Buy recommendation	SKX
Estimated intrinsic value	39.54/share
Pessimistic intrinsic value	12.72/share
Current share price	19.56/share
Upside/downside	+102%/-35%

The Story

Most of you are likely aware of this company.  Skechers is a US shoe company and is currently the #2 North American shoe company by LTM sales.  The majority of their revenue currently comes in the form shoe manufacturing and wholesale, however they also have a large retail operation, an online sales website, and license their brand for clothing and eyewear.

The stock has been extremely volatile in the last year with a fast run-up and subsequent fall down almost entirely driven by the story of one particular shoe line, the Skechers 'shape-ups' toning shoe.  This is a new category of footwear that is somewhere between a casual shoe and an athletic shoe and as a result of this newness, retailers, analysts and even the company didn’t have much to go on for projecting attributes of the category, namely seasonality and maturity of demand.  Towards the middle of the 2010 summer it became clear that the meteoric rise in demand for toning was leveling and the company was likely to run into an inventory situation until it stabilized production to match demand.  The company did a poor job of signaling just how much inventory it would be stuck with leading to the over estimation of earnings by analysts and inevitably negative surprises.  The stock is absolutely out of favor at the present moment and the excess inventory and slowing of toning growth has caused many to question the ongoing gross margins of the business and it is being punished pretty heavily in the market.  I believe that this punishment is far overdone and with a pretty conservative set of assumptions I see a 50% margin of safety in the current stock price.

Just to get it out of the way, here’s the impact of toning to the business.  For FY 2010, toning will account for betwee 200-400 million of nearly 2 billion in sales (yes a big range, but that's what you get with as much opacity as we have to sales breakdown).  The excess inventory high water mark related to toning was around 75 million.  Keep this in mind as I walk through the valuation numbers so that you can judge for yourself the risk related to toning as a category.

This company has an 18-year operating track record, and has shown it’s ability to weather major economic fluctuations while delivering consistent long term growth, without being overly concerned with short-term outcomes.  In many respects this is being operated like a private business.

 

Notable Bullet Points (postive and negative)

Greenberg family has a death grip on voting rights

There are two classes of stock, equal in ownership but the insider owned shares have super voting rights.  There is a near zero chance of the Greenberg (CEO & board) family relinquishing control in the business.

Excellent record of growing top line revenue

A graph of revenue since the company went public in 1998 is pretty impressive.  I wouldn’t use this as a predictive tool for total revenue but just to give you an idea of how consistently the company grows I ran both a linear and exponential regression of revenue against time.  The R squared on each was .875 and .906.  From a statistical standpoint, this means that time as an independent variable explains nearly 90% of the variation in revenue price.  In other words, revenue growth is very highly correlated with time.

Year	Annual Sales
1998	372.68
1999	424.60
2000	675.04
2001	960.39
2002	943.58
2003	834.98
2004	920.32
2005	1006.48
2006	1205.37
2007	1394.18
2008	1440.74
2009	1436.44
2010	1940.87 (E)

This is cited as one of the reasons that the excess inventory numbers came in larger than expected.  Skechers would rather hold the inventory themselves versus letting their retail partners feel the pressure and get too aggressive with price discounting.  The margins of retail partners are something that management keeps an eye one, which makes good sense if you want to maintain a stable long-term relationship.

Bad at managing street expectations

This has partly earned the depressed stock price.  Hell hath no fury like an analyst scorned.  A lot of people had egg on their face when the q3 numbers came out and management seems to care little in this regard.  The lumpiness of the business and bad street management do give us opportunities to buy at a discount when out of favor, however.  If I had to choose between operating ability and street management I know which I’d pick.  Some may argue that their operating ability is weak because of the lumpiness in business performance on a yearly basis, but looking at any multi-year history and these guys do a good job of making adjustments for the long-term.

Lumpy reinvestment profile (due largely to fluctuating inventory levels)

On any given year reinvestment as a percentage of NOPAT is very unpredictable, ranging from -68% in 2002 to 200% in 2008.   Management is definitely operating this as a growth company though and average multi-year reinvestment comes in around 60%.  Historically inventory comes in at about 16% of LTM sales, and while I’m not sure what metric management uses to balance inventory needs, it’s clearly some revenue based metric and as a consequence working cap changes year to year are hypersensitive to unit sales numbers.

