I started covering Skechers USA (NYSE:SKX) on Seeking Alpha last October and pitched it as one of the best long ideas for 2016. The company had reported a 2.5% miss on revenues and the stock had lost ~35% of its market cap in a couple days. Since the start of 2016, the stock has been outperforming the broader markets and it reported Q4 & full year 2015 results last week. Let's start with catching up where we left, go on to analyze the current quarter and then see what 2016 has in store for us.
Q3 2015: Quick Recap
- The miss on EPS was due to one-time charges ($13.5 Mil For-ex losses, $10Mil legal fees), which I insisted should not be taken as seriously as it was, because the currency effect may fade and legal costs might not show up again.
- Revenue miss was due to domestic retailers not willing to go in with fully-priced inventory into the holiday season. The sluggish retail environment affected timing of orders.
- YoY growth rates for major business segments were: Domestic wholesale up 11.8%, International wholesale up 52.9%, and Retail up 20.9%.
- While analysts were worried about increase in inventory, I believed the increase was well explained, but the levels did warrant a watch. Same with the legal proceedings.
- I interpreted their guidance from my experience of reading the management and paraphrased it as 'They will be in-line for Q4 & might beat on Q1 (16)'. Factors to watch out were: How holiday season turned out, and Star Wars line up.
Q4 2015: Tracking Key Matrices
Skechers reported its Q4 & FY 2015 results last week. As I expected, they reported in-line numbers with a beat on revenues. Revenue for the quarter grew ~27% YoY to $722.7 Mil and EPS was up ~34% YoY to $0.19. Sparing you the wordy details, let me cover sequential comparisons on key business matrices as bullet points
- Growth rates of business segments: Domestic wholesale up 8% YoY (down from 11.8% YoY in Q3), International wholesale up 64.9% YoY (up from 52.9% YoY in Q3), and Retail up 20.2% YoY (Same rate).
- Worldwide comp. store sales in company-owned retail stores: Up 9.1% YoY (down from 10.1% in Q3).
- Volume v/s Price increases: Domestically, pairs shipped grew at 5.4% YoY (up from 4.6% in Q3), and price increase was 2.5% YoY (down from 6.8% in Q3).
- Total stores: More than 1300 now, v/s 1210 at the end of Q3 (Target mentioned in last call for year-end was 1280). 2016 target is now set at 1,650 stores (~27% increase unit growth).
- Inventories: Up 36.7% to $620 Mil (was up ~38% to $500 Mil at the end of Q3).
- Backlogs: Up 9.5% YoY (were up 28% in Q3). This was impacted by orders pulled over from January to December. However, incoming order rate for January was quoted as 'strong'.
- For-ex losses: $10.1 Mil in Q4 vs $13.5 Mil in Q3.
- Profitability: Gross Margins improved sequentially as well as YoY from 45.2% to 45.6%. Operating margins at 7.57% vs 5.79% YoY, and Net Margins: 4.07% vs 3.85% YoY.
- Cash balance: $508 Million (almost flat QoQ, up ~9% YoY).
- Guidance: 'Comfortable' with consensus range of $885 million to $920 million in net sales and $0.50 to $0.55 in earnings per share for the first quarter.
FY 2015: Highlights & Comments
Again sparing you from the wordy details, I'll highlight the most important bullet points here (all comparisons YoY)
- Net Sales: $3.15 billion compared to $2.38 billion (Up 32.4%). All business segments grew more than 20%, with international contributing the most dollars.
- Gross Profit: $1.42 billion compared to $1.07 billion (Up 32.9%). Slight gross margin expansion seen.
- Efficiency: Gross margins at 45.2% (up 0.1%), Selling expenses at 7.5% of sales (down 0.1%), G&A expenses at 27% of sales (down 2.1%). Efficiency improved across the board.
- Earnings from operations: $350.8 mil compared to $209.1 mil (11.2% of sales, v/s 8.8% last year). Operating margin improved as a result of leveraging scale.
- Tax rate: 21.7% compared with 20.5%. Annual effective tax rate is expected to remain stable at 21-22% for 2016.
- Net income: $231.9 mil compared to net income of $138.8 mil (Up 67.1%). Growth rate far outpacing revenue growth, as a result of faster growth in higher margin business.
- Diluted EPS: $1.50 compared to $0.91 (1.1 Mil more shares issued in the year).
- Total Inventory, including merchandise in transit: $620.2 mil (up 36.7%). Quality of inventory though is recognized as 'fresh' at the end of 2015.
- Long Term Debt: $84.6 mil compared to $116.5 mil. Upon discounting for cash on books, company is essentially debt free.
