Description

Thesis:

We are recommending a long position in Skechers (SKX). Shaqtastic had written up a short pitch on Skechers in the summer of 2014 that was focused on the thesis that Skechers was at a peak cycle in terms of both earnings / margins and that the company would revert back to its boom / bust cycle that investors have become accustomed to. Therefore I will not give a full description of the company, but rather focus on why the company’s performance since the 2014 write-up is to be believed. Skechers is fundamentally a different company than the one that saw a 20% revenue decline on the toning shoes meltdown.

We believe an entry in Skechers today allows an investor to earn double digit returns over the next few years given a forward FCF yield of ~7% and the opportunity to grow the topline at above double digit rates. The 15%+ returns are before any operating leverage or re-rating of the multiple is taken into account.   

Alongside of NKE expected to grow topline ~10% over the next three years and UA ~25%, we believe that SKX is among the fastest growing retail / footwear company in its space (both domestically and internationally) and comes at a much cheaper FCF yield than either of those two category leaders. It is hard to find a company compounding EPS growth trading at FWD earnings yield of ~9%.

Lemelson Capital disclosed a short interest in SKX at around a price of $44 per share. This is obviously smart money and adds volatility to the stock. However, I would note that we are recommending SKX at a price below $30 given and would agree that at a price of $44 the stock would reflect an overwhelming amount of its value in growth expectations. However, below $30, we like the risk / reward skew of the stock – the 2015E ex-cash P/E of the stock is ~15.5x or a nearly 7% earnings yield. In a no growth scenario this is only slightly below the high single digit returns implied by the S&P (4-5% earnings growth + 2% div yield + 2% share repurchase).

A brief history of the Shape-Up disaster:

Coming out of the financial crisis, SKX was beating estimates at an impressive rate. The company was capitalizing on sales of its “toning shoes” (i.e. Resistance Runners, Shape-Ups, and Tone-Ups) and raising ASPs to increase margins to peak levels – SKX had taken up to 10% of the footwear market, an all-time high.

Around July 2010, the first Shape-Up lawsuit was filed and the company’s stock price slid. SKX fought the suits and even signed Kim Kardashian to advertise for the shoes – I am sure we all remember Kim Kardashian proclaiming in a super bowl ad that she no longer needed a trainer because she had her Skechers Shape-Ups. Clearly, the advertised benefits of the Shape-Ups were completely overblown, and product and injury lawsuits ensued.  It took nearly two years, but by mid-2012 the company had settled most of its Shape-Up claims.  

What has changed?

While I agree with Shaqtastic’s thesis if one were to assume SKX is the same Shape-Up disaster company, we believe SKX is actually a much more diversified company today in terms of SKUs, geography and distribution capabilities.

The significant points that make SKX a different company than the volatile one of 5 years ago are:

• Skechers is no longer investing unilaterally in individual product lines like they were 5 years ago; rather the company is investing styles the capture on the “Athleisure trend” such as the GO Walk – SKX sells volumes at multiples of the next competitor in the Walking category, New Balance.

• All pieces of Skechers SKU mix are growing – athletic, work, kids / women’s / men’s etc. (Men’s, Women’s and Kid’s all grew at  10%+ rates in Q3 YoY). SKX used to appeal mostly to men, but now is 50% women by sales.

• Skechers performance brands (the GO line) have been performing exceptionally well with GO walk, run, golf and train. The company has been able to increase the ASPs on these products and its other kids / performance / casual lines given new product innovations like memory foam insoles that make more than a pure cheap knock-off brand – ASPs up ~5% through November YTD on wholesale products.

• SKX has developed its own line of athletic shoes that compete with brands like Nike / UA / Adidas and is now the #2 player in athletic footwear domestically. SKX has around 6-7% footwear share, according to SportScan, which is down from its peak of around 10% in the Shape-Up bubble in 2010/2011. We believe SKX can grow its share domestically as its US backlog builds and wholesalers like DKS (which did not feature SKX until this year), FINL and DSW begin to push more SKX brands as its value proposition is resonating with consumers. The SKX US backlog was up 24% as of Q3 2015 indicating strong “pull” forces in the wholesale channel. Skechers has spent the past few years investing in product innovation and diversification alongside athletic / performance centric footwear and is now paying dividends as it enters wholesale agreements with major players like DKS. The main point here is that the increase in market share to #2 is not from one particular product as was the case in 2010 / 2011.  

