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Introduction

Deckers Outdoor Corporation (DECK) is a global footwear provider of niche brand name shoes. The company owns six brands, with the most business coming from UGG, Teva, and Sanuk. Other segments of the business include 'Other Wholesale,' which is the other three brands, 'eCommerce', and 'Retail Stores.' Based on proprietary discounted cash flow analysis done by the Oxen group, DECK shares are a solid HOLD with a price target at $40.

The knock on DECK has been that their revenue makeup is based too much in it UGG products, make up 88% of revenues. The company will need to improve their lineup diversification in order to be more appealing in the future. From a quantitative prospective, DECK shares trade at about 10.8x trailing EPS and more importantly 13.3x forward EPS, a discount to the market and its peers. The key to DECK is the success of diversifying its portfolio as well as the continued popularity/success of UGGs, which is developing into a diversified line itself. The introductions of new styles in the fall and spring seasons have improved the brand and decreased its seasonality, yet the firm still derives most of its EPS in Q4 (or the holiday quarter) and from winter boots. The UGG brand is very valuable, the brand's position as a mid- to upper-price luxury staple is at the core of DECK's future success.

Profile

Deckers Outdoor Corporation, founded in 1975, strives to be the premier lifestyle niche brand in the world. The company sells products including accessories, bags, outerwear, and footwear for casual and high performance use. The firm seeks to differentiate their products by offering, "diverse lines that emphasize authenticity, functionality, quality, and comfort and products tailored to a variety of activities, seasons, and demographic groups." The company's main brand UGG Australia is a luxury/comfort brand and a pioneer in sheepskin footwear space.

Thesis

Valuation -

DECK trades with similar footwear companies in the consumer cyclical space. The average forward multiple in this sector is roughly 14.8x and the median is about 13.9x. DECK's 13.3x forward multiple trades below its industry average and median forward multiple. Due to the company's strength in one line and lack of diversification worries investors about future growth. Additionally, the company has shown waning popularity for their UGG shoes. UGGs made $1B in 2011. In 2012, that number will likely decline. Revenue from UGGs dropped 11% in Q3 2012 and 0.5% in Q2 2012. The trend down is not positive and is the reason for a lot of the weakness in shares. The question now is, are shares cheap even if the business is not as strong or is more downside on the way.

One positive for the company is that it executes at a better rate than competition. In net margins, DECK outperforms its peers by a healthy 'margin.' The average and median net margins for DECK's peer group are 7.5% and 7.4% respectively. DECK beats these metrics at 11.4%. Similar companies are Crocs (CROX), Steve Madden (SHOO), and Wolverine Worldwide (WWW). The three operate with net margins at 12.8%, 9.1%, and 7.7%, respectively.

Additionally, DECK's operating margins are better than 84% of it peers at 15.7%. CROX, SHOO, and WWW operate at 14.6%, 13.9%, and 9.8%. Once again, DECK executes at top of the line and has solid pricing power.

DECK's management also outperforms the competition. The firm's ROE is better than 83% of the footwear industry at 22%. What we can see, therefore, is that DECK is undervalued not due to solid execution.

The problem is two-fold. The company is not well diversified and top product is looking weaker, and at the same time, the company's diversification into TEVA and Sanuk further may weaken the company's solid margins. With this dichotomy presented, shares are a Hold.

Catalyst -

There are upside potential catalysts for DECK as well as downside catalysts.

The upside argument for DECK is that the company sees solid growth in Sanuks, Tevas, and other brands. Further, the company has to be able to convince shoppers that they are more than a winter boot company that is popular with a small sect of the female population. Recent results in Teva and Sanuk are promising. Teva saw 22% increase in sales in Q3 of 2012 and Sanuk saw an increase at 18%. Both brands are still a tiny portion of the company's sales. Therefore, for the next one to two years, the company will need to diversify its UGG lineup. The jury is still out on this, and therefore, we are not sure if they have an upside catalyst. Our take is that UGGs have lost some fashion appeal but some of that lost appeal has been made up for with new buyers from males and other products outside of winter boots.

Economic Moat -

DECK's business basically revolves around UGG. The UGG brand name, and the quality that backs it up is DECK's only economic moat. UGG wholesale makes up 75% of all sales, while ecommerce and retail stores make up the remaining 13% of total UGG sales. 64% of revenues are derived from the USA as well. The company operates in a very fickle market of fashion, which worries us and gives little economic moat. Diversification in markets and products further shows a lack of moat. As an investor, these are serious questions to have.

