Long Deck

Deckers: A Compelling Risk/Reward Opportunity For Long-Term Investors

October 17, 2012 | 2 commentsby: Jan Kalas | about: DECK

Disclosure: I am long DECK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Deckers Outdoor Corporation (DECK) is trading down roughly 51% YTD and has not lived up to the investment community's expectations. DECK is currently facing pressure from declining margins, increased inventory, and economic uncertainty in Europe. Investors have become focused on these short-term events and cease to value DECK based on normal business conditions. Valuation is low at 4.4x LTM EV/EBITDA, 1.9x P/B, and 8.5x 2012E earnings. As DECK continues to grow revenues, and business conditions begin to normalize, I expect its EBITDA multiple to rise from 4.4x to 7.0x, resulting in an upside potential of 53.4%.

Company Description

DECK is a leading designer, producer and brand manager of innovative, high quality footwear and the category creator of the sport sandal, luxury sheepskin, and sustainable footwear segments. Its primary objective is to build footwear lines into global lifestyle brands with market leadership positions.

Figure 1: Financial Summary

Year	Sales	Growth	EBITDA	Growth	Margin	EPS
2010A	$1,001	--	261.4	--	24.9%	$4.10
2011A	$1,377	38%	313.8	20%	20.7%	$5.16
2012E	$1,515	10%	266.8	-15%	14.5%	$4.26
2013E	$1,636	8%	302.1	13%	14.6%	$4.76
2014E	$1,751	7%	330.3	9%	14.7%	$5.10

Source: company filings, consensus estimates

Investment Thesis

1. Market leading brands. Well known and established brands include Teva, UGG, and Sanuk. Each brand has a strong following within its targeted market due to each products high level of functionality. In a 2011 survey (Canaccord Genuity's Presentation), the UGG brand was the market leader among the top 10 women's brands sold in department stores.
2. Margin Expansion. During Q112 gross margins were down 4% as a result of record high raw material costs. Once the current inventory is cleared out, and sheep skin prices come down from record highs, I expect operating margins to expand towards normal levels.
3. Strong Management Team. Angel Martinez joined DECK in 2005 as CEO and has a significant amount of industry experience after spending 21 years at Reebok. His previous achievements include building a distribution network in the U.S., and turning around the Rockport division by diversifying the company's product offering. Angel has established a successful track record growing footwear brands, and I expect him to continue this strategy with DECK in the future.
4. Strong Balance Sheet. The balance sheet is in good condition with no debt, and $114 million in Cash & Equivalents. DECK recently completed its repurchasing program by purchasing 1.5 million shares during Q212 for $80 million. A new repurchasing program for $200 million was announced at the end of the quarter.
5. Economic Moat. The growth of the UGG brand has led DECK to consume a majority of the high-grade sheep skin on the market. If another company wanted to compete with UGG, the increased demand for high-grade sheep skin would increase the commodity price. I believe the potential for decreased profit margins is enough to keep large competitors away. Additionally, DECK has proven to be successful in recent lawsuits banning counterfeit products.
6. Low Valuation. DECK trades at 7.6x 2012E FCF, 4.4x LTM EV/EBITDA, and 7.3x FY 2013E earnings. Comparable companies trade at significantly higher multiples.

Risks

1. Fashion Risk. DECK is focused on expanding products under the UGG, Teva, and Sanuk brands. It may be unsuccessful in accomplishing this. To hedge this type of risk, DECK has focused on building products to serve a functional purpose. For example, UGG boots are marketed as a high end comfortable boot. Teva sport sandals are built for water related activities with special purpose straps to make sure the sandal isn't pulled off in the water.
2. Commodity Risk. In the Q112 earnings call, management noted that 2012 sheep skin prices are up 40% vs. 2011. Further price increases could have a negative impact on profit margins. There are a lot of moving parts that factor into the supply of high quality sheep skins, which include seasonal changes, the price of wool, and the price of lamb meat. Overtime, I expect sheep skin prices to normalize as farmers increase flock sizes, and slaughter rates increase to meet demand for lamb meat. In the Q212 earnings call, management said they see sheep skin prices coming down in 2013 in comparison to 2012.
3. UGG Brand Sales are highly cyclical. UGG brand sales make up roughly 85% of total revenues. If UGG product sales decline the other brands owned by DECK may not be able to offset the decreases. Typically, UGG product sales are higher in the third and fourth quarters.
4. Customer Concentration. In 2011, Deckers' five largest customers accounted for 24% of net sales vs. 28.9% in 2010. Nordstrom is the largest customer, and accounted for greater than 10% of sales in 2011, with the majority of those being related to UGG products. If DECK were to lose one of its customers it would have a material effect on revenues.
5. Inventory Risk. As DECK is working hard to grow its brands both domestically and internationally, it has been steadily increasing its inventory over the past couple of years. The warm winter in 2012, coupled with worsening economic conditions in Europe left retailers with more inventory than anticipated. If retailers are unsuccessful in clearing inventory DECK may be forced to cut prices again.
6. Climate Risk. The 2012 winter was the 4th warmest winter on record for the U.S. according to NOAA, which had a negative impact on UGG boot sales. Historically, weather patterns are volatile and conditions tend to change drastically from year to year. Winters with record high temperatures do not tend to occur back to back. I expect weather patterns to normalize over time and have less of a negative impact on UGG boot sales in the future.

Valuation

My $56.00 price target is based on a range of multiples from public comps and the results of a 5-year discounted cash flow analysis. I used consensus revenue estimates for years 2012-2014, and for years 2015-2016 I assumed an annual 5% growth rate to reflect slowing UGG boot sales. DECK has made a goal to reach revenues of $2.4 billion by 2015. My revenue estimates have them falling short of that goal by $470 million. I calculated a WACC of 10.2% and used a range of 10%, 10.5%, and 11% in the model. I expect operating margins to increase 10 bps per year as sheep skin prices decline, and UGG offers more products that aren't made with sheep skin.

Comparable Company Analysis

I calculated the median LTM EV/EBITDA, 2012E P/E, and P/B for competitors including NKE, SHOO, CROX, WWW, ADDYY.PK, and SKX to be 11.3x, 17.2x, and 4.3x. DECK currently trades at 4.4x, 8.4x, and 1.9x. With strong free cash flow, return on invested capital higher than its cost of capital, and operating margins above 14% I strongly believe DECK is being undervalued on a relative basis.

Conclusion

I believe DECK offers long-term investors a nice potential upside, and limited downside at a current 35% discount to fair value. The fundamentals behind each brand have not changed, and DECK will continue to execute the same strategy in the future generating strong free cash flow. Returns to shareholders will come through share repurchases, growing sales from Sanuk/Teva/UGG, and future acquisitions.