Past history with CEO Robert Greenberg and a spectacular flameout of LA Gear

Most are probably familiar with this.  I personally don’t know much about the story, but from what I gather one could spin a yarn where Greenberg isn’t the bad guy in this story.  I’m happy enough to judge him on his solid operating history with SKX in a competitive industry over a near two-decade timeframe.

Toning category doesn’t appear to be having the bottom drop out

Based on some footwear industry reporting, toning still seems to be a pretty healthy shoe category.  The blistering growth may be over, but there doesn’t seem to be any reason to predict declining unit numbers based on retail demand.  Gross margins for toning should improve over the next two quarters as inventory is worked out.  Check out the Matt Powell link at the bottom.

International Wholesale and licensing upside

With so much market attention on toning, there are a couple of sleepers in the business that could be nice upside.  International wholesale is growing at a very healthy pace and should be unaffected by the toning shenanigans.  2011 revenue is expected to be flat, and this is largely due to international wholesale picking up the slack of margin compression in toning in the US.  As a percentage of total sales international wholesale will exit 2010 at 21% and will likely exit 2011 at 26% with close to 30% growth expected next year.  The company is investing big overseas in lots of markets and this is a good pairing to the maturing US business.  Also of note is the hint at increased licensing revenue related to eyewear and clothing.  This is relatively new for the company and if it takes off at all would be almost pure profit.  I’m excluding licensing from my models, it has clear upside but I’m uncomfortable putting a price on it, but just be aware it’s there.

Relative Valuation

Top line revenue and gross margins are the most important factors for driving business value in SKX.  As such, I believe TEV/S to be the best multiple by which to measure relative value.  TEV/S is most sensitive to operating margins as predictor of multiple size.  Given that the majority of revenue comes from the whosale segments (domestic and international), I chose a collection of 15 similar US based footwear wholesalers and performed a multiple regression of TEV/S versus estimated 2 year sales growth and operating margins.  Below is a chart of the regression data as well as predictions of SKX share price within 95% confidence intervals of the model.

There is a pretty wide range of possible error on these predictions, however it is clear that when controlling for margins and growth, SKX is cheap relative to it’s peers.

Note that when referring to TEV in this context, I’m using book value of debt as opposed to market value (where I include lease obligations as debt).  This is in order to be consistent with the other companies in the comp list.

Regression stats
	Estimate	Std Error	t-value
Intercept	0.2144	0.3683	0.582
Growth	6.0671	3.6392	1.667
Op margin	6.7385	1.3967	4.824
Residual standard error		0.7522

Regression prediction
Actual TEV/S	0.43
Predictions	95% conf low	95% conf high
TEV/S range	0.8123	2.4415
TEV range	1576.57	4738.63
Share price	36.17	100.01

 

Intrinsic Valuation

Performing an intrinsic valuation entails a great deal of subjective considerations.  Here are some of my major assumptions and an overview of my methodology.  Note that all of these numbers are fluid.  Discount rates, debt ratios, etc, do change with time; please do your own calculations if much time has passed since this posting.  I believe that even my optimistic DCF is pretty conservative and I can easily see the company outperforming on many of the key metrics.  I'll spare supplying all of the minute calculations for each, but if anyone would like more detail, please just ask I'll be happy to post in the comments or elsewhere.  I'm also sparing you all the historical numbers.

• CAPM-esque risk model
• Risk free rate = US 10 year treasury rate
• Implied equity risk premium (4.66% as of end of December 2010)
• Bottom up firm beta, using industry comps per reported segment
• Betas controlled/unlevered for operating leverage, financial leverage and cash
• Adding foreign risk premium for portion of firm exposed to country risk ~47bps
• 1/4/2011 Cost of equity = 9.29%
• Treating lease obligations as debt
• Default spread gleaned from Jan 2011 8-k for 5-year notes from Dec 2010
• 1/4/2011 After-tax cost of debt = 3.21%
• Weighted Cost of Capital = 7.89%
• Holding WACC constant for DCF.  Increasing foreign exposure will push foreign country risk premium up, but this will be counterbalanced by international comp betas being 10% lower than US as segment revenue mix changes.
• Not making predictions about direction of risk free rate or implied equity premium, this is a market neutral valuation
• Ignoring small NOL carry forward.  In a foreign jurisdiction and with a valuation allowance, likely valueless
• Adjusting EBIT for operating lease ‘debt’ (lease expense – lease asset depreciation)
• Capitalizing R&D and 1/3 of marketing costs as an asset with a 3 year life, the 1/3 marketing represents branding investment
• Adding acquisitions to capex (two small ones)
• Treating minority interest at book value
• Using company supplied market value of outstanding unexercised options
• For projections, separating costs into COGS% and non-COGS%, allowing for separate manipulation of gross margins versus operating margins.