• Skechers is much more geographically diverse than in previous years.  SKX is around 30% international compared to ~20% in 2010.  SKX has a 3-5 year goal of making international 50% of its total revenue. With China increasing 100+%,  international wholesale overall growing at 40-50%, and the international market representing higher price points for footwear than the US, this is a positive story for the topline, margins and FCF stability.

• China will probably grow around $125 -$175MM next year or 65 – 85% YoY - Points of Sale in China are expected to increase from ~1100 in Q3 to ~1600 by year end 2016.  

• Backlogs up significantly in Europe (35-40% - which include FX effects so actually much strong in dollar denominated) and adverse currency translation have covered up pricing power that company has shown there. The company grew at double digits rates in Europe in the Q3 – above industry rates of mid to high single digits.

• Middle East should be up 50-100% YoY in 2015E

• Only Brazil, Venezuela, and Russia are not performing well for the company – although that is more macro than anything else and we expect that no retailer is doing well in those locations.

• According to Euromonitor, SKX has less than 1% market share internationally. However, the growth rates SKX has shown internationally (50%+) far outpace the mid to high single digit growth rates of international footwear. We believe that SKX has the opportunity to continue to take share in Europe and grow in India / China / Singapore etc. Skechers growth in England (exceeding $100MM in sales and 20% of international segment) and Germany shows the SKX brand value proposition can work abroad. We believe the market underestimates SKX brand and growth opportunities abroad.

• Skechers is coming off a large CapEx cycle during 2010 – 2012 where CapEx averaged 5% of sales – compared to a historical average closer to 2-3%. As a result, SKX upgraded its distribution network allowing it to better manage inventory which has led sales to outpace inventory growth from 2012 through Q3 2015 by ~1000bps.  As a result of this investment and ASP increases from product innovation have led to a steady increase in operating margin. The only major project going on for the company now is its expansion of its main European distribution center from 500K SqFt to 1MM to handle increased product demand abroad (should be completed in 2016 and the company expects to see immediate margin benefits).

• Skechers has shown that is it committed to managing inventory better so it does not have to resort to write downs that drove down the stock down in 2011. Skechers has lowered its inventory days from a high of 141 in 2012 to 121 today. Additionally, Skechers has shown better discipline in controlling its brand image and refusing to discount its product with ASPs growing at least low to mid-single digits each quarter since mid-2014 while maintaining its value niche position compared to NKE / UA / Adidas etc.  As mentioned earlier, SKX has done a good job of growing inventory in line with sales and backlogs, which should prevent SKX from the same kind of fashion risk it felt in 2010 – 2012 (i.e. they won’t have a material buildup of useless inventory – they have invested heavily in distribution so that they have the flexibility to hold inventory only based on backlogs).

What caused the Q3 Selloff?:

The market saw a combination of inventory build-up, slowdown in domestic wholesale and top and bottom line misses. Investors feared that the boom and bust company of the past was repeating itself and the stock sold off ~30% - now has sold off ~40%. However we believe the selloff is overblown and presents a compelling entry point into a stock with double digit growth potential.

• Inventory increased by roughly 39% YoY in Q3 compared to 27% sales growth and ~20% sales growth expected in Q4. The market is worried that SKX will have to write it down amidst selling the inventory at clearance prices.

• However roughly $20MM of the inventory build was due to timing differences of shipments being made in Q4 versus Q3 – representing ~6% of the inventory buildup.

• Additionally, the company has stated that it was turning inventory at an unsustainably fast rate last year and has since increased its inventory stock, leading to a higher YoY increase proportionally to sales.

• Management has stated – and is consistent with SportScan data – that SKX continues to sell-through well at full and increasing prices and that the inventory on the BS is all spoken for in the company’s backlog. In fact, the build-up of inventory at the channel level that had to be discounted in Q3 and Q4 of 2015 should clear shelf space for SKX to steal share at stores like DKS / FINL and DSW.

• SKX missed top line estimates in Q3 by ~$30MM due mostly to lower than expected sales in domestic wholesale.

• Again – We believe this is due to a shift in shipment from Q3 to Q4 and a buildup of general footwear inventory at the channel level (one reason why retail broadly has sold off so much in 2H 2015) that should clear the way for SKX to steal share domestically in Q1 of 2016.