How good were the results?
We all know the company did beat on revenues and came in-line on EPS. But let's understand the retail backdrop and technicality in company's reporting to present both the good and the bad side of what it looked like on paper.
It is no news to anyone who follows the consumer sentiment or retail environment closely, that the last year has been tough to get through. The benefits of lower fuel prices and increased wages have not inspired consumers enough to go out and spend. Due to their dwindling confidence in the state of economy, they're choosing to pay down their debts or saving instead of spending. Which is good in the long run, but terrible for the retailers in the short term. Most of big-box retailers have struggled to even keep revenues flat. Even with the athleisure trend, we have seen stores like The Finish Line (NASDAQ:FINL) cutting their costs and announcing major store closings - which is not good for branded manufacturers who fight for shelf-space.
With such a sluggish domestic retail environment, and challenging moves in currencies worldwide, 9.1% growth in comp store sales is no short of a home run. Since last couple quarters, we all are accustomed to see beats on the bottom line only coming with misses on the top line, and Skechers has to be one of the very few stories that actually beat on revenue consensus (which was in place since mid-2015), while increasing profitability (gross margins). Talking about EPS, it missed just by a cent, and that was a tax impact - not something I'll nit pick about. All in all, increasing sales momentum, enhanced profitability and waning worries teamed up to deliver a fantastic quarter.
However, before claiming a victory across-the-board, I'll mention how the quarter was slightly less better than it looks on the face of it
"Our major customers have no obligation to purchase forecasted amounts, may and have canceled orders, and may change delivery schedules or change the mix of products ordered with minimal notice and without penalty. As a result, we may not be able to accurately predict our quarterly sales - Skechers' 2014 10-K Report"
Quoted above is one of the risk-factors straight from Skechers' 10-K report, and we see this playing out often. Looking back, the company scored a big beat in Q2(2015) and a big miss on Q3 - To an outsider, it might look like being a business with volatile fundamentals. But if you listened to both the earning calls, you'd figure that business was improving gradually and the beat/miss was due to timing of orders from retailers, which isn't in company's control. Sometimes big orders come in just before the quarter-end and sales would go up, sometimes not. In the long run though, it evens out. Coming to the current quarter, the beat on revenues of $30 Mil included $15-20 Mil worth of orders that were moved from January to December, and hence Q1 sales estimates should now go down by that amount.
It is still a very impressive beat, and it doesn't really matter in the long run. I'm just being objective and giving a reason to dilute the positivity a bit with another fact.
How Does 2016 Look Like:
"We believe the greatest potential for our growth is in our international markets and we believe the growth we're achieving across Asia and Europe is particularly indicative of the broad acceptance of our brand. We expect to continue to broaden our product assortment and open more Skechers stores to meet this demand with 1340 open to date, of which 517 are Company-owned Skechers stores. As we look at 2016, we believe our Company-owned retail stores are on target with mid to high single digit comps recorded in January- David Weinberg, COO & CFO, Skechers"
Management made sure to cite multiple matrices to highlight how strong the start to 2016 has been so far. Looking back to several earning calls, I don't find them giving so much details about the current quarter ever - which is a good sign for this one.
Sales were up 35% for the month of January (YoY), followed by a strong start to February. The number of pairs shipped in Europe and China doubled over last year. Yes, the comps for January were easier this year (with distribution infrastructure problems in Europe last year), but these are still accelerating numbers which show no signs of slowdown.
We will also be seeing Skechers Burst (by Demi Lovato) and Meghan Trainor campaigns being launched this spring, along with positive publicity of Los Angeles Marathon this weekend. All put together, I see a rosier forecast for the business, than its inventory or backlog numbers currently indicate. I don't see company missing the estimates for the current quarter and would rather expect it doing better, unless the consensus moves up. However, we will have to look at it with the guidance for Q2, which we'll now discuss.
"We will have higher growth in Q1 than Q2 obviously. There were more puts. Europe, there was the port strike here. There were weather differentials here. Easter was in the second quarter, not in the first quarter, so last year second quarter was a perfect storm that chances are won't be repeated - David Weinberg, COO & CFO, Skechers"
I believe Q2 2016 will be the toughest quarter for the company to match. If you remember, it scored a big beat on Q2 2015 numbers and a lot of it was due to Q2 taking away shipments from Q3. That makes matching Q2 difficult (and Q3 a bit easier). Add to that, Q2 last year included Easter and company fixing its distribution center issues in Europe. Three of them put together, we should see estimates for Q2 this year go down and I hope they do so further by the time the company reports Q1 numbers. Because if they don't, the guidance will be cited as having 'missed consensus' and the stock will take a beating for something we already know at this point.
