Skechers: Little Downside at Today's Prices

Jan.27.11 | About: Skechers USA (SKX)

Skechers shares (NYSE:SKX) have been cut in half over the past six months as investors worry about the future prospects of the company's popular Shape-Ups brand (a toning shoe). A huge build-up in accounts receivable and inventory, along with mounting competition from Reebok and Adidas in the toning category, and continued fears that the toning category is a fad have all combined to scare investors away from Skechers.

However, this post will argue that an investor at today's prices risks very little downside if all of the investor worries come true while having huge upside in the event that SKX can continue to dominate the toning market, or if the company can convert some of its toning customers into its other shoes.

Skechers shares currently trade for unbelievably distressed valuations. The company trades at a trailing P/E of under 6.5x and a forward P/E of less than 9.4x, contrasted to Nike’s (NYSE:NKE) 20x trailing and 16.5x forward. Its P/S is almost 0.5x (Nike = ~2) and P/B of 1.1 (Nike = 4x) represent more of a distressed retailer than a retailer generating record profits.

To put in perspective how low that valuation is, even if SKX’s inventory of $326m and receivables of $290m were completely worthless, the company would still trade for just ~3.1x book value compared to Nike’s 4 (yes, completely writing off AR and inventory and comparing book values is somewhat crude, but it’s useful for showing an incredibly discounted valuation). The company also has an incredibly strong balance sheet, with 20% of its market cap made up of net cash and ROE of a hair under 20% (Nike = 21.2%).

So let’s look at what would happen if the company’s toning shoes are, in fact, a trend and prove to be completely worthless. In that case, the company would likely have to write off most of the toning inventory and may have trouble recovering some of the accounts receivable, though the AR shouldn’t be too much of a problem. Near term revenues and earnings may take a hit (and volatility could increase), but the company should be able to recover.

Skecher’s didn’t release Shape Ups until June 2009, so earnings in 2006-2008 should serve as a good starting point for what the company would earn without the toning business. In 2006, the company had operating income of 112.5m; in 2007, 112.9m; and in 2008, 57.9m (for reference, from 2006 – mid 2008 (before the financial crisis really started), the company’s stock price hovered between the mid 20s and mid 30s). Trailing TTM operating $235.4m, so the toning shoes have caused a boom in profits, but if the company simply immediately returned to their pre-crisis, pre-tone up level of earnings, shares would trade for around 7.5x EV / EBIT and around 12x net income- still a bargain compared to Nike, and this assumes no increase in brand strength / sales from all of the Shape Up advertising / publicity.

While shares would likely warrant some discount to Nike given Nike’s stronger brand, international presence, and stronger ROE, 12x versus 20x seems a bit extreme, especially with 20% of SKX’s market cap in cash.

In some ways, the company reminds me of Deckers (NASDAQ:DECK) in mid-2009. The company was sitting on a tremendous amount of cash and had a great brand name and phenomenal growth opportunities. However, a still rocky market and investor fear that the company was a fad combined to keep the company's stock price at depressed levels. From then to today, Deckers has proven to be anything but a fad, and the company has begun to use the popularity of their boot brand to move into other fashion categories (clothing, men's, etc.)... and the stock price has more than tripled.

While SKX likely doesn't have quite the same upside, they also have a very established brand outside of the toning category with a long history of profitability. In my eyes, the company represents great risk reward- on one hand, if the toning shoes are a complete fad and have to be completely written off, you buy a company with a great balance sheet and strong earnings history at reasonable valuations. If the toning shoes category has any success going forward, that would represent an added boost to the earnings.

If toning shoes continue to sell at the rate they have for the past 12-18 months, then you have an easy double or triple on your hands. It's not quite heads, I win, tails, I win even more.... but in my eyes, it's pretty close.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.