• The U.S backlog for wholesale was up 24% this past quarter and points towards low double-digit growth in the domestic wholesale business.

• SKX missed EPS by ~9 cents in Q3 ($.43 compared to $.54)

• However, when one adjusts for $11MM in legal fees that SKX had to pay for a Shape-Up settlement and the $13.5MM of expenses due to currency translation – SKX really reported EPS of ~$.59.

Valuation

Looking at the historical revenue, EBIT and ROIC for SKX shows the bumpy history of the company. Revenue growth turned negative on two occasions since 2007, once for the ’08 recession and again in 2011/2012 for the Shape-Up fad as the company had concentrated a majority of its inventory in Shape-Up designs that were no longer in demand and could not be sold through the channel – effects particularly felt in the domestic wholesale division where SKU concentration is greatest.

However, we believe the returns for the company since 2004 show that if they do not allow themselves to be caught up with inventory concentration in a fad shoe design they have the ability and the distribution model to earn well above its cost of capital.

We have laid out below what we believe is a reasonable prediction for revenue growth for a company no longer concentrated in fad shoe lines, but rather diversified across geographies and product lines such as work, casual, golf, walking and running in men’s, women’s and children’s categories:

See appendix for Segment ROIC / IRR calculations for the various divisions

Domestic Wholesale:

• We believe the most susceptible to a slowdown in growth is the domestic wholesale line which is the company’s most volatile and lowest return business.

• Management guided at the Morgan Stanley retail conference in November that Q4 2015 domestic wholesale should be in the low double digit range like Q3. Therefore we have modeled in a 10% YoY increase.

• However, going past 2015E, we believe this segment is likely to slow down closer to GDP levels of growth as SKX can no longer take shelf space at the same rate and its rollout in DKS stores proves tough comparisons to beat going forward.

International Wholesale:

• Management has guided that Q4 should be up 40-50%, and we took the lower end of that range.

• Going forward, we expect that the European business slows down to the expected footwear growth rate of mid-single digits and that while China / India / Middle East and Singapore continue to grow quickly, they come down from the 50-100% growth rates currently being felt by the company.

• According to some of the research and sell-side materials we have seen, we believe broad athletic footwear and apparel in Europe is growing in the 5-7% rate, Asia in the 8-10%, and LatAm, 6-8% going out to 2020E. We have international wholesale nearly converging to a blended average of those rates by 2018E.

• It is worth pointing out that management is increasing points of sale for its International Wholesale business 300-400 in China and 500-600 in other international locations this coming year. While it is tough to know the exact number of PoS locations internationally, management did mention that there are ~1100 in China currently. Therefore, we believe POS locations should be increasing annually internationally for the next couple of years well into the double digits.

Retail:

• We believe that retail is likely to see a slowdown in SSS in Q4 from its Q3 level of ~10.5%. Management has guided and SportScan data points towards mid to high single digit gains on a LFL basis in Q4. Going forward, we feel more comfortable assuming mid-single digit comps trending towards GDP.

• Management also guided 60-70 store openings per year for the next couple years, however we believe they can probably open around 50 net stores next year with that figure declining going forward.

• The historical implied productivity level of new stores has averaged around 80% and that is what we have modeled going forward (assuming all new stores represent that average store size in square footage).

E-Commerce:

• Skechers E-commerce business has been its achilles heel in terms of the top line and we do not project it to grow this business like other retailers (e.g. Nike) and instead predict it to grow at GDP levels going forward.

Taking all of the divisions together, we believe SKX has the ability to grow the top line at a ~10% CAGR through 2018.

In terms of bridging down to FCF we projected out through 2018 using the following assumptions:

• Kept gross profit at 45% going forward – this is somewhat of a peak level historically but the bump has come in the shift towards retail sales, international sales and more innovative product features such as memory foam all of which drive higher ASP at a sustainable level. FX has the potential to either be a headwind as it was in 2015 or a tailwind if the dollar weakens a bit in 2016 as some expect. 45% GM is slightly below average levels among peers such as COLM, DECK, NKE, UA, and VFC. Increasing wages in China – where SKX outsources its productions – have the possibility of being a headwind, but increasing ASPs and efficient distribution methods should help combat those pressures.

