Deckers Outdoor Corp. (DECK) has an amazing business. Since 2001, it’s grown revenue at a CAGR of 33.5% and it continues to grow in 2008. More importantly, it’s grown EPS at a CAGR of 55.6%. But what’s probably the most amazing thing about this business is that it’s grown with minimal reinvestment. A significant portion of FCF has been put in the bank each year, growing cash & investments from $3.9 million in 2002 to $175 million LTM. This compares to total CFO over the same time period of $212.6 million. Of course, past performance is no guarantee of future success, but it doesn’t matter because you’re not paying for it. The stock trades today at 10x earnings. On an EV basis, it’s about 20% cheaper.
Overview of Business
DECK manages a portfolio of footwear brand names including UGG, famous for their women’s sheepskin winter boots that are so comfortable half the buyers refuse to wear them with socks. For obvious reasons, fashion aside, UGG lovers have to buy a new pair every season. DECK also manages the Teva brand name, which provides some counter-seasonality to the UGG brand, and three other smaller brands, Simple, TSUBO, and Ahnu which specialize in environmentally friendly footwear, high-end casual comfort shoes, and trail-running sneakers respectively.
With 84% of 2008 sales coming from UGG, the obvious concern is that either a) the retail environment will be so harsh for the next few years that UGG will stagnate, or b) UGG is a fad that’s run its course. Fortunately we have Google trends to provide timely global insight into demand. So far UGG seems on par with the last two years. Keep in mind, 2008 looked identical to 2007, but sales grew 67%. Part of the UGG strategy has been to keep supply below demand each holiday season, and to demand orders from retailers far in advance. Management might have some insight they’re not willing to share with the public, but quarterly inventory numbers reveal the truth. 2Q09 inventory is up 29% YoY. Q2 is the only quarter with inventory turnover less than 1x, indicating that this is a key reserve-building time of year for DECK. As this inventory is backed by orders, these numbers imply that UGG might be one of the few rays of optimism from battered and cautious retailers. Inventory is a decent measure of future sales as DECK generally only accepts returns for damaged or defective products. Allowance for estimated returns was 2% of accounts receivable at the end of 2008.
Earnings vs FCF
FCF has generally lagged earnings by less than 10% as DECK builds accounts receivable and inventory faster than ST liabilities. On a quarterly basis cash flow is far more volatile than earnings while inventory builds up. Cash flow is usually negative heading into Q4, and LTM cash flow should always be down YoY if management expects higher Christmas season sales. Therefore, especially before the year-end, investors should focus on the income statement over cash flow as a basis for valuation.
One of the reasons for Deckers’ profitability is that it outsources manufacturing to China and sells its goods wholesale to retail chains. However, in recent years, DECK has begun opening its own stores. In 2008, same store sales grew by 32.7%, meaning the existing 7 stores generated $24.393 million of revenue. At average operating margins of around 17%, we see income from operations of $4.147, which is $2.965 million after tax. In 2008, DECK opened 5 new stores for CapEx of $7.323 (which doesn’t break down into maintenance and growth, so we’ll assume the worst, that this is the total cost of new stores). If 7 stores earn $2.965, 5 stores should earn $2.118, which indicates an RoIC of 28.9%. And of course this doesn’t take into account the fact that I’m basing my analysis off store profitability in the midst of an economic meltdown.
The obvious argument is that profitability should decline as the business expands, but 5 of the existing 7 stores were located in New Jersey. I think profitability will at least stay flat of the foreseeable future as DECK expands into new markets and refines store design. This investment opportunity is a good reason to value DECK on EV rather than market cap. With $175 million of cash before this year’s earnings season, DECK could grow NI by 51% just investing existing cash in new stores. This would obviously require additional working capital, but I’m looking at the cash balance after Q2. At the end of 1Q09, DECK had $230 million to spend.
What’s the holdup?
