Description

Position / Company: Short / SKX (NYSE: SKX)

Current Price: $46.28 (LTM EPS= $1.66; LTM P/E = 29.0x; LTM EV/EBITDA = 12.8x); Dividend Yield = 0%

6-month Price Target: $24 (Normalized EPS= $1.75 @ P/E= 13.5x)

-     Exp. Return: 45%

Description: 

-     Skechers is a $2.3bn market cap company with ~$1.9bn of sales. It sort of floats under the radar given that it doesn’t have much sell-side coverage (only covered by seven banks – one bulge bracket – vs. typically more than ten for apparel stocks) and given that many have been burned by it in the past, either on the long or short side. The stock is up more than 3x since 2012, almost 40% year-to-date, and short interest is only at 4% of the float.

-     As a quick background, Skechers designs, markets, and retails "reasonably priced" Skechers-branded footwear. It has a tendency to knock off shoes from other brands. For example, today you can buy Skechers branded BOBS, which look and feel exactly like Toms. Skechers even donates a pair to charity every time it sells one pair, just like Toms. The company is known for using celebrities, like Brooke Burke or Kim Kardashian, to market its products.

-     The company sells about 70% of its products through wholesale and 30% through retail (25% international). In wholesale, 75% of sales are through specialty retail stores like Famous Footwear, Rack Room Shoes, DSW, Shoe Carnival. The rest are through department stores like Kohl’s, JC Penney, Dillard’s.

-     It has a dual class share structure, through which Skechers’ founder, current CEO & Chairman Robert Greenberg effectively owns ~70% of the votes and ~20% of the company. This includes those shares held by his two sons, Michael, who serves as President, and Jeffrey, who serves as Senior Vice President, and a family trust.

Investment Thesis: 

-     Trading at 29x trailing P/E and 13x trailing EBITDA, is significantly overvalued for a company that has a history of poor management and execution issues, exhibits enormous earnings volatility given the cyclical nature of selling faddish products, does not generate any cash, and is unlikely to sustain its recent growth as it approaches the peak of a product cycle and peak margins (as evidenced by recent and historical insider selling patterns). Normalized earnings are significantly below current expectations and out-year Street estimates overestimate the business’ on-going earnings power.

Key Points:

-     Fundamentally, we just don’t think this is a business anyone would want to own. It’s historically been a poorly run business (with missteps in regards to inventory, order, and expense management) in a tough and competitive industry. As evidence of this, we note that Skechers has never consistently generated cash flow, generating cumulative free cash flow of $100mm over a 15-year period, on a $2.3bn market cap.

-     Part of this is given its cyclical nature, as it is driven by product cycles. For example, in 2009, when Skechers knocked off toning shoe brand MBT with its own version (you could lose weight just by wearing the shoes!), sales grew 40% in 2010, but fell 20% in 2011. EBITDA turned from $220mm to negative $20mm. SKX's stock peaked at between at $44 and fell to $11 as management misjudged demand for its products and Street expectations had gotten ahead of themselves. Since 1999, the stock has hit ~$35-40 three times prior, each as a result of extended expectations around a product cycle. Each time Skechers stock fell all the way to $5-15, or 60-80%, in the 6-12 months post-peak due to the fad-like nature its products. We believe we are nearing the next peak.

-     Recent performance has been strong. Sales grew 20% in 2013 and through H1 2014 due to the successful launch of Skechers’ GO Performance division shoes, which has imitated products from Nike, such as the Nike Free. Skechers also added its trademarked “Relaxed Fit Memory Foam” to shoes, contributing at least 3-5% to pricing. Analysts are bullish and estimate EPS will almost double in 2014 and then grow 20% in 2015 on top-line growth 17% and 11%. We believe double-digit sales growth the Street is modeling is not sustainable due to the fad-like nature of Skechers’ products and its history of being unable to sustain growth. Skechers just happens to be “trendy” right now, but its products have short shelf lives. Further, pricing comps become increasingly difficult over the coming quarters and incremental pricing levers are minimal given the pricing ceiling posed by Nike (it will be game over for Skechers if Nike starts discounting some of its recent innovations like the Flyknit or others). Gross margins have increased >500bps since 2011 as promotions are effectively at trough levels. Management has effectively told analysts the current gross margins are too high, yet Street estimates continue to assume an expansion. We also don’t believe SG&A is as scalable as analysts expect. This is effectively a marketing company. As sales inevitably slow from current growth rates, we expect the marketing budget to be flexed (as it has in the past) to compensate.

