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With more than 40% of the shares already short, a buyback in place, softball 3Q guidance and a depressed P/E multiple of 11x on my street low $3.15 EPS estimates I wrote Deckers (DECK) was a dangerous short in the mid-30s and suggested investors cover before Q3 was reported. (See note here.) Well, my numbers were directionally correct, but I was wrong on the stock as the shares have traded down another 17% after hours to below $30.

Here is a snapshot of the debacle:

1) Sales were $376 million, down 9% vs last year with Ugg brand sales down 11% (and same store sales at retail down 13%). That was even worse than I expected ($390 million in sales) and much worse than consensus of $413 million.

2) Gross margins compressed to 42.3% from 49.0% last year and reflect price cuts the company confirmed it had made in an attempt to forestall order cancellations and spur sell through. Management expects margins to be 47.0% in Q4. We'll see.

3) SG&A came in well below my estimate at $99.7 million (I had $120 million) and below last year's $112.2 million. More on this later.

4) Despite the lower than expected sales and gross margins, the SG&A variance, a slightly lower tax rate and a lower share count (from the buyback) enabled DECK's EPS to actually beat consensus of $1.04 by 13% and come in at $1.18. But that "beat" is meaningless because more than 40% of the company's business is derived in Q4 which is what investors are correctly focused on (and of course on the long-term growth and cash flow generation potential of the company).

5) Inventories were a whopping $486 million of which $451 million was Ugg branded stuff. That's a 36% increase against a declining sales trend. Uggly.

A couple of things stood out in the press release which weren't discussed on the analyst conference call but are worth raising:

1) The company drew down a whopping $275 million on its seasonal line of credit to fund not only a ballooning inventory level but also about $85 million of share repurchases in the 3Q. In the 10Q from the second quarter (released mid 3q) the line was reported to be $102 million so it appears inventory was still piling up at quarter's end. Also the average share repurchase price was $46/share which suggests management may have believed their own excuses about weather, etc. because why would you buy stock in front of disastrous earnings like DECK released today (unless it was under a 10b-5 plan and they didn't control the trigger finger on purchases)? The stock hasn't been close to $46 since mid September.

2) The cut in SG&A was surprising but likely included an adjustment to the bonus accrual. For instance, accrued payroll dropped 43% from last year and did not build as it normally would as the company periodically accrued bonuses. If this is the case, bonuses should be leaner this year given the results but with this cut it isn't clear another cut this size can be made in Q4 if needed to offset further disappointing sales.

3) While I still believe management remains delusional in its belief that the weather is to blame and there aren't other consumer demand issues at play here (fashion, etc.), gross margins could bounce back some since accounting rules would require all inventory be marked down to net realizable value (NRV) after a price cut. Thus the inventory on the books as of 3Q has presumably already been marked down somewhat (if below NRV) and the really low 42.3% 3Q margin presumably reflects the full impact of that write down. Next year it sounds as though price cuts will be more than offset by sheepskin input cost reductions.

Something to look for in the 10-Q: Buried in the second quarter 10Q was a footnote that the company had borrowed $102 million subsequent to the second quarter. This raised concerns for me that inventory was still ballooning out of control. That proved to be correct. Those borrowings have grown to $275 million as of 3Q end but where are they now? If down from $275 million that would be a positive sign about inventory levels getting under control. The forthcoming 10Q should provide an update. Check the footnotes.

My FY12 estimates are now:

Revenue: $1,375 million

EPS: $3.45 (reflects share buyback)

EBITDA: $197 million (after stock compensation, $214mn before)

The shares trade at 8.7x my EPS and 6.2x my EBITDA estimate. At 5x my EBITDA estimate the shares would be $23 which may represent the downside case. At 10-12x my earnings estimate (about right for a flatlining, major brand company) the near-term upside case could be $35-41.

I still don't like the risk/reward of the short opportunity in Deckers' shares especially given how crowded it is. As they say, "sheep get sheared and pigs get slaughtered" or something along those lines. However, I still cannot recommend going long (unless you are patting yourself on the back and covering your short which wouldn't be a bad idea in my view). Once a consumer trend gains inertia (in this case negative inertia) it takes time to reverse. I think Deckers is in for a long winter irrespective of the weather.

Source: Investors Sheared Again; Long Winter Ahead For Deckers