x, COLM 18x, PVH 15x).  This is before accounting for reduced share count, margin expansion, and reductions in capex as the store build out and headquarters projects are completed.  I am not suggesting that at this point in its life cycle DECK deserves to trade inline with the aforementioned luxury comps, but I don’t believe it deserves this much of a discount either.

Also of note: recent sell side pieces have mentioned DECK as a potential M&A target.  For reference, recent comparable announced/completed deals were:

Cole Haan at 1.1x sales and Timberland at 1.4x sales.  Note that these are both mature brands while DECK is continuing to evolve.

Other:

As 10/25/12 the company had repurchased $185M worth of stock over the past year and left $115M on their buyback authorization, which at current prices is ~8.5% of shares outstanding.  This potential reduction in share count is not factored in for the above valuation, but clearly adds to the margin of safety.  The company did access $275M of their credit facility to pay for these buy backs as well as the retail expansion.

CEO Angel Martinez purchased 10,000 shares of stock in the open market in June for a price of 45.90.

Risks:

The usual consumer slowdown risks and uncertain short term inventory and pricing issues are present.

Acquisition risk – DECK is a portfolio of brands and may seek to add new brands in the future.

The company has accessed their credit facility to the tune of $275M to fund their buybacks and retail expansion.

DECK enjoyed several years of growth w/o meaningful up ticks in capex through reliance on a distributor model and sales through non branded stores.  DECK is now entering the next step of their life cycle which will ultimately make the business more profitable, but in the short term results in higher capex and lower margins.  Cyclical upticks in input costs further mask the true value.  Patient investors will be rewarded as the true value of DECK is exposed as raw material costs mean revert and growth capex rolls off. 

Shorter term, there are several non-economic factors at work that could lead to a rapid run up in share price.

Catalyst