This Company Needs To Face Reality

By Chad Henage - August 13, 2012 | Tickers: DECK, NKE, UA, VFC | 0 Comments

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Sometimes I don't enjoy being right about companies that I used to hold in my portfolio. I've written before about Deckers Outdoor (NASDAQ: DECK), and I honestly was hoping that the company would prove me wrong. However, after looking over the company's most recent earnings I can say that I'm confident that selling the shares was the right move. 

In the recent quarter, though sales were up 13.1%, without the company's acquisition of the Sanuk brand sales would actually have decreased by about 5%. In fact, the results at two of the company's three major brands appear to be getting worse. Since the UGG division is the largest revenue and income driver, let's start there.

UGG sales were up less than 1% last quarter, and this quarter they actually declined by 0.3%. This division is nearly three times larger than Teva, and almost four times larger than Sanuk. As the largest division, this brand determines the company's short-term future. Some would say this brand does not do well with the warmer weather the country has experienced in the last multiple months, but this puts a lot of pressure on sales expectations for the back half of the year.

In addition, the UGG division is picking up new competition from brands that customers might not expect. Nike (NYSE: NKE) has been expanding their cold weather footwear into boots and even Under Armour (NYSE: UA) is producing hiking, hunting, and training boots. Timberland, which has been a traditional competitor for the UGG line, was acquired by V.F. Corp. (NYSE: VFC). While UGG sales have languished, Timberland showed growth both domestically and internationally.

If investors are hoping that Deckers' second largest line, Teva, will pick up the slack, that is definitely not happening. The Teva division saw sales decrease by 15.4%, which was much worse than the 2.18% decrease last quarter. Since most of Teva's products are specifically designed for warmer weather, the company cannot use the weather to explain two straight quarters of year-over-year declining sales. Since Deckers did not acquire the Sanuk brand until the midpoint of last year, we don't yet have comparable sales figures. However, since this brand is faster growing, it's a positive sign that the division contributed over 16% of total revenue compared to 13% a quarter ago.

The two bright spots for Deckers were the company's retail stores, and eCommerce divisions. Retail stores showed an increase in sales of 25%, driven by same-store sales up 6.8%. In addition, eCommerce sales increased over 40%. Unfortunately this only represented $8 million worth of total revenue. These results are ironic because when Deckers' brands are featured in both their stores and their website, sales increased significantly. However, when their products are sold elsewhere alongside competitive products, sales do not perform as well.

While end demand is created by the consumer, inventory levels are managed by the manufacturer. This is a lesson that Deckers' management will have to learn soon and the results may not be pretty for shareholders. With the company clearly struggling with end demand for its two largest brands, management should have been more careful about inventory growth in the last several quarters. However, that has not occurred, and the company even said it still had inventory from the 2011 holiday season. When inventory rises faster than sales it's a red flag that investors need to pay attention to.

There are two significant numbers that I noticed in the company's financial statements that should worry investors. Total inventory grew by almost 65%, but even more troubling is UGG inventory grew by nearly 73%. Considering that in the last two quarters UGG sales have barely moved, I have to assume that this additional inventory is part of the leftovers from last year's holiday season. While some investors might guess that the company is just stocking up for their busiest time of year, there's yet another number that suggests this is not the case. Consider for a minute the difference in inventory levels carried by multiple shoe competitors relative to their level of sales:

You can see that while there are differences in the level of inventory on hand, Deckers is carrying a level at least double their competition. This will become a problem if the company isn't able to clear out this excess in the next two to three quarters. Too much inventory will mean markdowns, which will ultimately lead to less profits, and potentially inventory write-downs on the balance sheet.

A final issue with Deckers is the moving target that is their growth rate. When I originally bought the stock last year, analysts were calling for EPS growth of better than 18%. About a year later, those same analysts have cut their expectations to 12.73% growth going forward. Though the stock looks cheap at just 9.5 times forward earnings, I don't know how realistic this revised growth forecast is, considering the lackluster performance of the UGG line.

If investors are looking for a play on the footwear industry, the Timberland and Vans divisions of V.F. Corp. appear to be the best choice at the current time. V.F. Corp. sells for about 16 times forward estimates, and is expected to grow earnings at 13.46% over the next few years. In addition, V.F. Corp. is a dividend aristocrat and pays a yield of close to 2%. Until the inventory situation with Deckers is resolved, I would avoid the shares. With 73% more UGG inventory and sales slipping into the negative, if this fall and winter don't equate to spectacular sales, this could get UGG-ly fast.

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