On December 22nd, 2010 we published our article “Skechers (NYSE:SKX) and the markets strange reaction to Sterne Agee.” In summary we indicated that readers should buy shares of SKX at $16. At the close of market Friday November 25th, 2011, the shares could be acquired for a mere $12.18 – a decline of some 23.9%.
We were wrong on how the market would price the shares. However, we do not believe we were wrong regarding the value of the company, despite the markets pricing – so we purchased more shares for investors between $11.86 - $12.77 per share.
On December 22nd, 2010 we wrote in part:
"On November 20th , we published our own analysis, in which we cited that “the jig was up” for toning shoes, we enumerated at that time the reason why we felt the end of this product line was irrelevant in the long run and that ultimately we thought the stock was worth at least $24 per share and probably much more."
It seems obvious now, but at the time it wasn’t – the fact that the traditional toning line had seen their best days. They are no longer an important part of Skechers present or future plans. The company overshot the mark with this product line, and created a huge inventory glut for 2011. The market equated this somewhat normal merchandising event with shoe Armageddon, and decided that SKX and their management team had somehow committed the "eighth deadly sin" by getting their inventory requirements wrong. Anyway, traditional toning is dead, as we said it would be, and the whole debacle is over - so what's left?
The market's road kill:
- 20 years of successful operation and high growth.
- 2010 profit approx. double that of 2008 and 2009.
- Split 2010 earnings in two (to cover 2010 and 2011), and you have consistent profitability from 2008 – 2011.
- The enterprise value of the company (or it’s effective purchase price to an acquirer on November 25th, 2011 was only $498 mln. dollars (for a company with about 2 bln in sales in 2010).
- Net Current Assets (current assets minus all liabilities) is $523 mln. or $10.59 per share.
- 60 mln. Tax refund due to the company in 1H 2012 (about $1.21 per share) – think of it as the lost 2011 earnings (since expenses were overstated in 2010). When this is added back to point 3 above, the company was actually even more profitable over the 2010-2011 time frame than the prior 2008-2009 period.
- With the tax refund, the company’s Net Working Capital, or Net Current Assets is actually $11.81 per share – the stock sold for $11.83 per share on November 23rd – basically just Net Working Capital (meaning the remaining ~420 mln. in tangible assets are essentially free at that price).
- Price to book is only .65.
There is more than room for number 2:
Nike’s (NYSE:NKE) management team is really second to none, but their shoes are expensive and well, so is their stock. For folks who don’t want to pay a premium for a pair of shoes, there’s always Skechers, and for investors who don’t want to pay 4x + book for a stock, well again, there’s Skechers.
There is not only room for number two players, they are necessary – few other competitors have the breadth of product offerings and the multi-tied approach to product delivery that SKX does – we like it - and we like the current price of the shares even more.
Another view of things:
If the company had consistent earnings for 2010 and 2011 instead of a huge year in 2010 and no earnings or slight loss in 2011, would the market have punished the shares so radically (a decline of 73% peak to trough in about 18 months) even though the financial result is effectively the same? Was the toning deal all bad? They sold a boat load of shoes with their brand all over it. The line (which was highly profitable) surely funded a large part of their ad campaigns in 2011, and thus contributed to brand awareness – it brought the company to two billion in sales. Then, just as with all fashions and gimmicks, it was suddenly over. Maybe the question isn't “does the punishment fit the crime,” but more appropriately “what’s the crime again?” We seem to have missed it – perhaps we’re just not smart enough to figure it out.
The investor in the shares today is still left with the same machine that dreamt up all the former money makers (including the traditional toning line), and they’ve dreamt up a few other nice products as well - SRR and LIV are doing well, though we think the GOrun line will take the spot light in 2012. Will they be the cash cows the traditional toning shoes were? Hard to know, and they don’t need to be - we think they will lead the company back to profitability in 2012 regardless – if this comes to be, 2011 will seem like an anomaly.
On Nov. 17th, 2011 we wrote:
We’re just postulating here, but aren’t great companies allowed a merchandise snafu or two? Some of the greatest brands in history have made marketing and merchandising missteps. Usually these companies recover quickly. After all, these companies are in the business of developing “new” products all the time.
