Deckers: Not Bad Is Not Good Enough

| About: Deckers Outdoor (DECK)
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Recently, I previewed the Deckers Outdoor (NASDAQ:DECK) earnings report, stating that if guidance was good, shares would rally. Deckers has been plagued in recent months by a warm winter, high sheepskin costs, and rising operating expenses. I started recommending a short position on Deckers in the low $90s late last year, and have continued that recommendation down to current levels. On Thursday afternoon, Deckers reported its fiscal second-quarter results. It was a mixed report. Deckers shares rose on Friday, but gains were limited. Let's look at where things stand and where shares may go from here.

Second Quarter Results

Deckers reported revenue of $174.4 million, up 13.1% over the prior year period. This number handily beat analyst expectations for $166.7 million (8.1% growth), and Deckers' own guidance for 8% growth. Deckers reported a second-quarter loss of $0.53, beating its own and analyst expectations for a $0.60 loss.

That was the good news. But here is the bad. The entire gain over the prior year period and then some was a result of the Sanuk acquisition. Sanuk branded sales for the period were $28 million. If you take those sales out, Deckers' total revenue was $146.4 million, compared with the prior-year period of $154.2 million. Excluding Sanuk sales, Deckers reported a 5% decline in overall sales.

The following table shows how Deckers' Q2 margins have fared.

Q2 Margins 2009* 2010 2011 2012*
Gross 39.77% 44.32% 42.74% 42.18%
Operating 3.14% 9.64% -7.00% -16.46%
Profit 2.81% 6.54% -4.76% -10.22%

*2009 Operating margins include an impairment loss, excluding the loss, operating margins would have been approximately 3.75% to 4%. In 2012, the company reported a gain on foreign currency hedging and a translation adjustment. Without those two impacts, net profit margins would have been -11.55%.

Teva and UGG!

Teva sales fell 15.4% over the prior-year period, a drop of more than $6 million. As you can see from the table below, this was the worst quarterly decline since 2009.

Teva 1Q 2Q 3Q 4Q Year
2009 -5.7% -10.6% -19.5% -14.8% -10.2%
2010 21.4% 38.4% 51.7% 26.2% 30.5%
2011 16.8% 29.1% 7.3% 45.9% 23.1%
2012 -1.1% -15.4%

The company also announced that it expects Teva sales to be flat to down for the year, compared with prior guidance for low to mid single digit growth. It will be the worst year for Teva since 2009.

That's not even the worst news. Sales of UGGs, the company's most prominent brand, declined by 0.3%. As you can see from the table below, this was the first year-over-year quarterly decline since Q1 of 2006. That was a long time ago. The worst quarters since then have been the last two, and three of the past five.

UGG 1Q 2Q 3Q 4Q Year
2006 -20.9% 19.2% 18.4% 40.1% 23.2%
2007 67.7% 65.2% 67.5% 61.8% 64.4%
2008 83.6% 130.6% 57.1% 62.0% 67.5%
2009 66.9% 22.9% 19.1% 15.7% 22.3%
2010 14.2% 34.6% 20.2% 23.8% 22.7%
2011 42.2% 8.0% 47.3% 37.7% 37.6%
2012 6.5% -0.3% 10.0%

UGG sales still represented 62% of Deckers' total in the quarter, so this is nothing to shy away from. The number I've bolded above is Deckers' forecast for UGG sales growth in 2012. It will be the worst year in quite some time.

Balance Sheet / Share Repurchase Plan

Deckers saw its cash levels decline in the period, due to inventory buildup and share repurchases. I've provided some key financial ratios for the firm in the table below. All are as of the end of Q2.

Key Financials 6/30/09 6/30/10 6/30/11 6/30/12
Current Ratio 5.90 5.28 5.20 2.74
Working Capital $334,305 $447,819 $558,684 $433,739
Debt Ratio 15.34% 17.58% 17.99% 29.74%

Deckers saw all three primary ratios worsen over the past year. Part of that had to do with the Sanuk acquisition, which cost over $150 million. However, Deckers also saw trade accounts payable rise by nearly $150 million in Q2 of 2012. I assume this has a great deal to do with the $140 million inventory increase in the period, as Deckers gears up for the second half of the year, its busy season.

Deckers did state that current inventory still contains carryover products from the 2011 holiday season, as well as product with increased costs. Now, if you read my preview article linked above, I mentioned that sheepskin prices have fallen substantially as Deckers' problems have expanded over the past 6-9 months. I would have expected some relief by now, but apparently, it's not happening.

As for Deckers' share repurchase plan, the company reported that it bought back 1.475 million shares at a cost of $80 million. That works out to an average of $54.24 per share. During the second quarter, Deckers' stock traded in a range of $42.16 to $69.80, with an average closing price of $55.39. So Deckers was able to buy back shares slightly below the average closing price of the quarter.

The company also announced a new buyback plan of $200 million, but did not give a time frame. With shares trading in the low $40s during the last couple of weeks, investors are hoping that the company can continue to buy shares at low prices. However, over time, Deckers will need to grow revenue and earnings, so investors cannot just count on share buybacks for share price increases.

