Skechers and the Market's Strange Reaction to Sterne Agee

| About: Skechers USA (SKX)
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Skechers USA (NYSE:SKX) fell almost 8% on Tuesday after an analyst said it may have overestimated demand for its toning shoes, and downgraded the stock to "Sell." From Bloomberg:

Sterne Agee analyst Sam Poser said Skechers has more toning shoes inventory than it can sell as sales of the specialty shoes slow. Poser said he has seen the shoes at discounters Ross Stores Inc. (NASDAQ:ROST), TJX (NYSE:TJX) stores, which include T.J. Maxx and Marshall's, and Costco (NASDAQ:COST), selling for $39 to $52.99. That puts pressure on Skechers partners like Famous Footwear, where the shoes sell for $59.99, Poser said.

Sterne Agee also slashed its 12-month price target to $16. Let’s examine the implications of this research note further.

On November 20, we published our own analysis in which we cited that “the jig was up” for toning shoes. We enumerated at that time the reason why we felt the end of this product line was irrelevant in the long run, and noted that ultimately we thought the stock was worth at least $24 per share -- and probably much more.

Sterne Agee believes the stock's price will now be harmed until the toning products are essentially in the past. But this says little about the value of the company they are encouraging owners to now sell -- in our opinion, at precisely the wrong time. We are still not sure what relationship stock “price” and company “value” have to one another – we can only reiterate what has already been said: “Price is what you pay, value is what you get.”

Other than that, the two are often distinctly unrelated. The first can be “determined” by an irrational mob, while the later is often “discovered” in a moment of clarity by someone who is willing to be unpopular, at least for a while.

So at $16 (and that’s the one-year price target), Sterne Agee believes the entire SKX business would be worth about 20% less than its book value today (which is 95.5% tangible assets), and about a 15% discount from its tangible net worth – let’s call it $760 mln. If we assume a modest 2% decline in the value of those old dollars in one year's time, we can round the value off to $745 mln -- if the whole company were to be purchased.

Now, Sterne Agee is not predicting a loss of any sort in 2011, so we can only assume that retained earnings and shareholder equity will grow during the exact same time period, as it is suggesting an additional 15% decline in share price from its already depressed level. Therefore, if the price does hit $16 per share in one year, on an enlarged equity basis, the actual discount to book suggested would be 25 percent.

To repeat: You would be buying a multi-billion dollar established operation that is highly profitable, with great margins, efficiently managed owners equity, and tiny debt for 25% below what is basically tangible equity. It's like getting the business as a "going concern" for free, since the tangible assets alone might well bring .75/100 in a liquidation situation. Here is what the numbers look like at PT $16.00:

Stern Agee PT - 1 YR
Current Price $16.00
Net Working Capital per Share $13.34
NWC as % of Share Price 83%
Shares Outstanding 47,560,000
Market Cap $ 760,960,000.00
Shareholder Equity $942,639,000.00
Net Tangible Assets $900,080,000.00
Book Value Per Share $19.82
Current Price to Book $0.81

Truly, if that price target held true in a year, it would be spectacular. SKX has grown its owners' equity in aggregate some 21% per annum over the last five years, as we illustrated in our last article here. However, we're willing to go with it for now.

We are also willing, for the sake of argument, to go with the firm's revised earnings estimates, which it brought down significantly as part of Tuesday's call -- going to a profit of $1.56 a share for fiscal 2011 from a prior view for EPS of $2.37.

Let’s assume that instead of growing owners' equity by 21% over the next 12 months, as SKX has done in aggregate over the last five years -- which included years without “toning” shoes -- it increases owners' equity by only 10.5%, or half its average track record. In our previous article, we suggested that owners' equity would be about $1.14 bln within the next 12 months. If we halve the rate of increase in growth form 21% to 10.5%, then we come to a figure of about $1.04 bln.

Here is what the price profile of the company would look like in one year with equity of $1.04 bln, instead of Q3 2009's reported $942 mln.:

SA PT - 1 YR (updated SE)
Current Price $16.00
Net Working Capital per Share $13.34
NWC as % of Share Price 83%
Shares Outstanding 47,560,000
Market Cap $760,960,000.00
Shareholder Equity $1,041,616,095.00
Net Tangible Assets $994,588,400.00
Book Value Per Share $21.90
Current Price to Book $0.73

As you can see, the book value per share would grow to $21.90 (if historical growth in owners' equity was halved), and of the $16.00 per share that Stern Agee is suggesting is appropriate, 83% would be net working capital alone (i.e. current assets minus all liabilities) – that’s a full $13.34 per share. In addition, the company would then be selling for 39% of 2010 revenues, and if its estimate of $1.56 per share for 2011 is accurate, the company would still earn $74 mln or about 10% of its market cap., which we think is strong for any enterprise.

