Description

Skechers U.S.A., Inc. is a shoe designer and marketer which possesses a solid margin of safety at the current share price, trades at 2.5x EV/LTM EBITDA and 5x P/E, has almost zero net debt, and is mid-way through its expansion of its international operations. A downward revision to the forecast 4Q 2002 sales and earnings by management in November 2002, and a lot of popular press regarding the increasingly competitive nature of athletic footwear, has left the stock over-sold.


Company Overview
Skechers designs and markets branded contemporary casual, active, rugged and lifestyle footwear for men, women and children in over 100 countries. The Company’s product line has over 1,500 active styles (organized into 10 major product lines). The Company has spent the past several years creating an identifiable brand name and targeting “fashion forward” 12 - 25 year-olds seeking affordable and stylish shoes. Skechers’ shoes are sold in a wide range of department stores (Macy’s, Nordstrom’s, etc) as well through the Company’s fast-growing network of retail stores, and online.


Financial History
The Company is 10 years old, and has been growing rapidly for the last several years. The last few years provide a useful background. (LTM is as of 9/30/02).

2000 Sales: $675.3, 2001 Sales: $960.5, LTM Sales: $976.8
2000 EBITDA: $87.3, 2001 EBITDA: $103.8, LTM EBITDA: $119.3
2000 Net Income: $43.8, 2001 Net Income: $47.3, LTM Net Income: $57.6

Debt: $119.9; Cash: $108.1
Sh/Out: $37.5; Mkt. Cap: $282; EV: $293MM

Current market price: $7.50; 52-week high: $24.40


Comparable Companies Analysis
I do not like to rely heavily on compco analysis and want to get it out of the way first:
Ent. Value EV/LTM EBITDA P/E (trailing) Price/Book

Brown Shoe Company 586 11.3x 39.2 1.6x
Kenneth Cole 398 9.2x 24.1 1.4x
Nike 11,564 8.4x 16.3 3.0x
Reebok 1,526 NM 14.7 2.0x
Steven Madden 156 4.3x 15.7 1.7x
Stride Rite 237 5.1x 16.3 1.1x
Timberland 1,254 7.6x 14.3 3.4x
Vans 31 46.8x NM 0.4x
Wolverine World Wide 658 NM 13.1 1.7x

Skechers 293 2.5x 5.2 1.1x

Excluding the high-end outlyers and Skechers, for the above companies the mean EV/ LTM EBITDA is 6.9x, the mean P/E is 15, and the mean Price/Book ratio is 1.6x. Skechers is significantly lower on all counts.
Although SKX has traded at a discount to the above group over the past several years, the Company could fall into the trading/multiple ranges of its peers once it is accepted as a long-term player.


Valuation

EV/LTM EBITDA: 2.5x
P/E (trailing): 5.2
P/2003E: 6.3
Price/Book: 1.06

On a trailing basis the Company is trading very cheaply. Clearly, the Company’s sales and earnings are largely expected to be somewhat ‘cyclical’ going forward now that the Company is no longer in a hyper-growth phase, and the market expects that cash flow will decline significantly in 2003. However, if we assume LTM EBITDA is too high a number for normalized cash flow earnings, and instead use a 5x EBITDA multiple for a back-of-the-envelope valuation, normalized EBITDA would need to be $59MM to arrive at the current share price and mkt enterprise value. If you use a 4x EBITDA multiple, normalized EBITDA would need to be $73MM to get you to the current mkt valuation. To get to these EBITDA levels one would need to assume that despite a 3-year CAGR of EBITDA of over 40% (and doubling of sales over the last four years), normalized EBITDA is below pre-2000 levels.

Everyone does their DCF analysis differently and I won’t go into my assumptions, but I’ve found that even with very conservative assumptions about 2003 EBITDA, discount rate, growth rate, etc. the current price is very cheap, and I encourage you to do your own if you are so inclined.


Strong Balance Sheet/Liquidity Profile
The Company has virtually no net debt and plenty of availability under its revolver facility, so there are no liquidity issues. The $108MM of cash allows the Company to be well-positioned for a prolonged downturn in demand as well as the continued build-out of its international business. (As a side note, the Company issued $90MM of 4.50% convertible bonds - $26/share conversion price - in April 2002).


Successful Business Model
The Company has successfully created a market for its styles by targeting “fashion forward” teen consumers who are interested primarily in trendy and comfortable sneakers. By using endorsement agreements with distinctive celebrities such as Britney Spears, Robert Downey Jr., Rob Lowe, Matt Dillon and Rick Fox to market its shoes, the Company has established a very distinct image and consumer base for both its sneakers and casual shoes.
There are a few things about the way the Company does business that I think limit downside and are worth pointing out:

1) Skechers’ design of shoes is largely based on its imitation of other brands. The Company’s designers work by spotting trends of the styles of sneakers, sandals and loafers on the streets of metropolitan areas, and quickly developing Skechers styles in accordance. In addition to using its own retail/‘concept’stores to improve brand recognition, the Company uses these higher-margin stores (which they are expanding) to test new product lines. Per the 10-K, the Company strives to determine with 2 weeks after initial introduction of a product whether there is substantial demand for the style, which helps limit the Company’s exposure to fashion duds.