DECK's brand loyalty is small due to its short-term success.

One issue to its moat is counterfeiting shoes. In 2009, US Customs seized over 60,000 fake shoes, shut down thousands of fake shoe peddling websites, and took down tens of thousands of fraudulent eBay posts. These customers may not actually translate into sale, but it is important that DECK keeps its brand synonymous with quality and luxury and stays vigilant against criminals.

Revenue and EPS Outlook -

Revenue trends may be a catalyst that could push shares down to our price target. DECK's Q3 year/year revenue was down over 10%, but to balance that out, Q1 and Q2 year/year revenue growth was up 13% and 20.5%. The issue for DECK is that the company is in no way a fundamental staple. It's a growth stock that needs growth to stay relevant and show upside.

The eCommerce section of the business has positively affected revenue. In Q3, eCommerce increased 29.3% in sales and retail sales increased 12.8%. The company is expected, by The Street, to double the number of retail locations and add more outlet locations. DECK provides good reason for these efforts in SEC filings.

"Through our outlet stores, we sell some of our discontinued styles from prior seasons, plus products made specifically for the outlet stores. We sell Teva products as well as some of our other brands through our UGG Australia outlet stores."

The ecommerce section of sales is doing great. Across DECK's various brands, the eCommerce section of sales grew 12.6% on average and for the UGG section grew 15% in the last quarter.

And on a final note, it is interesting to point out that investment bank Credit Suisse is expecting sheepskin costs to come down 11% and help gross margins, when in prior years it was indeed a drag on EPS.

Revenue growth could bounce back in 2013, but we do not expect a big comeback until 2014. 2013 could be a flat year before a strong comeback in 2014.

Price Target Analysis

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

226

235

262

275

305

Taxes

79

82

92

96

107

Depreciation

52

54

56

58

60

Capital Expendit.

-81

-60

-65

-70

-80

Working Capital

52

52

52

52

52

Available Cash Flow

66

95

109

115

126

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for DECK: 6.00%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9091

0.8264

0.7513

0.6830

*

PV of Available Cash Flow

60

78

82

78

*

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.

Cap Rate for DECK: 6%

2016

Available Cash Flow

$126

Divided by Cap Rate

6%

Residual Value

2,104

Multiply by 2016 PV Factor

0.6830

PV of Residual Value

$1,437

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

$298.71

PV of Residual Value

$1,437

Cash/Cash Equivalents

76.50

Interest Bearing Debt

0

Equity Value

$1,812

Step 5.

Divide equity value by shares outstanding:

Equity Value

79,025

Shares Outstanding

3,810

Price target

$20.74

Profit/Value Industry Comparisons

Profitability:

DECK

DECK is Better Than X% of Industry

Gross Margin

46.68%

94%

DECK

Industry Avg.

Dividend

0%

1.2%

From an operating prospective, DECK's gross margins are at the top of the footwear industry, but capital is not being returned to shareholders in the form of dividends.

Variant

DECK has captured the interest of the Wall Street short seller. Over 40% of the available shares have been sold short. This is indeed a risk to the story. There is potential for a short squeeze, but the heavy short interest creates a lot of volatility and beta. That up and down roller coaster can create a lot of pain for investors as well as could produce short-term results masking long-term trends.

Another risk to the HOLD rating includes the traction of other brands. DECK's portfolio of other brands do not pull their own weight, but should they even come close contributing more, there is upside to DECK.

Finally, unallocated overhead costs really pull down on income from operations. This comes from the change in distributor models to direct wholesale models, but should these come under better control there is also upside in DECK, but more detail should be disclosed on this line-item in SEC filings.

The Bottom Line

DECK is an interesting company, but it might as well have the ticker UGG. The company derives nearly 90% of its revenues from the UGG brand. This may present a significant risk if tastes change. This may also be a reason DECK trades at a discount to its peers. The company, however, performs very well on mostly every performance or managerial metric. If the company can diversify the UGG line and its product line, it could become a retail staple. Economic trends may be bullish, but DECK's 'fad-like' revenue distribution may prevent multiple expansion. All things considered, DECK shares are a solid HOLD.

Source: Deckers Outdoor Has Potential But Must Prove A Lot First