Casey Flavin, one of the analysts on our Retail Team, has done what I think is exceptional work on Skechers. He knows this thing cold. He visited the company a few weeks back, modeled it six ways til Sunday, and has been hitting me hard on the bull case. He thinks that the company will smoke estimates this quarter (released after the close tonight), and that the consensus is low next year by as much as a buck (yes folks, that’s 100%). Check out his note to me below. The irony is that I think that he’s spot-on, but I still can’t bring myself to hop on the bandwagon. They may do $2.00 next year, but there’s no reason why they can’t revert to a buck the year after.
I guess my problem rests in that the crux of the upside here is in the product cycle and the success of Shape-Ups, one of the better products that SKX has nailed in recent years. What’s bugging me, however, is that I am not convinced that SKX has the infrastructure to sustain the current throughput. Consider the following…
- SKX has already delayed the distribution center that was to be put in place last year. They claim that they’re fine with existing capacity, but the new DC was planned for a reason – to facilitate growth and efficiency.
- SXK’ revenue per employee is – by a long-shot – head and shoulder above the group average. How does that happen? I have NEVER seen an employee base that is above average productivity where the company is overly invested in capacity to facilitate growth.
- As it relates to product cycles, SKX is heavily susceptible with knock-offs on this one. Heck, being the king of the knock off, SKX should kow about this better than anyone. We’re already seeing similar product priced at a 60% discount at retailers like Payless.
This time last year our call heading into Q3 was that margins would be cut in half due to a confluence of factors (see our 9/3/08 note “Misery Likes Company”) – as it turns out, SKX reported 4% operating margins in FY08 down from 8.1% in F07. So far in FY09 profitability has continued to slide. While many of the structural flaws of this story remain, several factors are starting to improve considerably such as Fx, product costs, and the company’s sales/inventory/margin triangulation, which has shifted from the worst place possible this time last year to one of the best in just three quarters. After visiting with management a few weeks ago, not only am I confident that the company is going to beat the quarter, but also that the incremental contribution from Shape-Ups will prove current Street estimates to be too low for next year.
Let’s start with the quarter – anecdotally, two competitors have indicated strong 3Q results so far with DSW’s preannouncement last week (comps up 6%-8%) and SCVL’s commentary of 11% comps in August. With only 20-25% of revenues derived from owned retail this is positive albeit modestly for SKX’s top-line. Additionally, we are seeing improved trends in domestic wholesale. Based on our analysis of industry trend data, I expect Shape-Ups to contribute an incremental $10-$12mm, or ~5% in Q3 wholesale sales helping to offset low double-digit declines in backlog exiting the 2Q. All things considered we’re shaking out at a 7-8% yy decline in revenues on a consolidated basis.
The upside lies with gross margins. Based on our sourcing calculation (similar to PSS with 95%+ sourced from China), we expect a ~100bps improvement from lower product costs and another ~50bps from Fx and higher margin Shape-Ups combined. Despite a clean inventory position, we’re accounting for 50bps degradation from promotional activity and 100bps of net expansion in Q3. As for operating expenses, mid-single digit G&A savings will be offset by slightly higher Selling costs related to Shape-Up spend resulting in modest operating margin contraction of 25bps – a significant improvement to the 800bps+ seen over each of the last three quarters.
Consider the facts regarding Shape Ups:
Shape-Ups were first tested domestically in Dec/Jan in select owned stores and then in larger quantities in March-May before officially launching this past summer. By the end of Q3, Shape-Ups were in just over 10% of SKX’s 12,000-15,000 domestic doors and were already sold out in several distribution channels. The shoe recently entered Europe, which is 5-6 months behind the US, and testing has been met with even greater fanfare. Even at this early stage of demand for the product, domestic and international order interest is on pace for over 1mm pair/qtr combined (primarily domestic).
SKX’s most successful product to date was the Energy shoe from 1, which generated ~$200mm in revenues at its peak at an ASP of $20-$22/pair at wholesale. Five-years later, the company has a larger store base, more distribution channels, and a product with a ~$50/pair price tag at wholesale. As the company broadens distribution domestically into the athletic channel (~5% of distribution currently), within existing doors and internationally, demand for 8-10mm+ units/qtr is certainly feasible. The question then becomes one of allocation. Assuming a fulfillment rate of 20%-25%, we are modeling a sell-through of ~2.3mm pair, or $130mm in revenues from Shape-Ups next year.
While Shape-Ups are a nice incremental boost, the direction of the core business is key to top-line trajectory. After mid-teen declines in core domestic wholesale revenues and low double-digit declines in core international wholesale revenues in FY09, we are modeling core revenues down 2% and 4% in domestic and international revenues respectively in FY10. Offset by 4% growth in same store sales in retail and $130mm in Shape-Up related revenues, we expect sales growth of 7%-8% next year. In addition, we’re modeling 250bps of gross margin expansion due to lower product costs (100bps+), higher margin Shape-Up sales (100bps+), and a greater percentage of owned retail sales. Given the expectation of selling expense to outpace sales growth and leveraging of G&A, we expect the company to return to 5% operating margins and generate earnings 40% higher than consensus estimates in F10.
Let’s not forget about the ongoing DC transition plan that has been years in the making. The latest expectation is for a 3Q of F10 or 1Q of F11 start date. While said to be immediately accretive to earnings, the company will have to spend another $35-$40mm of capital in the 2H (assuming 3Q start) towards the installation of equipment, software, & programming, which will impact FCF. The current facility holds roughly 13-14mm pair of shoes and turns roughly 1mm pair/week so there should be no issue handling the incremental stress of a successful new line (I would be happy to provide interested subscribers with further details).