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Ugg boot-maker Deckers (DECK) reported awful third quarter results Thursday afternoon. Revenue fell 9% year-over-year to $376 million, which was worse than consensus estimates. Earnings fell 26% year-over-year to $1.18 per share, roughly in-line with consensus expectation. We are placing shares of the firm under review due to the materially more negative guidance.

However, headline numbers were far from the worst developments during the quarter. Gross margins fell 670 basis points year-over-year to 42.3%, negatively impacted by both rising costs and the need to lower prices. We wouldn't be too worried about this number after the huge surge in sheepskin prices (key input to Ugg boots), but the company's decision to reposition its pricing is an enormous red flag suggesting demand may be waning. Further, a laundry list of excuses from CEO Angel Martinez frustrated investors and revealed a lack of responsibility for the business' performance. Martinez has spoken many times as to how Uggs are a fashion brand, but he proceeded to blame warm weather in the US as one of the primary drivers for the brand's weakness.

The firm's balance sheet also took a turn for the worse, as inventories ballooned to $486 million, a 36% increase compared to the same period a year ago. Concurrently, Ugg sales tumbled 12% year-over-year to $332 million. The combination of declining sales and increasing inventories can only end negatively, in our view. Plus the company's cash reserves fell to $61.6 million, and the firm increased its loans outstanding on its credit revolver to $274 million. The firm spent $28 million on a new corporate headquarters, and $29 million to expand its retail footprint-which posted negative same-store sales growth of 13.1% during the third quarter. The firm also repurchased $84 million of shares during the quarter. The company's capital allocation plans have come into question.

On top of poor capital allocation, the firm provided investors with terrible full-year guidance. Revenue is now expected to increase 5% versus prior guidance of 14%, and earnings are expected to fall 33% year-over-year, compared to previous guidance calling for a 9%-10% decline. We think management has misled investors with respect to proper expectations, and we are not at all pleased with management's capital allocation decisions.

We will be reviewing the firm's future prospects and valuation (click here to learn about our valuation process), but for now, we plan to stay away from the company due to poor stewardship and uncertainty with respect to the fate of Uggs. Deckers provides an intriguing example of the downside of heavily relying on one product Crocs (CROX) is in a similar situation. Shares look inexpensive at current levels, but fourth-quarter performance could also be materially worse than expected. We doubt Uggs will disappear, but the brand may have to go through significant right-sizing to become a financial success again.

Source: Decker's Third Quarter Performance Was Absolutely Terrible