-     The reality is that Skechers has never grown earnings more than three years in a row. With the stock up more than 3.5x over the last 2 years on the back on this performance, any hiccup is bound to hurt. Hiccups could come from slowing same-store sales growth at retail stores, weaker gross margins as a result of promotions, or simply a fashion miss like in the past.

-     It’s unclear to us why Skechers would be totally immune to the challenges that everybody else in retail is experiencing. DSW, a shoe retailer and one of Skechers’ customers, saw its stock decline almost 30% recently as it guided lower given soft sales and a continued highly competitive promotional environment. While it isn’t a perfect read-through, it makes Skechers’ results seem too good to be true in this environment of retail landmines. Continued poor retail performance will ultimately affect manufacturers like Skechers.

-     Another source of risk is Skechers’ aggressive expansion of its own retail channel in recent years. It now operates more than 320 stores in the US, up 50% from a few years ago, and through partners and company-owned stores, has more than 400 stores internationally, up from 100 just a few years ago. The plan is to continue opening significant stores going forward, opening 60-70 in 2014, or 20% square footage growth. We’ve seen other businesses, like CROX for example, aggressively expand retail channels that ultimately conflict with and impair the health of wholesale channels. The concept almost never works as it ultimately reduces cash flow, returns on capital, and significantly increases leverage.

-     From a valuation standpoint, Skechers has a tendency to lose money from now and then, so historical valuation can be tricky. P/S can be useful here. Skechers is now trading at a P/S of ~1.1x, in line with its historical peak, and 70% above its historical average of 0.7x. On a two-year forward P/E basis, it’s now trading at 18x FY 2015 consensus, compared to an average of 13x over the past 15 years.

-     We estimate that the downside of the short is that trends continue to be strong a bit longer than we’d expect and Skechers earns ~$2.75 in 2015 and trades at 20x P/E to $55, or 20% downside. The upside is that they earn $1.75 on a normalized basis (based on average ~7.5% EBITDA margins over the past 15 years). Putting a multiple in line with historical average numbers of 13.5x on $1.75, gives ~$24, or a 50% return, or 2.5:1 upside-to-downside. We don’t give any credit for Skechers’ net cash, as the likelihood of it being returned to shareholders is virtually zero in our view.

-     Management also has its own agenda. CEO Robert Greenberg doesn’t seem concerned with appeasing shareholders or managing to the Street (as evidenced by the fact that the company provides no guidance, meaning the Street flies blind and volatility around earnings can be large), he doesn’t need to given that he effectively controls the company and that one of his son could be his successor. Recently, it was even rumored that Skechers was mulling a bid for the LA Clippers, an NBA basketball team, using shareholder cash. Further, even though the company has always maintained a solid balance sheet, with always net cash, the company has never repurchased a single share, even when the stock was trading at under $10. Management has been handsomely rewarded in the past, most recently with the CEO selling $8mm worth of stock at $33 in December 2013 and another $8mm in April 2014 at $41. In the past, his timing has also proved to be fortuitous. He sold ~$10mm worth of stock in December 2009 at ~$28, prior to the stock trading down to ~$11.50 in 2011. Prior to that, in March 2007, he sold ~$15mm worth of stock at ~$35, before the stock traded down to ~$5.50 in 2009.

-     The bull case is that the sell-side and the company both say the company learned its lessons from the past, is better at inventory management and distribution, and has reduced its reliance on the wholesale channel. However, looking back at past transcripts, the company has promised this every time it messed up in the past and so far, there is no evidence that things have changed. It’s still the same promotional management team that chases every last sale and ran L.A. Gear into bankruptcy in the late 1990s (http://marshallinside.usc.edu/deangelo/Publications/LAGear.pdf)

Disclaimer: Author has no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. Author makes no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained in this presentation. Author expressly disclaims all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this presentation. Discussions regarding potential future events and their impact on any issuer are based solely on historic information and our estimates and/or opinions, are provided for illustrative purposes only, and are subject to further limitations as specified elsewhere in this write-up. No guarantee can be made of the occurrence of such events or the actual impact such events would have on any issuer's future performance.

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