• Selling expenses at 7.3% of sales (consistent with Q3 LTM) – Selling expenses, mostly made up of sales reps, advertising and commissions, probably do not have the opportunity to leverage much with the top line as the company has repeatedly shown they will reinvest growth in advertising, channel distribution and product innovation.

• 40% G&A fixed at 5% growth and 60% variable with top line – Based on the growth in G&A (comprised of costs related to corporate salaries, store opening costs, retail overhead, bad debt expense, distribution inspections and automation costs, legal and accounting, D&A, and legal) historically, we believe around 60% of this expense is fixed at these levels of sales (used regression of sales to G&A growth - closer to 70-80% historically, but company has levered due to growth since 2013). We assumed this fixed cost ratio stays the same going forward (despite an increasing revenue base) and that the 40% of fixed G&A costs grow at around 5% as they probably have to increase faster than overall wage growth but there is some opportunity to leverage overhead and distribution expenses as the company grows its revenue base and the heavy investment in CapEx is mostly behind them (with the exception of the expansion of the European Distribution Center in 2016). We see EBIT margins increasing to just below 13% by 2017 which would be closer in line with peers such as DECK, NKE, SHOO, VFC, VSTO. It is worth noting management believes they can achieve 13-14% margins with ~$3.6Bn in sales.

• 21.5% tax rate per management guidance of 20-23% effective tax rate – This is based on lower marginal tax rates in the company’s various business jurisdictions and includes no projected use of DTA.

• Company pays off debt at end of 2015 – the company generates enough cash and has enough on its balance sheet to pay off the debt the company raised to complete its European distribution facility. Interest expense goes to zero.

• 10% Minority interest stake paid out in cash – The Company has a number of joint venture projects in Asia where the franchise model as opposed to retail / wholesale is a primary form of distribution (primarily China).

• D&A 2% of sales - consistent with historical levels and implies a 7-8 year useful life of assets.

• CapEx – per management guidance and in-line with historical levels of ~2-3% sales.

• We have included our analysis of Inventory, Accounts Receivable and Accounts Payable that show the company will have to reinvest ~16% of sales growth in NWC.  

• We believe that an investment today in SKX today represents an entry of an Fwd 7% FCF yield / ~9% earnings yield (stripping out excess cash from the capital structure).

• SKX has the opportunity to distribute this cash to shareholders starting in 2016 through dividends or share repurchases, but given management has made no such indication we believe the best way to value the company is on an ex-cash basis. We believe that the company will report around $3 per share in cash for Q4 2015 or ~10% of the current share price

• SKX should trade at a discount to the FWD P/E of category leader NKE of ~25x but at a premium to companies such as WWW / DECK / COLM / SHOO / CROX that traded in the mid to high teens before the Q4 2015 sell off in retail.  Those comps either do not have the product diversification of SKX or do not have the growth possibilities of SKX (12% top line CAGR and 17% NI CAGR through 2018E).

• We believe the correct way to think about this opportunity is purchasing a company with double digit top line growth potential at a 7% FCF yield implying 15%+ annual returns over the next 3 years. You also get very probable upside potential from cost leveraging and multiple re-rating once SKX proves it is not the same boom and bust company of 2011.

• Base Case: SKX since 2010 has traded in a 1 std dev range of ~12x to 30x with an average slightly above 20x. Applying a 20x fwd. P/E multiple to 2016E EPS of ~$2 and adding in $3 of estimated net cash per share on the BS by 2015E provides a share price of  $43 share price or  ~60% upside. (50% chance)

• Bear Case: SKX proves that its sales growth is short lived and maxes out revenues at current level of $3bn. Operating margins revert to ~8% - low end of footwear peer set historically.  This would imply net margins of ~6%. 156 shares outstand brings you to a normalized bear case EPS of $1.15. SKX would trade towards the low-end of its historical P/E range at 12x (about a turn above its 2010 trading average during the Shape-Up crisis) – adding in $3 per share of cash by 2015E provides a share price of ~$17 or ~35% downside. We do not view this scenario as very likely given that SKX has invested heavily in distribution and diverse product / geographic mix to de-risk its earnings stream and improve margins and growth potential. (20% chance)

