Skechers looks like a strong company whose price has been knocked down by investor overreaction to potential slowdown and unresolved lawsuits.
The overall balance sheet appears strong. The company has substantial cash reserves, a negligible amount of long-term debt, and current/quick ratios of 3.39/1.98 respectively. The company currently sells for just over book value (1.1x). The only red-flag is the rapidly rising of inventory.
After the most recent earnings report management admitted that inventory growth is higher than they expected [http://skx.com/press.jsp]. They say that “several accounts over-booked,” which is basically a nice spin on “oops.” The news came out on October 28 and the stock dropped 20% the same day, so clearly somebody’s worried.
Looking at relative and historical data, investors might be overreacting on this one. Inventory as a percentage of total assets is currently 26.55%. That’s significantly above last year’s figure (22.51%), but it’s worth noting that 2009 was lowest inventory level the company has ever had. Current levels are only slightly above the five-year average (25.53%) and well below the ten-year average (29.22%). I also think it’s an encouraging sign that, even in the face of rapidly rising inventory, inventory turnover has increased substantially from 3.36 to 3.95. They might have too much on hand, but they’re moving it out the door at a decent pace. I think the main investor worry here is tied to sales of toner products (more on those below).
Earnings and Margins
Although it looks like Skechers suddenly had a breakout year after a period of stagnant earnings, it has actually been improving earnings for longer than raw net income figures indicate. At first glance earnings from 2008 to 2009 appear to be essentially flat. Dig a little deeper, though, and gross/operating margins were both higher in 2009. On equivalent revenue that should translate into higher profits, so what gives? Taxes.
In 2008 Skechers received a large tax credit as a result of negotiations with the IRS, reducing its effective tax rate for the year from 23.4% to 11.9%. The tax rate the following year – the apparently “flat” year – was 28.4%, a $12.9M difference that effectively hid the year’s improvements from a cursory inspection.
2010 has been a banner year for the company. Net income from the first nine months alone is two and a half times that of the entire previous year ($132.9M vs. $54.7M). Move that up to trailing twelve months and Skechers is up to $161M (more than twice its best year to date), selling for 6.17x earnings.
The increase has been driven in part by record sales (number of shoes sold is up 28% for first nine months of 2010 vs. 2009 for the segment they report it) and in part by improved margins. Operating margin (ttm) increased from 5% to 12%. About 4% came from a decrease in COGS and 3% from a decline in SG&A expenses.
With all this in mind, the big question is “why does this sell for 6x earnings?” The two factors seem to drive the stock down: (a) between the inventory backlog and high margins, investors lack faith that this level of performance will continue and (b) they’re worried about the lawsuits.
As far as (a) goes, concerns are exaggerated. Inventory levels are only slightly above the recent average when viewed as a percentage of assets and days inventory has actually fallen to its lowest level in five years. The COGS numbers are historically low and started creeping back up in recent quarters, so it’s fair to expect them to return to something like their historical average. SG&A, on the other hand, actually did regress to its long-term average, so that seems sustainable.
As far as (b) goes…
Trouble with John Law
In 2010 Skechers has been hit with three class-action lawsuits in the state of California concerning their new shape-up toning shoes. Here’s a summary California’s Unfair Competition Law and the filing from the most recent lawsuit.
California UCL Law Details: http://www.stroock.com/SiteFiles/Pub168.pdf
Lawsuit details: http://www.courthousenews.com/2010/08/27/Skechers.pdf
The suits basically allege that toner shoes don’t work and that their marketing is a pile of lies. Since Skechers is a big player in the toner shoe market (55% according to some articles) and since the company doesn’t break down shoe sales by product line, this seems to have a lot of investors worried. Potential damages from a settlement or unsuccessful trial could be ugly and sales could take a big hit.
Judging by the filings, the threat of big legal losses might be a bit overrated though. If you look at the actual submission, the plaintiffs’ lawyers mention possible health issues but don’t emphasize them or base their case on them – the main issue is the supposed lack of calorie burning benefits. They aren’t suing because they got hurt, they’re suing because their shoes didn’t give them buns of steel (gee, you think?). To me, that seems like it vastly reduces the possibility for large, ugly settlements. Sales were at their highest level ever in 3Q 2010, so it’s safe to say that consumers were not discouraged by the lawsuits. It’s also encouraging to see that California’s UCL law is often used for frivolous lawsuits (meaning that these might be knocked down) and that Skechers has taken the issues seriously and hired a top-notch legal team. At worst they’ll pay a fine and kill the product line.
That outcome seems to be exactly what a lot of investors are afraid of, so I’ve worked out a little about the impact of toner products on Skechers’ sales numbers.
“People” say that the toner market is currently worth about $1.5 billion, of which 55% belongs to Skechers. We’ll play with this number a bit to show how (a) it’s sensationalistic BS and (b) Skechers is less dependent than people believe on toning shoes to make their money.