A store visit at Downtown Crossing:
Visiting Boston’s downtown crossing around Christmas time is fun. The particular area where the Skechers store is located has other shoe stores all around so comparing foot traffic in real time is easy. The day we visited, the Skechers store appeared to be the busiest, and we were fortunate, this particular location was one of only 6-7 on the Eastern seaboard which had the GOrun line in stock, so we had a chance to examine them first hand. Like all Skechers shoes, we like them, they’re cool, and they’re not too expensive. The store manager indicated that they were selling extremely well (apparently the GOrun had sold out in NY already), but that LIV was doing the best at that location.
As always, we asked a lot of question. Then we took a step back, looked at the store crawling with customers and asked ourselves one question “what is wrong with this company and its products?” The answer: Nothing. There is nothing wrong with the company or its products. The stock is a screaming bargain.
The most basic questions:
At the heart of the matter there are a few important questions:
- Will this company continue to lose money (and therefore possibly go out of business) which is how the shares are priced, and if so, why (i.e. what is fundamentally wrong with the company)?
- Will the company resume it former profitable operations (as has been the case for several decades)?
- Do the current products reflect the potential for reasonable profits that are aligned with the industry?
- Is the current market pricing rational?
The recent market price is equivalent to a liquidation scenario. When we wrote our original article last December the shares were a great buy. Now they are pricing in liquidation of the entire concern, but as far as we can tell the company has nothing in common with the likes of say an American Airlines (AMR). Nonetheless in such an unlikely event, we think a purchaser of the common shares today would be covered in a chapter seven filing tomorrow – but the company is nowhere near such an event. There is almost no risk left in the shares. In our mind, given inflation, owning the shares is safer than cash in the bank.
The company will probably have to pay a fine to the FTC for the empty promises of the toning line which makes our article “Two Great Brands – One on sale. SKX and NKE” on Nov. 17th, 2010 seem especially prescient.
We opened the article with the following paragraph:
"Virtually all marketing promises more than a product can deliver. This is particularly true in retail consumer marketing. If Marketers didn’t seek this outcome, we would not be living in such an acute consumer driven society. On some level, almost all products have the latent and subtle promise of somehow making our life easier, and better. There is nothing new about this. It is a promise that always goes unfulfilled in the long run, which is why we have to keep consuming."
A few quarters after this was written SKX indicated in their 10Q that the FTC had filed an action against the company for the traditional toning product line and its related marketing claims. However, we see no reason why an FTC fine in this case would be substantially higher than that paid by Reebok for similar offenses.
In the end our opinion of the value of Skechers may have changed after all, we indicated before that we thought the shares were “worth at least $24 per share and probably much more,” however, we believe Skechers will return to healthy profitability in 2012, and with this event we feel comfortable suggesting that the real value of the company is probably north of $36 –or about 2 x book value, which would still be the lowest premium of all of the major publicly traded footwear companies (although it may take some time for the market to agree). This of course puts us in even starker contrast to other analysts following the company.
2011 was the hangover for SKX from an intoxicating 2010. We don’t fault the company for exploiting the trend in toning – it worked and increased brand awareness. The company only took a loss in Q2 2011 in order to deal with the glut of inventory. Any company could have made the same mistake on inventory, but not every company is as good at seeing trends and capitalizing on them as SKX.
It is also curious that the market seems to be overlooking the 60+ mln. Tax refund the company has coming to its owners in 1H 2012 – this is like guaranteeing a part of the profit for the upcoming year and represents ~13% of the enterprise value of the company as of the close of Market on Nov. 25th – the vast majority of which is tangible.
We think buying the shares around $12 has been a lot like an asset sale where the buyer also gets the company as a going concern for free – the price is basically just Net Working Capital. The company books no entries for good will on the balance sheet and only ~6 mln. for intangibles – but we are certain there is real goodwill well beyond zero for this company.
Again, it seems far more likely the company will return to profitability in 2012, then repeat the losses taken in Q2 of 2011. In fact inventory has gotten so lean, and the new products selling so well that the company has indicated in their Q3 CC that it is necessary to actually build inventory again.
Perhaps the FTC settlement once finalized will be the catalyst for the market to begin to assess a more appropriate value for the firm. In the meantime, we continue to help ourselves to the stock on behalf of investors' accounts.
Time will tell if we’re right.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.