• Bull Case: We believe the right way to think about the bull case is the growth runway of the company. 2015E / 2016E are more clearly in view given that the company’s backlog is up 24% domestically and 35-40% internationally. This provides a good amount of visibility into 1H 2016 (backlogs are for 6 months out wholesale orders). If SKX opens stores at management’s projection of 60-70 a year (being closer to 50-55 on a net basis), and extends its growth in international wholesale through increased PoS given the whitespace opportunity for athletic footwear internationally and the increased pricing power compared to domestic, then SKX should be able to earn $4.6bn by 2018:

Management believes the company can have 13-14% operating margins on ~$3.6Bn of revenue, which would imply about a ~10% NI margin or a 2018E EPS of $2.85. We do not think the multiple would go into NKE territory, but that the 20x FWD P/E multiple would still is appropriate for a company with this amount of growth. Discounting this back at a CoE of 10% to the end of 2016 and adding in $3 of estimated cash per share by 2015E implies a share price of $51 or 90% upside to the current share price. (30% chance)

We like the 2:1 risk/reward skew on this investment. It is worth noting that the company is currently trading at 2015E ex-cash P/E multiple of ~16x. Depending on whether you want to use a 10% or 12% CoE, the market is implying between a 3-5% growth rate. We believe there is ample room for upside to these numbers. We believe this implies the market believes SKX is likely to lose share in a growing global athletic footwear and apparel market growing at 5-7%. Therefore, at a 12% CoE, you are simply underwriting that SKX will grow with the broader footwear / apparel average – something it has done on a long-term basis (obviously with some volatility year to year).

Side Note: As some will notice, our estimates for SKX are slightly below street. While we believe we are being conservative in our projections, the real question is why do we see a multiple re-rating and 15%+ return profile in the stock with below-street projections? We believe the current pessimism behind the stock price / multiple is that the market fears SKX is just riding another fad and will soon see a catastrophic fall. However, we do not see what division / line of casual or performance brands that could have the same impact the toning disaster did. Therefore, it is not necessarily exactly how fast the company grows specifically (i.e. 10% versus 12%) – it is rather the proven stability of the earnings stream and legitimacy of the product and geographic expansion that should drive the stock and bring in a more long-term oriented investor base.

How to play the opportunity:

• If you are cautious about the sustainability of SKX’s growth, we would buy the call options out until July 2016 or Jan 2017. We believe that SKX is likely to clear most of its inventory buildup in Q1 when the bulk of its backlog is expected to ship, especially internationally (international growth is responsible for a large portion of the inventory buildup). This should assuage the current fears priced into the stock and it will give the call option holder time to review more quarters to decide if they wish to convert / the story is sustainable.

• The July $35 are $1.5 and the July $30 are $2.65.

• For those looking to pair trade, we think there a few directions to go in:

• Adidas could be a useful short as we believe it is losing share to SKX and NKE in Europe and yet has been up ~60% since 2014 compared to NKE’s ~35%. (Adidas might honestly be a more interesting pair with NKE). According to SportScan, Adidas has domestically lost 1% market share in footwear and seen pricing decreases of 4% YTD and yet has seen its FWD P/E multiple trade is ~6x from 16x to 22x.

• DECK and WWW are also interesting pair trades.

• DECK has the single product exposure with UGG (2/3 of sales through wholesale and 75% is UGG and 85% UGG sales for company overall) that is now being shifted down the channel to more mid-tier distribution sites (like a SKX) and should have margin pressure from mark-downs. DECK has been seeing inventory growth outsizing its expected sales growth (nearly 2 to 1 for the past 5 quarters) and we do not believe they have the backlog of demand like SKX to sustain historical ASPs. Further, DECK is highly volatile during the year and extremely exposed to the downside to a warm winter like the current one.

• WWW is a wholesale play on brands like Sperry, Saucony and Merrel. However, the brand has shown that it is not moving as well through the channel as SKX (does not have exposure really to athletic footwear). WWW saw inventory grow 6.3% while sales are guided to be down 5-7% in Q4. WWW is probably growing in the low 3-5% range overall and would have a forward PEG of ~2.75x compared to SKX Fwd PEG of ~1x. WWW trades at trough multiples, however we think this is probably more a value trap than a bargain as weak growth results are likely to persist  

Risks:

• The major risk to the stock is the possibility that management has misguided about underlying demand for SKX inventory and strength in terms of product sell-through at the channel level. Management will have to write down its inventory like it did during the Shape-Up fallout and will confirm what investors currently fear.