55% of $1.5B (after adjusting 3/4 for nine months) comes to $618.75M. That’s Skechers’ entire year-over-year gain for 2010 and then some. According to the same sensationalistic articles, the toning market grew 500% this year. If Skechers had the same share last year, that would be 55% of $250M. That in turn comes to $137.5M, which I’ll attribute to the previous year. With that in mind this year’s net gain from toning shoes is supposedly $618.75 – $137.5 = $481.25M
$481M is basically the entire y-o-y increase, so if that’s true you can see why Skechers investors are running for the hills at the first hint of trouble with the product line that (supposedly!) brings in 40% of the company’s revenue. That figure, however, doesn’t seem to square with the rest of Skechers’ books.
Take their domestic wholesale business, for example. So far this year it has posted a y-o-y gain of 66%, amounting to a $360M gain. That comes from an increase of 28.3% in pairs sold (up 8 million) and an increase in Average Sale Price from $19.17 to $24.81. Figuring that toning shoes have an ASP of $80 (that’s a conservative estimate – if you check the website, you’ll find that those shoes are almost the sole occupants of the $75-99 and >$100 categories), let’s see how the numbers work out. Remember, the entire revenue increase for 2010 thus far is theoretically supported by toning shoes.
A weighted average of sales prices:
$19.11 x (28.4/36.4) + $80 x (8/36.4) = $32.49 as the 2010 ASP
Since $32.49 is a little higher than $24.81 (the actual ASP for 2010), something is a little fishy here. Either Skechers is telling fairly blatant lies about its sales figures or observers have widly overestimated the size of the toning shoe market/Skecher’s share of said market. Also, using last year’s ASP for the first 28.4M pairs sold actually understates the company’s real performance. This year has had fewer sales and close-outs, bringing up average prices on all products. If the base ASP is adjusted upwards from $19.11 to reflect this then the result becomes even more outrageously high.
What’s it all mean? It means that Skechers is much less dependent on the toner market and much less vulnerable to those pending lawsuits or changing shoe fashions than investors seem to think.
Adjusted Earnings and EPV
With all that in mind, it’s possible to start making a few basic predictions about where Skechers’ earnings might go in the future. Major factors include: revenue, toner sales, margins, and lawsuit outcomes.
Trailing twelve month revenue will be used for the base revenue amount. That starts the predictions off with a conservative estimate, figuring that sales from 4Q 2010 merely match the previous year (realistically, they’ll probably beat it by at least 15%). Then the base revenue can be adjusted to reflect various scenarios ranging from worst-case to slightly optimistic.
(assuming 30% tax rate for all scenarios and that the toner numbers refer to their effect on overall sales)
|Base Revenue||Revenue Growth||Toner Sales||Operating Margin||Lawsuit Outcome||2011 Earnings|
The disaster scenario is ugly compared to its present performance, which is probably what’s got a lot of folks headed for the exits, but it’s basically the same performance that the company had in 2008/2009. Not great, and a big step down from the present, but not doomsday either. Even more important, though, is weighing the odds that this scenario actually happens. For it to occur, Skechers must: see revenues decline 10%, lose another 10% of that from the rapid decline of toner sales, pay out $25M in an embarassing settlement (which caused that ugly sales decline), and see its margins shrink to historically low levels. Given that Skechers just posted its best quarter ever in spite of those pending lawsuits, it seems unlikely that this perfect storm of disaster will ever actually come together (good to be aware that the possibility exists, though…).
On the other hand, let’s look at the slightly optimistic scenarios. 8% operating margin is a substantial step down from the 3Q operating margin of 10%, which itself was below the nine-month average of 12.5%. A cautious projection has to assume that margins will regress towards their historical averages (especially in the absence of any lasting factor to push them away) so that’s a fair number. The lawsuit outcome reflects my belief (this is the optimistic scenario) that Skechers will escape the lawsuits with little/no consequences. It also reflects my belief that people will always want something for nothing, which includes workouts for no work.
Cost of Capital (virtually all equity): 9.66%
EPV = Net Income / WACC
Scenario 1: $561M
Scenario 2: $1126M
Scenario 3: $1183M
Like I said, the disaster scenario ain’t pretty. I think it’s unlikely but investors looking for a large margin of safety would do best to look elsewhere. The less melancholy projections have it as moderately undervalued on an earnings basis.
On a relative basis it also looks underpriced. It currently sells for only 6.54x earnings, while other shoe retailers have a P/E in the mid-teens. Skechers has historically traded at a similar level. If it earns $108.81M next year (the middle scenario), then it would sell for about $27.41 at 12x earnings. Neither condition seems particularly unlikely.
In light of its appealing relative and absolute valuations, as well as its limited exposure to the effects of the pending lawsuits, Skechers looks like a good buy overall.