WACC Breakdown	1/4/2011
Cost of Equity	9.30%
Cost of Debt	3.21%
Market value of equity	1018.80
Cash	248.83
Market value of debt	556.64
WACC	7.89%

Optimistic DCF on FCFF

• 2011 revenue flat (guided by management)
• 2 years of growth at 3% (2012, 2013), 1% TV perpetual growth.  This sales growth is below even the pessimistic analyst opinions and is way below historical track record
• Dropping gross margins to 42% for next 3 years, 41% for TV.  This is the low end of the historical range and I think is beatable.
• Holding other operating costs stable at 32% of revenue, dropping to 31% for TV.  This is a lumpy number year to but on average company is able to pull it in line over multi-year time spans
• Increasing tax rate from LTM effective to 40% for TV
• Negative RIR in 2011 as a result of big swing in toning inventory
• Assuming that ROC is equal to cost of capital

Optimistic DCF
	2010 (Est)	2011	2012	2013	Terminal
Revenue	1940.9	1990.0	2049.7	2111.2	2132.3
Gross Margin	45.30%	42.00%	42.00%	42.00%	41.00%
non-COGS costs %	33.27%	32.00%	32.00%	31.00%	31.00%
Tax rate	31.98%	32.00%	34.00%	36.00%	40.00%
EBIT(1-t)	166.1	135.3	135.3	148.6	127.9
Reinvestment rate	134.16%	-10%	60%	60%	13%
Reinvestment	183.1	-13.5	81.2	89.2	16.2
FCFF	-16.9	148.9	54.1	59.5	111.7
PV		138.0	46.5	47.3	2075.

Firm Value	2307.59
Cash	248.83
Market Value of debt	556.64
Minority Interest	34.80
Outstanding option value	6.84
Equity Value	1958.14
Share count	49.53
Value per share	39.54

 Pessimistic DCF on FCFF

• 2011/2012 revenue flat
• Perpetual negative 2% revenue after
• Dropping gross margins to 40% next year, 41% forever
• Holding other operating costs at 32%
• Increasing tax rate to 40%
• Perpetual reinvestment at 40% of NOPAT in the face of forever declining op income

Pessimistic DCF
	2010 (Est)	2011	2012	2013	Terminal
Revenue	1940.9	1990.0	1990.0	1930.3	1891.7
Gross Margin	45.30%	40.00%	41.00%	41.00%	41.00%
non-COGS costs %	33.27%	32.00%	32.00%	32.00%	32.00%
Tax rate	31.98%	32.00%	34.00%	36.00%	40.00%
EBIT(1-t)	166.1	108.3	118.2	111.2	102.2
Reinvestment rate	134.16%	-10%	60%	60%	40%
Reinvestment	183.1	-10.83	70.9	66.7	40.9
FCFF	-16.9	119.1	47.3	44.5	61.3
PV		110.4	40.6	35.4	793.2

Firm Value	979.67
Cash	248.83
Market Value of debt	556.64
Minority Interest	34.80
Outstanding option value	6.84
Equity Value	630.22
Share count	49.53
Value per share	12.72

 

More opinions and industry info

http://counterkicks.com/?s=matt+powell&x=30&y=11

http://seekingalpha.com/user/729278/instablog

http://seekingalpha.com/author/gregory-m-lemelson/articles

http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/905

http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/3098

http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/3572

 

Q4 numbers should show improvement around the excess inventory, but numbers honestly could be all over the place.  It's hard to say how big of a hit margins will get from discounting and it's not unlikely that there will be another negative surprise.  The timeline of the full turn-around related to toning will play out over Q1 and possibly into Q2, so patience is a virtue on this one.

• Inventory returning to normalized levels relative to sales
• Decreasing uncertainty around toning
• Positive surprises in 2011 due to low bar setting on 2011 numbers management
• Probably >100 million in FCFF produced in 2011 as a result of working down inventory.  There is an outside chance company would issue a div or buyback.  More likely is heavy international investing over the year.
• Big growth in international segment