Deckers Outdoor Corporation (DECK) has experienced explosive growth over the last decade, led by demand for the company's flagship UGG luxury brand. The stock has dropped from a 52-week high of $118.90 to a recent $40.59, as the slowdown in Europe (Deckers' number one export market), increased sheepskin prices, and costs associated with the company's retail expansion have hurt growth and margins. The brand management company is in the middle of an aggressive build-out of company-owned retail locations in major cities across the globe, in addition to leveraging the UGG brand into different styles, clothing, and accessories. While these moves might increase the upside potential of Deckers earnings power, they certainly also do increase the operational risk for the firm. We believe that at current prices Deckers offers a compelling risk/reward for the long-term investor, but to reduce the risk and stack the odds in our favor, we are selling put options to take advantage of the extremely high implied volatility in the stock. This allows us the opportunity to obtain well above-average income potential, with a worst case scenario of owning a business that we want to own at an even more attractive price.
Deckers future prospects are likely to be based on the success that the UGG brand has in protecting and enhancing its cachet as a luxury comfort brand. UGG is primarily known for its sheepskin footwear, but the company is introducing new styles, clothing, and accessories as well. Deckers' other two major brands are Teva and Sanuk. Teva is an outdoor performance and lifestyle brand in the sport sandal market. Sanuk is an action sport footwear brand rooted in the surf community, including the patented SIDEWALK SURFERS shoe. Deckers has been very reliant on wholesale retail, with Nordstrom Inc. (JWN) being the company's number one sales channel, but a primary focus for the company is creating its own retail channel with flagship stores in major cities, and also increasing its focus on direct-to-consumer sales through the company's websites. While some companies such as Coach Inc. (COH) have successfully parlayed a successful retail brand into full-line branded stores, the expansion carries significant risks due to the increased capital needs required in implementing a retail network on its own. The benefit of controlling its own retail stores would be to capture the full margin on sales without middlemen taking their cut. In addition, the larger store footprint enables the company to show many more SKUs than what is possible selling through traditional retail channels.
The 2nd quarter was a very difficult one for the company. Including Sanuk ,which was incorporated into the financials beginning July 1, 2011, sales increased 13.1% to $174.4MM compared to $154.2MM for the same period last year. Gross margin declined to 42.2% from 42.7% YoY, and the diluted loss per share was ($0.53) compared to ($0.19) a year ago. UGG brand sales decreased 0.3% to $107.9MM, Teva brand sales decreased 15.4% to $34.1MM, and Sanuk brand sales were $28MM. International sales decreased 14.7% to $61MM compared to $71.5MM a year ago. Same store sales increased 6.8% for the 13 weeks ending July 1, 2012, and eCommerce sales increased 40.1% to $8MM. Europe has been a great market for Deckers, but the significant economic issues plaguing the region had a material impact on recent results. Northern Europe's climate is ideal for UGG products in particular, and we are willing to bet that the international sales declines are temporary as opposed to reflective of declining brand value. The warmer winter has been an excuse for the disappointing sales and I'm sure it did have an impact on the UGG brand, which is obviously better suited for colder weather.
The balance sheet of Deckers is relatively strong with $114MM in cash, or $3.02 per share, versus long-term liabilities of $55MM. On June 30, 2012, inventory had increased 64.8% to $346.3MM from $210MM at the same time last year. Most of the growth was attributable to the UGG brand for fall 2012 inventory, including the consumer direct division. Also Sanuk's inventory is attributable for a portion of the increase. Deckers sold-off recently on a report that core UGG products are being offered at substantial discounts on certain websites. While this is discouraging and will likely further pressure short-term profit margins, I believe it is the type of excess inventory-related mistake that is somewhat understandable given the expansionary business plans, as opposed to a true diminishing in the appeal of the brand. While our analysis could be proven incorrect over time, it is rare to be able to acquire a true growth company with solid, and in our estimation defensible, brands, at a below market earnings multiple, so for it to happen there has to be some "hair" associated with the company.
Between 2004-2012, Deckers' returns on invested capital have been between 16-27%, and the company does not have any long-term debt. Gross margins have varied from 42-50% and operating margins have had a range of 17-25%. Deckers has been buying back the distribution rights in various international markets in recent years to capture the additional margins once the markets have been developed enough to warrant the additional investment. According to Morningstar, the mean Wall Street EPS estimates for Deckers are $4.46 for 2012, and $5.78 for 2013. At $43.95 the stock is trading at just over 9 times 2012 earnings, and 7 times 2013 earnings estimates. This allows a little bit of room for comfort if earnings end up being a little weaker than expected. For a company with a 10-year average revenue and EPS growth rate of 31.15% and 56.74% respectively, the cheap valuation offers a compelling call option on any future growth that Deckers can achieve.
The company executes most of its sales in the 3rd and 4th quarters of the year so we would expect the company's cash and inventory positions to improve considerably. Deckers expects full year 2012 revenues to increase approximately 14% over 2011 levels and diluted earnings per share to decrease between 9 and 10%. Included in these projections are for the UGG brand to increase sales by about 10%, Teva to be flat to slightly down, and Sanuk brands are projected to contribute about $95MM in sales. The company believes, and I tend to agree, that Sanuk in particular offers compelling growth prospects which can certainly be leveraged over time through the enhanced distribution that Deckers will provide. Sheepskin prices have declined, which should prove beneficial to Deckers gross margins moving forward.
The Board of Directors recently authorized a $200MM share buyback, which we feel would be quite accretive at current levels. We believe that including share buybacks long-term EPS growth of 12-15% is certainly within reason, and even if the company were to only grow at 7-10%, we would still make decent money, even assuming no multiple expansion. If we were control investors in Deckers we would have no problem just buying the stock at current levels, but because we do have some trepidation with the current business plan of expanding its own retail channel, and product lines beyond footwear, we require an even greater margin of safety. This is provided to us by the extremely high implied volatility in the put options of Deckers. We can sell the January 2014 $40 puts for $9.70 giving us a target profit of 32% on our maximum risk of $30.30, which also happens to be our breakeven price if we were to be exercised on this stock. If the stock sells off, we would continue selling puts, staggering the prices to accumulate our full position.
If Deckers executes in the crucial 3rd and 4th quarters, and 2013 results improve from this transitional year, the company could easily warrant a 15-17 multiple on forward earnings allowing for upside of 50-100% from current levels. While our estimates are likely more conservative than management's, we still believe that the discount to intrinsic value is sufficient and we would be perfectly happy being exercised on our puts and owning the stock outright for the long-term.