In case the estimates stay high and the company beats on Q1, while guiding 'lower' for Q2 and the stock drops dramatically, that might be a good point to add to the position.
"Now, we also anticipate that as we go into back-to-school next year with easier comps, very difficult in the first two quarters and last year's second quarter was a perfect storm with Easter moving and after [indiscernible] and us finishing our distribution center in Europe, so I anticipate we have tougher comps to meet in second quarter and we would accelerate the increases as we go into the third quarter with fresh products and hopefully a little healthier retail environment - David Weinberg, COO & CFO, Skechers"
Internal adjustments in Q2 along with expected macro improvements in second half should bode well for the company going past the mid-year.
First, due to the same reason discussed above (Q2 2015 taking away shipments from Q3), Q3 comps will be easier this time around. Secondly, Q3 is anyway the biggest quarter and the company has many campaigns lined up for it (details in the call). Thirdly, last back to school season was sluggish and did not create the expected momentum. At the same time, management does currently see a better domestic retail environment going into the second half of the year - thus also helping this back-to-school season. All put together, I anticipate Q3 estimates to move higher by a magnitude slightly more than the anticipated decline in Q2.
If the stock stays low through the mid-year, Q2 slowdown would've been baked into the price by then and I will look to add positions further.
To make this 2016 growth story very simple for you, let me break the business by its segments (by the % of revenue they generate, their growth rate and their margins) and highlight some key themes that will play out.
|Business Segment||% of Revenues||% Growth Rate||% Margins|
^ Numbers above are at the end of FY 2015.
- Evolving Business Model
As you can see from the table, international wholesale is not just the fastest growing segment, but also now the largest reporting segment for the company. Here is where the greatest potential of growth is. Usually, there is a huge risk of brand acceptance whenever a local brand goes national, or a national brand goes global. Skechers seems to have crossed that barrier in 2015. Demand across Europe and Asia remains strong.
Europe now has new distribution infrastructure in place and is expected to grow faster than it did in 2015. Asian Joint ventures recorded 114% growth for 2015, with triple digit gains in China - which makes China the growth engine for 2016 and beyond. For reference, China sales ended up going from $86 Mil in 2014 to $220 Mil in 2015, and are expected to hit $400 Mil in 2016. China will thus represent a ~10% pie of total revenues that is growing head over heels.
"Obviously we can't grow at the same levels as we did last year, and I think what you see is we do have better sell-throughs - David Weinberg, COO & CFO, Skechers"
I would like to alarm the extreme optimists though that domestic and retail growth slowdown should be expected in 2016. We can no longer expect domestic and retail growth above 20% going forward. While I am more optimistic on retail with new POS and strong comps, I believe domestic wholesale will slow down a bit. It is fair to assume an early teens growth percentage for 2016.
If I own a business in this environment where 40% of its business is growing at 40-50% and rest of the business is growing at 10-20%, I don't find many reasons to complain. Plus, that comes with a continuing change in business mix - the slowest growing segment is the one with lowest margins and highest taxes. Thereby, we have increasingly bigger parts of the business with faster growth, better margins and lower taxes: which is evolution of a business model where it diversifies itself (thus reducing macro risks) and gets more profitable. This 2016 theme will drive profits at a higher rate than revenues.
- Forex Comps & Margins
2015 was a very tough year to ride through international currency movements. The company took forex losses over quarters, the most drag due to adverse movements in Canadian Dollar, Brazilian real and the Chilean peso. While this can continue, 2015 movements were really extraordinary and they will have to be accompanied with a much worse macro events to repeat themselves in 2016. And as we talk, US Dollar has now stabilized against the Euro for some months now, which in itself can provide better stability with growing European business.
Going forward into the year, I see the currency comps getting favorable and forex losses hopefully coming down. These could add a percentage or two to the margins.
I mention this as one of the things that will need to be watched. The street is definitely more worried about the company's inventories than I am, but it was the same last year as well. What makes them worried? Inventories rose 37% in the last quarter and that rate is higher than the rate of top line growth. This is usually a poor indicator for anything retail. But I believe we also should look in terms of growing points-of-sale (POS). Skechers is expanding very rapidly and is targeting ~1,650 POS (from ~1,300) by end of 2016. When you are in the high-growth phase, inventories don't always grow at the same rate as revenue. In this case, new stores will have to have a certain inventory sitting on their shelves before they can start turning it around and thus the growth in POS should alleviate rising worries around inventory.