2) In the U.S., Skechers’ sneakers are priced and designed for 12-25 year-olds, which significantly limits price competition with the Nikes and Adidas’s of the world: Skechers’ sneakers typically sell for $40-$65, whereas Nike, which stresses high-performance and name brand recognition, usually sells its shoes in the $80-$200 price range. Adidias’ sneakers are usually priced between $65-$130, and Reebok’s shoes are priced between $40-$100. While Skechers’ competitors have typically emphasized the athletic nature and specific-to-a-sport quality of their sneakers, Skechers has focused on emphasizing the stylish look of their shoes and advertising itself as a “lifestyles” company instead of an athletic footwear company. Skechers’ philosophy, which I strongly support (as does marketing research), is that over 80% of sneaker purchases are based on how the shoe looks or who endorses it rather than on their intended purpose or ostensible athletic performance qualities.

3) Skechers’ focus on style and comfort rather than athletic performance allows the Company to make shoes with less expensive materials and with fewer bells and whistles compared to Nike, Adidas, etc, which enables the Company to continue selling profitably in a cheaper price range.

4) The Company designs all advertising in-house which reduces costs relative to using advertising agencies and allows it better control and direction of its marketing.

In addition to pursuing growth overseas (below), the Company is also expanding via other product lines based on the Company’s sporty/stylish brand image, most recently having signed the Advance Group and Kid Headquarters to develop Skechers-branded watches and children’s sportswear respectively; both new product lines will be available in 2H 2003.


International Growth Opportunity
For a few years now, management has stated its desire to expand the international business (currently at 15% of sales) to 30% of sales in the next few years. To date, management has steadily built sales and established direct distribution of its product in Europe and Canada (in September 2002, the Company signed a 25 year lease for a 200,000+ sq. ft. distribution warehouse in Belgium to support its brand launch in Belgium, the Netherlands and Luxembourg). A higher proportion of sales should provide a useful ‘hedge’ to the Company’s domestic business. A weak dollar can only help in this regard.


Recent History
Apart from the weak U.S. economy and retailers’ fear of inventory build-up in the 2002 holiday season, the Company’s other stated reasons for the decline in revenue and earnings in 4Q 2002 were the West Coast dock workers’ strike, the elimination of the Company’s mail-order (money-losing) division in 2002, set-up costs associated with the Company’s warehouse in Belgium and reserves due to pending disputes. These four events are one-time items and should have no impact on 2003 results.
In mid-January 2003, management raised its estimate for 4Q 2002 results in part due to earlier than anticipated shipments to its Spring 2003 product line, and seems to have implied an upbeat expectation for 1Q 2003 results given the reception to the Spring line. In addition, the Company mentioned that its inventory levels are “clean and on plan”.


Key Risks/Issues
Three significant issues facing the company and its reputation in the market are:
1) Increasing competition: it is widely speculated that Nike, among other bigger players, have begun to expand into the ‘fashion-conscious’ and ‘retro’ sneaker markets that Skechers has built its core business in. Steven Madden (another ‘trendy’ shoes designer/seller) just announced it is moving into the European market.

2) Robert Greenberg, the Chairman, CEO and founder of Skechers, was the founder of L.A. Gear which ended up filing for ch. 11 protection in the early ’90s. In addition, the Greenberg family controls 90% of the voting power of the Company. My view, which is probably far from unanimously held, is that the Greenberg family has a strong operational background in the sports/casual shoe industry, and they are a real plus for the Company. I am also not phased by the sales of the stock by the Greenberg family that took place in 2002 (I subscribe to Peter Lynch's view that insider buying is far more insightful than insider selling) and believe that mgmt is not egregiously compensated, but again, I’m sure there are those that disagree.

3) Reputation as a ‘fad’: as a fashion footwear designer and marketer, the Company’s shoes are perceived as a fad, and the Company’s share of the market for less-expensive, trendy sneakers for young women is likely to be attacked. A major fashion mis-step could destroy profit margins by forcing the Company to use discounts to move inventory, but I think that the market has already (over-)priced in all of these expectations. In addition, I have three responses to this concern:
A) On the whole, consumer purchases of athletic and stylish casual footwear does not appear to be diminishing and appears to be on the rise.
B) The Company has 1,500 styles of shoes and very different major product lines currently being marketed. (I know that’s too glib a response, but you get the point that the Company doesn’t have all of its eggs in one basket)
C) In mid-January, the Company has said it is pleased with the response to its Spring product line and is acting upbeat about 1Q 2003 (for what its worth)

Summary
This Company has been oversold primarily because of murky growth prospects and fears of it being a fad. Having reinvested operating cash flow into working capital in the past, C/F from operations for first 9 months of 2002 was $93MM, and this Company is well-positioned to continue generating significant cash flow. Retail- particularly for shoes- is a cyclical business but the current share price provides a substantial margin of safety, and implies that normalized EBITDA is about 55% of what the Company has been able to produce over the last two years. In addition to possessing significant brand value and market share in a niche space of the sneaker/casual shoe market which is below the price range of bigger players, the Company has meaningful growth opportunities in the form of international sales and new product lines. It’s a shame that the business is privately-controlled and by a family name which the market has a stigma towards, but I don’t think that this justifies the current valuation of 2.6x EBITDA.

Catalyst

1) Continued strong cash flow
2) Seems like 1Q’03 results and 2003 guidance will be better than what the current share price implies about the Company’s near-term prospects
3) Announcement of a share buyback program- Company has said it’s a possible use for the Company’s $100MM+ of cash