Here is where we are left scratching our heads. Stern Agee maintained a "buy" rating on the stock up until this two-notch downgrade yesterday. During the time the “buy” rating was out, the shares went down 28% year-to-date, and have dropped more than 50% since hitting a 52-week high of $44.90 on June 21. All this happened before the downgrade, meaning this company (up until Monday) was already at a bargain, and represented a far better value. Stern Agee was saying to buy at much higher prices, which were probably fair at any rate, but were by no means a screaming bargain. We think it’s a steal now -- and they're saying sell?

If it happens to go to $16, as Stern Agee suggests, we would have to add another notch to the rating scale -- two notches above "buy," where it's the little-known "mortgage your grandmothers house to buy the stock" rating . The $16 price range would be something like a company about to go into bankruptcy, although at that price, the common would almost be covered in liquidation, so we are making a public appeal for anyone who might have knowledge of SKX's impending bankruptcy to send us an email. In the meantime, we'll be willing to go the "mortgage..." route at about $19.

Wouldn’t it be nice if Stern Agee had a "sell" rating on the issue up until this week, then realized that at around $19 a share investors would be getting a world-class business (still run by the founding family) with precisely nothing wrong with it (other than a temporary inventory glut) for the price of just tangible assets -- and decided to upgrade it to a “buy”?

A commenter on our last article pointed out that a search for the shoes customer feedback ratings on produced invariably pleased customers. We thought that was shrewd investigative work, explored, and indeed found it to be true. If Stern Agee's previous “buy” rating was wrong (if we are to speak in terms of price performance alone, and not intrinsic value), then isn’t it possible the “sell” rating is also wrong?

It's a curious thing how those who give advice on matters of the wise investment of capital are often successful at proffering precisely the wrong advice at precisely the wrong time -- in remarkably consistent fashion, year after year -- and yet their services are always in demand, and their commentary followed closely. If the firm isn't careful, a poet or romantic songwriter might put to paper or song prose to the effect of "Do not yearn to agree, with Stern Agee..."

Last time we checked, Mom and Pop ice cream shops sell for 38% of revenues and discounts to book value. Deckers Outdoor Corp. (NASDAQ:DECK) and Nike (NYSE:NKE) garner ~5-600% premiums over book, and NKE is growing owners' equity only about half as fast as SKX; due to its size, NKE could not possibly have the same rate of growth potential as the much smaller SKX.

DECK, on the other hand, is commanding a whopping ~600% premium over book for its shares. To put that in perspective, DECK has half the revenue as SKX, yet roughly 3.5x the market cap. Yes, it sells Uggs, but we've got 50 bucks that says Uggs will be selling about as well as toning shoes in six months. That is what the fashion industry is; that is what it has to be. Obsolescence in clothes is not as great as companies in that industry would like, so things have to come in and out of fashion and then, when new ideas (if any exist) run out, the whole cycle starts over again.

For example, there was once a time when people actually wanted to own and wear the Nike Red Suede Cortez tennis shoe and exchanged authentic government notes for the product. When people no longer wanted to own or wear those shoes, it was hardly Armageddon for the company; it simply went on to design and develop other shoes.

For these reasons, we think it is reasonable to ask in the case of SKX if the crime fits the punishment. We think there are two scenarios that might apply:

  1. The analysts at Stern Agee are actually addressing speculators who may profit from short term volatility, and are not bona fide investors -- in short (no pun intended), those who care about price and not value.
  2. Somehow, a normal merchandising event is equated with the sudden loss of intelligence and experience in the entire management team of the organization -- even though the same management team had been smart enough in the past to build a multi-billion dollar, diversified, multi-national organization despite having small inconvenient competitors like,say, Nike.

We think "1" above is driving the price down; we think "2" above is the real underlying thesis of both the analysts and owners who are selling at or below tangible equity.

We recently observed something similar to this form of speculator hubris in our article on Western Digital Corp. (NYSE:WDC). Not too long ago, when sellers of this issue concluded that, despite 40 years of successful and profitable operations, the stellar management team of WDC suddenly did not see or understand the value of "solid state" storage (which apparently had just recently come to mind for commenters and sellers alike). Of course, this was not the most humble of ideas; it went something like this: While the speculators and commenters and analysts could clearly see the market trend towards solid state memory (having thought about it for about 24 hours), they concluded that solid state would take over memory, and WDC would be left out in the cold, and good thing too. After all, WDC deserved it, since out of its own stupidity it didn't see it coming.

It's a rather startling suggestion that the management team of WDC (who probably has thought about solid state memory seven days a week, 365 days a year, for years) could not somehow come to the most elementary conclusions: That a new form of memory exists that has some advantages over traditional mechanical storage.

How likely is that scenario? Yet that is precisely what happened. The result was the ability to buy WDC at around $23 when we published our article here. Two months later, the stock had appreciated about 50% -- in other words, closer to a fair market value.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Have advised others to purchase SKX.