None. There’s no lawsuits, no debt, no SEC investigations. The market is just pessimistic about consumer appetite for spending exacerbated by “conservative” management guidance. I’m not blind to these concerns, I recognize the credit contraction and unemployment rate are pressuring consumers. But at 10x earnings, the market seems to think that growth is permanently frozen, ignoring the possibility of an eventual recovery in the US or international expansion. Looking at the Google trends chart above, we see that of the top 10 cities searching for UGG, only 4 are in the US, with the other 6 in the UK. At the end of 2008, 16% of sales were international. For the 6 months ending in June, 33% of sales were international compared to 28% for the same period last year. In the 3 months ending June, 45% of sales were international, compared to 37% for the prior year. So while US growth might be a concern (although we’re up 17% domestically for the first half of ’09), international demand seems able to pick up at least some of the slack. For comparison Nike (NKE) generated 58% of its revenue overseas in 2009 (fiscal year ends in May) and if NKE grows at 3%/year, it would take DECK 14 years of 30% growth to catch NKE. Nike is arguably not a great comparison company because they manufacture many things other than footwear, but footwear accounted for 83% of 2009 US sales. In short, the growth story isn’t dead.
Shrinking demand for the non-UGG brands has weighed on earnings in Q2 and probably won’t help Q3. But this is a company that primarily makes winter boots. Teva sales, which have been weak for years, aren’t a good indication of what UGG sales will be. At the end of Q2, management updated guidance. Despite the fact that UGG sales had increased 23% YoY for the second quarter (excluding retail sales which were up 100%, but only 8.4% from same store sales), management only expects UGG to be up 9-10% for the year. They expect EPS to be flat to slightly up for the year, with a 10% improvement in the third quarter and a weak Q4. These numbers don’t make sense to me, and they apparently didn’t make sense to Todd Slater from Lazard Capital who questioned management during the most recent conference call:
Slater - I was just trying to get my arms around a little bit the conservative nature of the retail assumptions you're making in the fourth quarter, which are obviously impacting your guidance. And you have this, I guess, about a 5% increase baked into your back-half guidance for UGG. I'm just curious, what level of backdoor or reorders are you assuming in this guidance compared to last year? I'm just wondering, is it down versus last year? Are you being very conservative? Does it represent or reflect what you're seeing in the velocity of that business currently? Because it sounds like you are getting some terrific uptake, not just on the anniversary sale items, but on some of the full-priced product around it. I'm just curious about what assumptions you are making on that reorder business versus.
Ziv (COO) - Well, Todd, as I mentioned, we are assuming a similar level of the minor cancellation levels that we had last year. We're still being conservative vis-a-vis the pre-book. One area that we also take a cautious look at is our e-commerce business. As you know, it has been down in the second quarter. And right now it looks like, in our assumption, it's going to be down for the full year. So it depends how consumers buy and it depends how much they buy from our consumer direct business. That will impact our numbers.
Martinez (CEO) - By the same token, we are also anticipating a better December than we had last year, given the wheels falling off the cart on the economy at the beginning of December, certainly from a retail perspective. So I don't anticipate that happening this year. I think most of the bad news is out, and consumers are over some of that shell-shock. So we should see a smoother level of reorder compared to what happened last year, where everything just kind of fell off the table at the beginning of the month.
Slater - So if you take all that into consideration, July through January, I'm still -- it's not clear to me. Are you expecting the dollar level to be down at this moment, or at least guiding to that type of expectation in the hopes that you at least hit that, if not exceed it? Or can you give us a sense? Because I couldn't tell whether you were saying flat year-over-year or up or down, in terms of expectation for the full period.
Ziv (COO) - For the back half of the year, we're looking at UGG to be about 5% up.
Sltater - Great. Well, I hope your guidance is conservative as it has always been, and best of luck.
Again, I want to stress the fact that I don’t really care what happens in any single quarter, or even in a year. I think long-term prospects are strong. But even the short-term pessimistic scenario which analysts find hard to swallow is low or no growth. No one is expecting sales to decline. For $80/share investors get a business that generated LTM earnings of $7.82, $13.30 of cash, and another $15.84 of inventory and accounts receivable. The growth story is far from over, but it’s not necessary at present valuations for investors to realize significant returns.
Disclaimer: I own shares of DECK.