Full Year Guidance

Here is where things get interesting. Deckers announced an Apple (NASDAQ:AAPL) like issue. It expects Q3 to be absolutely horrible, but expects Q4 to be tremendous. I'm not totally buying what the company said yet.

Deckers reiterated its full-year guidance for 14% revenue growth. That is ahead of current analyst expectations for 12.6% growth, but only because analysts have cut their expectations so much. Deckers also raised its forecast for Sanuk revenue from $90 to $95 million for the year. This implies that of the roughly $190 million expected rise in revenue this year, Sanuk will account for $70 million of the gains, since Sanuk did $26.6 million in 2011 sales. Doesn't leave too much improvement for everything else.

Deckers also reiterated its full-year earnings per share guidance for a 9% to 10% decline. That implies $4.56 to $4.61 in diluted earnings per share. Until about two weeks ago, analysts were expecting $4.53 this year, but a few forecast cuts brought the latest number down to $4.43. Again, this number is ahead of analyst forecasts, but only because numbers have been cut several times. I was hoping for a raise in guidance here. A raise to $4.75 would have been nice, but it didn't happen.

Deckers still expects full-year gross margin declines of 250 basis points, which seems fair given the 248 basis point decline in the first half of the year. The company also expects selling, general, and administrative expenses to be 30% of revenue for the year. In the first half of the year, they totaled 48.4% of revenue, up from 42.05% in the prior-year period. So this assumes that Deckers' operating expenses, which are mostly fixed, will be a lesser percentage of sales in the second half of the year.

Deckers also announced that due to a higher percentage of domestic sales and pre-tax income, it expects its effective tax rate to rise to 31% from previous guidance of 30%. It also expects an additional $0.07 per share charge in relation to acquisition charges from the Sanuk acquisition ($0.30 charge versus prior guidance for $0.23).

Third and Fourth Quarter Guidance

Remember what I was saying about an Apple-like effect? For those of you who don't understand, it's when customers hold back on purchases of an Apple product, say the iPhone, waiting for a new one to come out. So instead of selling say, 30 million phones each quarter, Apple might sell 20 million phones in the quarter before the new one comes out, and then 40 million in the quarter with the new one.

Well, Deckers appears to be facing a similar situation, or that's what it is telling us anyway.

Deckers stated that it expects third-quarter revenue to be up 1% over the prior-year period. That implies about $418.5 million, well below the $447 million, or 8% growth, analysts were expecting. In terms of earnings per share, Deckers is estimating a 31% plunge. That equates to roughly $1.10, well below the $1.44 (9.4% decline) that analysts were forecasting.

But apparently, Deckers believes it will make up all of those sales in Q4. Deckers gave revenue guidance of 19% growth, implying about $718.6 million in sales, well above the roughly $690 million analysts were expecting. Deckers also stated that diluted earnings per share would be up 22% over last year. That implies $3.88 in earnings, well above the $3.37 analysts were expecting.

Now, I don't quite buy this forecast, not yet anyway. This is now the third time in a row Deckers has taken down the forecast for the following (current) quarter. It has now put Q3 expectations so low that I would almost be surprised if it didn't beat. But if it doesn't, it would be a terrible miss. At the same time, it is basically setting the company up for a huge Q4, which, if the trend continues, it could easily take down guidance when it reports Q3.

Conclusion / Recommendation

While Deckers did beat on both the top and bottom line for Q2, it was all due to Sanuk brand sales. As the company's purchase of Sanuk was completed in Q3 2011, Q2 of 2011 did not see any Sanuk sales. Deckers' core brands of UGG and Teva both saw declines, the weakest quarter in years for both, and that includes the fact that Q1 of this year was almost as bad.

Deckers also gave terrible guidance for Q3, the third straight quarter of bad guidance. Deckers appears to be gunning for a big Q4, but what's to say that it won't take down Q4 guidance when it reports Q3 results in three months? Deckers is reliant on a normal winter, and if it doesn't get it, things could get much worse from here. Analysts have already started taking down Q3 numbers and raising Q4 numbers, but overall, the guidance was the same as last quarter. Right now, that's just not good enough.

Deckers' shares rose nearly 6% on Friday, and have rallied nearly $5 off their 52-week low just below $40. However, shares closed Friday at $44.62, despite trading around $50 when results were released Thursday afternoon. The fact that gains were not held, with shares not trading above $45.50 on Friday, means that investors and traders were not completely sold on Deckers' comeback progress.

I am continuing my recommendation to short Deckers on pops until we get an idea that things have actually turned around. With Deckers setting the bar for Q3 so low, I wouldn't be surprised if it beat for Q3, but disappoint for everything else. The company did exactly that with Q2. But if it takes down Q4 guidance again, nobody will care if Q3 beats diminished expectations. I think shares will test that 52-week low of $39.90 again at some point.

I stated previously that Deckers would rally if guidance was good. In the end, Deckers just maintained guidance. So really, shares just rallied because guidance wasn't bad. There's a clear difference there, and it isn't positive for the name in my opinion.

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