Deckers Outdoor's (DECK) share price has been sheared of late and for good reason. Management's guidance and consensus Street estimates remain far too high. Management has been rolling the dice with guidance, clinging to false hopes that its UGG brand will miraculously begin to sell again in Q4 once the cold weather arrives. It has essentially kicked the can down the road by putting out softball near-term guidance in Q2 and Q3, with a huge rebound expected in Q4. Specifically, it is looking for a 1% sales decline and 31% EPS decline in Q3 (implying $1.10/share in EPS) followed by 19% sales growth and 22% EPS growth in Q4 (implying $3.84 in EPS). That's insane.
Meanwhile, inventory has been piling up (up 65% year over year, with sales up only 13% year over year in the last quarter). Sure, sheepskin prices have reportedly declined, which should help margins down the road. But is that because there are more sheep or less demand for sheepskin-related product? I would wager it's the latter. As is often the case with Wall Street "darling" stocks, analysts are slow to revise their numbers downward fast enough. Street consensus EPS estimates are for $1.12 in Q3 and $3.67 in Q4. According to Yahoo Finance, the lowest analyst estimates for Q3 and Q4 are $0.96 and $3.20, respectively.
In this case, Wall Street analyst ratings and estimates have become lagging indicators and should not be relied on. My estimates are $1.10 and $2.37, respectively, for full-year EPS of $3.15 on total sales of $1.40 billion compared to the consensus estimate of $1.54 billion. My estimates assume UGG sales decline 3% this year (11% in the wholesale channel offset by growth in e-commerce and retail sales channels) compared to management's guidance of 10% growth. I also assume the company cannot arrest SG&A growth fast enough (in part because it is driven by new store commitments) in response to slower sales to forestall operating margin compression. The shorts are having a field day piling on the name (11 million shares, or 30% of the total outstanding, were short as of Aug. 31, 2012, according to Nasdaq). The short seller's sales and EPS estimates are probably closer to mine.
With the stock declining daily and what I expect to be a significant earnings miss (or massive reduction in guidance) ahead in Q4, one would think I would be among the shorts. I am not. In fact, I was short but covered in the mid-$40s ($45.07 to be exact) because I did not like the risk/reward ratio anymore. Right now I believe DECK has entered "momentum stock" territory, but in this case with severe negative momentum. Shorts are piling on with the reasonable expectation of a downward revision in management's Q4 guidance when the company reports Q3.
The trouble is, I believe that sheep has already been shorn. The short has become crowded and the valuation, even on my significantly lower-than-consensus estimates, is no longer compelling from a short standpoint. My view would be vastly different if DECK produced a poor quality product and did not have such a stable of established brands, or if it had a high level of indebtedness. (As of Q2 it had no debt and $114 million in cash, but in the latest 10-Q it was reported the company drew down $102 million on a line of credit in Q3. That's a surprisingly large drawdown and perhaps suggests inventories haven't come down as fast as they should.)
Here is why I would consider covering before the Q3 earnings report. For one, I think management has given itself enough room on Q3 guidance that it has a good shot at making the $1.10 number. It sandbagged Q2 as well, and the stock rallied afterward. To get to $1.10, down from $1.59 last year, a lot of bad things can happen. In my model, I have UGG wholesale sales down 10% (they were down 8% in Q2) and overall gross margins down 400 bps to 45.0%, and I still get to $1.10. One of the drivers of revenue growth has been new store openings, which has also boosted gross margins. (DECK receives a retail margin plus the wholesale margin rather than just the wholesale margin. This could "mask" discounting in the wholesale channel for a while if the company needs to flush some inventory as was reported by an analyst at Sterne Agee. A quick check of Zappos does show more discounted SKUs than I observed earlier this year, with 34 UGG styles out of 591 on sale including certain colors of the Classic Short.)
While DECK may miss its Q3 guidance, I don't think the miss will be all that bad. So the important short catalyst is what is going on in Q4, and what does management say is going on in Q4 (potentially two different things to consider). Q4 guidance is likely going to come down, but that is already expected. The question is by how much. As my model suggests it needs to come down a lot (almost 40% to $2.37), but even at that low level the company valuation as a short candidate is not compelling. At the closing price of $35 on Sept. 25, the shares trade at 11 times my 2012 EPS estimate of $3.15 and 5.8 times my EBITDA estimate of $197 million. This is within the range of where private equity firms may begin to show interest as they have in similar consumer names. For instance, the underperforming surf brand Billabong has been the subject of bidding by private equity firms TPG and Bain (although Bain has reportedly dropped out) at 6 times EBITDA according to a Wall Street Journal article, and surf brand competitor Rip Curl is on the block with a reported 10 times EBITDA asking price. Whether private equity becomes interested or not, the company has its own $200 million share buyback program in place that could put pressure on short interest, especially with so few shares in the float.
I would take advantage of the current fear created by some good detective work by the analyst at Sterne Agee and cover before Q3 is reported. I am not recommending going long, however, because I fundamentally believe this company's growth is flatlining and the stock is likely to be "dead money" for a while. If management's Q3 commentary is as smooth as it was in Q2 and the shares enjoy a "dead sheep bounce" as they did after Q2, I will revisit the bear case and consider "hitting the DECK" again by shorting the stock.