Is VF Corp. (VFC) considering another large acquisition? VFC completed a very successful acquisition of Timberland in mid-2011 and the stock has continued to climb to new highs. Rumors have been swirling that Deckers Outdoor Corp. (DECK) is a potential acquisition target for VFC. Could VFC be planning to expand its brand portfolio once again?
As you can see from the chart below, the two companies' performance has diverged significantly in 2012 as VFC has outperformed Deckers by nearly 120% in the past two years. With this article I hope to educate VFC investors about Deckers as a company as well as to weigh the pros and cons of the potential acquisition. Should Deckers' investors be expecting a nice Christmas present or is coal more likely?
(Source: Yahoo! Finance)
Investors may not be familiar with Deckers but likely know about the wildly popular UGGs brand. The UGGs brand is known predominately for its winter boots but the company has been quietly expanding its product line. Deckers has three primary brand lines:
- UGGs: High-end luxury comfort brand with sheepskin footwear, handbags, and other apparel
- Teva: Medium-end lifestyle brand with sport sandals and various outdoor performance footwear
- Sanuk: Action sport footwear brand that has branched off into sandals and other footwear
Despite having three main brands, as you can see from the table above, the vast majority of sales are from the UGGs line. UGG wholesale sales account for a staggering 85% of brand wholesale net sales to customers. VFC might be able to successfully integrate and improve on the Teva and Sanuk brands due to commonalities but any acquirer would really just care about UGGs. UGGs have been exhibiting strong growth but income from operations has been under pressure due to higher sheepskin and other costs that have significantly lowered margins. The only other segment contributing any meaningful income is Sanuk but the 121% year-over-year increase in operating income was driven almost exclusively by a reduction in non-cash amortization expense.
For the nine months ended September 30, 2012 net sales have increased only 3.1% while cost of goods sold have soared 12.1%. Approximately two-thirds of revenue comes from the US, which exhibited 7.7% growth while international sales slumped 4.8%. The net effect of higher material costs is a 6.8% decline in gross margins and when coupled with a spike in SG&A (29 new stores opened during the year) results in a net income tumbling nearly sixty percent. The math is simple: revenue growth is slowing (and even contracting at times) while expenses continue to accelerate. Operations are highly seasonal with UGG sales concentrated in the third and fourth quarters with Teva and Sanuk sales occurring primarily in the first half of the year.
Expanding the analysis to the past nine months reveals that both Teva and Sanuk generated positive income from operations but each brand contributed less than ten percent of UGG's income. To reiterate, VFC may be able to unlock value with the additional brands but not enough to materially impact the company's performance.
Deckers has modest revenue concentration as its five largest customers accounted for 24% of net sales in 2011. In 2010 Nordstrom's accounted for more than ten percent of consolidated net sales due to UGGs but accounted for less than ten percent in 2011. UGGs are sold in high-end department stores such as Bloomingdale's while Tevas are sold in outdoor retailers including L.L. Bean and The Sports Authority. Most footwear is also available on Amazon's (AMZN) Zappos.com. Deckers only has one retail store in the United States so it is highly dependent on its retail partners. There is no indication that UGGs are a short-term fad and in fact have shown remarkable staying power but it is always alarming when a company's products have such a high concentration with a few retailers. A simple disagreement over sales terms or marketing strategy can be disastrous for the supplier.
As you can see from this analysis above, Deckers is essentially "the UGGs company" which means it is very seasonal and highly sensitive to key input costs. The UGG brand is valuable but is at a critical crossroads and has many obstacles to overcome.
The deal makes sense from a valuation standpoint as Deckers is a $1.4B company with $1.4B in sales and $155M in income. DECK's margins have been pressured but VFC has shown expertise in managing costs. I would expect VFC to succeed in dampening input cost volatility and generally reducing operations costs. DECK's balance sheet is healthy as the company is in a position of strength in terms of both liquidity and solvency. The billion dollar issue is turning around Deckers' recent operating slump.
The primary reason why I am hesitant about the deal relates to the fact that UGG is positioned as a luxury brand while VFC focuses on lifestyle brands (7 Jeans and The North Face are the closest to being luxury brands). Lifestyle brands are associated with higher emotion, lower price-sensitivity, and higher brand loyalty. Luxury brands naturally require a different management style and I would not like to see VFC veer from its core competency. Having said this, the more I consider the acquisition the more I believe VFC's management may have tremendous success in improving the appeal of UGGs in shifting it towards more of a lifestyle brand.
If VFC is able to acquire Deckers and broaden the brand's reach, then this could be a very successful acquisition. On the other hand, if VFC simply intends to continue down the luxury path with UGGs, I see minimal benefit to the deal. Part of the problem is that UGGs are primarily used in winter weather and it is difficult to generate the emotion of a lifestyle brand when the clothes cannot be a staple of one's daily wardrobe. Expanding the UGG line will not only enhance performance but dampen the volatility associated with the seasonal brand. Such a task is far from easy but the potential reward is certainly worth the risk.
I believe that it is only logical for VFC to consider acquiring Deckers but only if the price is right. Analysts have forecasted that a deal would be unlikely below $50 per share which indicates a minimum expected purchase price around $1.8B. Many parties, including private equity firms, will likely be interested in Deckers so the price could spiral higher. The Timberland deal was worth approximately $2B and I think VFC should use that as a soft-cap on the amount it would be willing to pay to avoid significantly overpaying.
As a standalone company Deckers is still compelling because it is not in financial distress and could turn itself around, then pursue a sale a higher valuation. I am sure this is not the last we will have heard about a Deckers deal. The talks may cool around the holidays as companies wait to see how Deckers performs during the critical fourth quarter but expect the rumors to reignite in Q1 2013. A negative resolution to the fiscal cliff (i.e. 'no deal') could negatively impact Deckers' valuation since it markets higher-end goods but should not have a long-term impact on the brand's value.
Disclosure: I am long VFC.
Additional disclosure: Please refer to profile page for disclaimers.