• SKX, like most retailers, is exposed to macro pressures from a slowdown in consumer spending in the US and Europe. While China is placing emphasis on turning to a more consumer based economy, a lack of QE execution there could slowdown SKX’s current 100%+ growth there.

• FX risk – although SKX is operating at peak margins, the company saw its EPS decline ~20% in Q3 2015 due to an FX loss of $13.5MM. While the company has been able to grow EPS significantly despite FX headwinds, this does present some added volatility and margin pressure to the stock.

• As of Q3, the Chairman and CEO, Robert Greenberg, and his immediate family owned 59.4% of outstanding class B stock (10 to 1 voting rights compared to Class A stock – 130MM Class A shares and 26MM Class B shares). Gill Schwartzberg, a trustee of several trusts formed by Mr. Greenberg and his wife, owned another 37.8% of Class B stock. Therefore, the CEO, his wife and their trusts together own ~65% of the voting rights of SKX – making this stock a tough takeover candidate.

Appendix: Segment level Returns

• For the above calculations we used revenue, gross profit, and total assets from the SEC filings. We extrapolated that full selling expenses should be deducted against the division since advertising and sales reps expenses grow with the underlying business. We believe the business moved from ~70% variable cost G&A to around 60% today – we deducted the variable portion from the business division. 9M 2015 P&L figures are annualized for the purposes of ROIC.

• We used the marginal US tax rate for NOPAT.

• We deducted the company level of accounts payable as a % of COGS from the assets of the division to get to a division level of net assets. This overstates net assets since the company’s cash is 5x its debt balance

• Clearly, the Domestic wholesale business is the more volatile and low return segment for the company – we believe this is the first time since 4Q 2010 the segment has started to be a positive NPV division for the company.

• We used the same methodology for the international wholesale division except that we used the expected blended effective tax rate for SKX (which probably overstates the international tax rate).

• Clearly SKX has been able to grow sales more efficiently abroad than domestically due in part to higher ASPs internationally.  

• We used a different methodology for SKX owned retail stores given the segment info in the SEC filings would point to absurdly high asset turnover ratios and ROIC for the segment.  

• We found that a run-rate retail store earns on average $1.5MM per year.

• It’s a bit volatile, but the typical productivity of a new store implied by overall growth and SSS growth is ~80%.

• The company uses stores after a full year of operation in its SSS count, so we assumed full run-rate sales by year 2.

• Given retail gross margins are ~60%, 1500bps higher than company level gross margins, we believe run-rate EBIT margins of 15% (ramping over 3 years) is conservative.

• We believe each store has about $500K of store opening costs that will temper year 1 margins to 7.5%. (management reported $31.6MM of additional G&A on 59 new store openings in 2014)

• The company spends conservatively ~$700K of CapEx to build a new store and our estimation of a typical lease is 10 years, so we have assumed a useful life of the store of 10 years. Maintenance CapEx equal to D&A each year and a store refresh of $350K (50% of original CapEx) in year 5.

• Assuming the stores converge to 3% SSS growth over time and have to reinvest 16% of that growth in NWC, this provides an IRR per store of ~17%. This compares to average low to mid-teens ROEs for the apparel and footwear companies for the past ~10 years.

Catalyst

Catalysts:

• We believe the main catalysts for SKX should come in Q1 as inventory should sell-through the channel and grow in line with sales again. Q4 is historically not a big quarter for SKX as it does not have a lot of Holiday season exposure in its product line (more back to school).

• The Q1 2016 announcement showing continued backlog growth, inventory management, and ASP growth should provide a serious catalyst for the stock and a probably re-rating on forward estimates. By the time the company hosts its earnings call in February, they should have good insight into Q1 inventory / merchandise sell through which would help assuage investor concerns.

• The main concern with SKX is execution – is the growth and margin improvement for real this time? We believe continued execution on the “Athlesiure” trend (which should prove itself not a fad like shaping) and geographical expansion (PoS increasing double digits internationally) should bring in a more long-term, bullish investor base.

• We would like to see SKX start buying back stock with some of the cash on its BS / internal CF. If management is confident in the stability and growth of the business it has the opportunity to reflect its execution and squeeze out the short interest.

• SKX is becoming a crowded short trade and we think there is room for a short squeeze on proven stability in the earnings stream.