However, I would mention what worries me about companies like Skechers in general: 'An impending but unexpected inventory markdown'. Because major sales take place around recent fashion and trends, once in a while inventories can grow 'old' and will have to be marked down, which will be assets written off of balance sheets. We saw that happen with Michael Kors (NYSE:KORS) last year, and we also saw its stock give away 60% of its value.
"I think it is fair to say we have more outlets to store inventory now. We had to put inventory into South America, we had more stores to put inventory, we had to put inventory into China - David Weinberg, COO & CFO, Skechers"
"We don't have any significant older stuff - David Weinberg, COO & CFO, Skechers"
In this case however, management has assured us that the inventories do not consist of any prior trends that have gone 'stale'. Of course this can't be taken at face value because we don't have the breakup with us, and we should continue to keep an eye, but no reason to fret on it yet.
- Future growth drivers
While international expansion is the known recipe of this growth story by now, I will like for the company to build future growth drivers, which would be more product-based in future. One of the things that the company has opportunity in, is apparel.
We talked about how Skechers has crossed the brand acceptance barrier globally in 2015 - which is a big one for any brand. However, once people start trusting a brand, it doesn't a whole lot for them to try on something else that the brand offers. We have seen this with Nike (NYSE:NKE), Reebok, Under Armour (NYSE:UA), Adidas, and many others. Given how intertwined apparel and footwear are becoming in the fitness regime, Skechers can bank big on expanding its merchandise. We have seen Skechers branded apparel in their concept stores already, but this is just the start and will take off in 2016, with an aim to be a considerable part of the business maybe in coming 3-5 years. All new merchandising efforts will be a part of uncharted product-driven growth which isn't factored in right now.
However, in the same breath, I would like to mention that I'm not really as satisfied with the company's product innovation as with Under Armour and some of their other competitors. Expanding into other areas shouldn't just be for the sake of it, but should offer unique technological advances, which strengthen the brand. There is a reason why Under Armour launches every new line of apparel, for example. Every new line has a unique technological advantage over its competition - something which isn't seen in Skechers Apparel yet. And even in footwear segment, I foresee the industry moving to smart, connected, fitness conscious and interactive footwear in future. I can see why Kevin Plank bought MyFitnessPal last year and why Asics bought RunKeeper last week. Skechers will have to do better to stay ahead in the race of smart footwear. But that threat maybe farther away than what I'm making it sound like right now.
Skechers is currently trading at $30 and is expected to report EPS of $2.08 and $2.47 for FY 2016 & 2017, respectively, (which is a growth rate of 38 & 19%). I have seen other articles comparing its valuations to Nike and Under Armour, but I feel due to enormous difference in scale of operations, business model and predictability of success, I would feel more comfortable valuing Skechers as a stand-alone entity.
For a company growing at much better pace than the industry and having increasing profitability, I would assign it a fair value of at least 1x PEG (Forward). The biggest assumption in here is the growth rate, though. Companies like Skechers go through bumpy growth phases and growth rate is far from certain (unlike Nike & Under Armour). We will have to keep a watch on the business momentum and update our growth assumptions. For 2016 and beyond, what I see right now, though, is a store growth in teens (%) and comp store sales growth in higher single digits (%). This gives us 20-25% range of growth with possibility of it hitting 30% if everything goes right (as it did in 2015). To be on the safer side, let's go with 20%.
With positive comments made by the management and continued business momentum, I personally believe that there is a scope of earnings revision upwards if the macro environment improves. Factoring in $2.50 for FY 17 & PEG Ratio of 1, fair value comes out to be $50 (and remember that we haven't factored in $3.29 cash/share). Stock definitely appears a bargain, but if I already have a sizeable holding (which I do), I'll like to pace my holdings in line with understanding of quarters mentioned above to benefit the most. If one doesn't have a position at all, now is a good time to start one.
Skechers is going through a very special arc of its growth curve where it builds upon a macro trend and strengthened brand to increase its reach globally. It is utilizing a capital light business model, initiatives in marketing and brand awareness to adopt a calculated but speedy expansion. All positives put together, it had one of its greatest year ever in 2015. With global expansion on track, evolving business model and expected better retail sentiment later in the year, it still remains one of my top picks or 2016.
At the same time though, it is important to understand the randomness of the business model, where its forecasting capabilities are limited by the whims of retailers who place and sell its products. While we have established that the stock currently is at a bargain, we will utilize our quarter-to-quarter understanding of the business outlined above to make the most of the patches on the 2016 track to make sure that we 'outrun' the most on street.
Disclosure: I am/we are long SKX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.