SKX: Management Needs to be Schooled

This quarter is a great example as to why SKX has been on my ‘avoid like the plague’ list. I’ve been getting a lot of pushback on this one because it looks so dang cheap. But appearances can be deceiving – especially when a 4-year positive fashion cycle and an 8-year ‘easy-money’ supply chain collided to lift margins near peak levels of 8-9%. Now we’re seeing SKX invest in the wrong initiatives at the wrong part of the cycle. People get hung up on the conference call about the impact of American Idol endorsements, and Cali Gear sales (Crocs knock-off). At the same time SKX is pushing hard to grow when the market for its product is changing for the worse and margins are taking a hit. Quite frankly, I could care less about the David Cook endorsement right now. Skechers is trying really hard to grow, and the real question for me is whether it should simply change its colors -- pull back on capex and working capital, boost margins, and flat-line sales. Ordinarily that’s really bad for a small cap growth company’s multiple. But at 6.5x EBITDA, the risk of multiple contraction would be pretty slim. In fact, I’d argue for multiple expansion given the ensuing cash flow stability. Instead, SKX is taking the aggressive path and is trying to grow when it shouldn’t, and is therefore likely to take margins another 3+ points lower over 2 years. That means that the stock looks cheap today at $23.74, and will look expensive in 12 months at $15.

I always pause and consider the contrarian case when I have so many reasons to be negative on a name. But there really were not many positive factors coming from this quarter. Here’s a couple worth pointing out.

1. The quality of earnings was abysmal. Sales +1%, EBIT -8%. The way I am doing the math, FX helped the top line by about 3.8-4% (management danced around the question and did not provide an answer on the call). Assuming a 25% flow-through rate, this helped EPS by about $0.04, pegging real EPS decline of about 15%.

2. While I’m on the topic of International, I still do not understand why this company should grow internationally!! It is a knock off company. Real aspirational brands work overseas. When brands don’t matter, then it’s speed to market, local consumer expertise, and low cost production that does matter. Perhaps with the exception of speed to market, I don’t think that Skechers excels at any of those things. The real challenge is that SKX falls squarely into the bucket of a company that has not managed through an unfavorable FX cycle. I challenge anyone to find me a company in retail that came out of its first negative FX swing with flying colors. I’ll dare not ask the question as to whether this management team is conservatively assuming that Big Ben will play some offense, take rates higher, and get the dollar to reverse course.

3. It’s clear from my sources as well management’s comments that the ‘low profile’ shoes that drove SKX’s business are seeing impact from what I think is a sustainable long-term downtrend (my 6/4 SKX post).

4. Bad debt exposure heading higher. With disproportionate exposure to troubled mid-tier retailers vis/vis its share of the total market, I think that the hits we’re seeing from Goody’s and Shoe Pavilion will only be the beginning. I guess a bigger question is why SKX is increasingly showing up as a large creditor (with Goody’s being the best example). That probably points back to the fashion shift and the need for SKX to find non-traditional channels for its wares.

5. I love watching the progression of how a management handles their respective business in different market environments. SKX is a textbook example of an organization that simply does not learn from its mistakes – specifically as it relates to inventory/margin trade-off. Check out my little Sales/GM/Inventory analysis. The vertical axis measures sales growth less inventory growth (i.e. a higher number is better) and the X axis measures the yy change in Gross Margin. Plotting SKX’s path over 2+ years is simply classic.

The narrative sounds something like this…
a. 1Q06-2Q06: “Business is solid. We’re on trend and margins are up. Life is good. Let’s order more stuff.”
b. 3Q-6-1Q07: Ok margins are still decent, but inventory is building. We’re gonna hang on under the assumption that we can sell this built-up inventory at a respectable margin.”
c. 2Q07: “We were wrong. Inventories are still too high, and now margins are down Ouch!”
d. 3Q07: “Ok, we messed up. Let’s clear the inventory – even if at an undesirable margin.”
e. 4Q07-1Q08: “We’re geniuses. Problem solved, and now we’re back on trend. Let’s up our growth plans again.”
f. 2Q08: “Uh oh. Inventory building and we’re back to where we started.”
A classic example of how not to trade off the income statement and balance sheet in retail -- courtesy of SKX execution. See color above.