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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.

PFCB – Taking the Right Steps in Today’s Environment

According to NPD data, the supper daypart, which represents 31% of eating out occasions, has declined the most, down 1% in the March-May 2008 time period relative to up 1% for both the morning meal and lunch dayparts. This help explains PFCB’s worse than expected same-store sales results in 2Q as dinner makes up 67% of revenues at the Bistro and 57% of revenues at Pei Wei. During 1Q08, the Bistro experienced positive daypart activity during the week at both dinner and lunch and positive weekend dinner trends. In 2Q08, dinner trends during the week turned negative, leaving dinners during the weekend as the only positive daypart.
  • PFCB’s same-store sales results were also impacted rather severely by the company’s geographic exposure to Arizona, California, Florida and Nevada, which accounted for 84% of the Bistro’s total comparable sales decline, and same-store sales declines in these four states worsened sequentially from 1Q08. Pei Wei experienced considerable weakness in its Phoenix, Las Vegas, Southern California and Dallas markets. These four regions represent 41% of the concept’s comparable units and were down more than 7% in the quarter after being down 6% in 1Q08.
  • Despite weakening top-line results, the company is taking the right steps to manage the parts of the business it can control. Although the company is facing higher commodity costs, management stated that it does not expect to increase prices at either of its concepts over the next 6 to 18 months as the risk to traffic trends and customers’ overall value perception is too great. With traffic down in the 6%-7% range at the Bistro and negative at Pei Wei, I would agree that raising prices in this economic environment would be detrimental to both concepts.
  • Additionally, the company announced that it is significantly slowing its new unit growth in FY09 and plans to open 12-14 Bistros (down from the expected 17 in FY08) and 6-10 Pei Wei restaurants (down from 25 in FY08). I would be happy to see the company stop its expansion of the Pei Wei concept all together until it can generate the necessary returns, but cutting the concept’s FY09 growth by more than 60% is a step in the right direction and management is focused on improving Pei Wei margins by 200-250 bps off of 2007 levels. I was surprised and encouraged to hear management say (in response to a question) that they are currently evaluating the existing Pei Wei locations and would consider closing some locations if they determine any sites don’t have the potential to get where they want them to get. Management was clear in saying, however, that no such units have been identified as of yet. As a result of this slowed FY09 development, capital expenditures are expected to come down in FY08 (now expecting to spend $80-$90 million versus prior guidance of $105 to $115 million), which will generate increased free cash flow in the current year. This capital spending number will come down even further in FY09.
  • As it relates to things management can control, the 70 bp YOY decline in labor expenses at the Bistro is somewhat concerning as such declines in labor expense can be a red flag for a company trying to protect margins at the expense of the customer experience. Management attributed the year-over-year decline to improved efficiency and scheduling in the back of the house and said that the magnitude of the decline is not necessarily sustainable, which is encouraging.

US Financials (XLF): Down Today, In An Up Tape

I talked about being net long for the market “Trade” this morning, but also said don’t chase Luskin and Gartman into the bear trap called Financials. The XLF closed down -0.13% today, and is starting to look as tired as Dick Fuld must be of trying to define what a “Level 3 Asset” is.

Provided that the XLF doesn’t close higher than 23.78, the negative “Trend” in this sector will remain firmly entrenched. The US Financial Industry needs a full makeover, not a 5 day rally. Sell high, Cover Low.
KM
(chart courtesy of stockcharts.com)

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Hershey (HSY): Giving The Shorts Something to Think About...

This stock's sentiment reminds me of that which used to be Budweiser's (BUD). One day, someone with Euros changed that negativity, and you know where BUD is now. I know, I know - but The Hershey Trust "will never bend". Some hedge funds have fun IM’ing one another with their narrative fallacies.

HSY reported a better than bad quarter today, and closed up +5.4% on solid volume. Short interest is vibrant at 11% of the float. If you're short it, and you think you have a unique thesis, you don't anymore (or a catalyst, for that matter).

If the stock can hold today's gains, you can buy it using a $36.17 stop loss. You'll get paid a 3.2% dividend to wait this turnaround out in the meantime.

See Howard Penney's notes for more.
KM
(chart courtesy of StockCharts.com)

Eye on Putin Power...

This picture is scary, for a lot of reasons. Putin may very well have gone too far too fast however. Now that natural gas and oil prices aren't bullet proof, his pedestal of would be global political power shakes.

The picture below comes from the two day visit Chavez is having in Russia this week. Yesterday he was lobbying Putin and Medvedev to form a "strategic alliance" with Venezuela. Chavez went on record saying "if Russia's armed forces want to be present in Venezuela, they will be given a warm welcome."

See our earlier post today on Russia's stock market breaking down for more.

Because geopolitical risks are ignored, certainly does not mean they cease to exist. That’s why one of my investment themes remains keeping an “Eye On Putin Power.”
KM
AP Picture From This Week

DIFFERENT PAULSON; STRONGER LEADER - THE MARKET NEEDS HIM

While I have been focused on Hank Paulsen’s reactive interpretation of providing the market leadership, John Paulson, who manages the $33B hedge fund Paulson & Co., has been busy coming up with proactive solutions.

Along with Peter Thiel at Clarium and Phil Falcone at Harbinger, Paulson is providing some light for an industry that is entering its dark cycle of rationalizing over supply. According to Bloomberg’s Saijel Kishan, “the money manager whose wagers against the U.S. housing market helped him earn an estimated $3.7 billion last year, is starting a hedge fund to provide capital to financial firms hurt by mortgage writedowns.”

Finally – a leader stepping up to take on risk and be held accountable to his investors for it.
Leadership is earned, not appointed. Let the healthy cleansing of US financial industry begin.
KM
New York Times Pictured Paulson In A March Article titled "Winners Amid Gloom and Doom".

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