SKX: Deal or Not, The Damage is Done

Let me paint this little narrative for you. Imagine a company that benefits from a 4 year fashion shift, a solid consumer, extremely favorable FX, and a margin-friendly sourcing environment. Margins go from 0% to 9%. Then all at the same time the company sees fashion pull a 180, a weakening consumer, unfavorable FX, and tightening capacity in Asia putting pressure on sourcing costs. Kinda puts that peak margin into perspective, no?

We’re talking, of course, about Skechers.

I’d love to have been a fly on the wall when management collectively realized that they were nearly out of growth runway.

So what do they do?
1) Accelerate growth in its own retail stores (if retail partners don’t want our stuff, let’s try to get it consumers on our own with expensive long-lived assets).
2) Broaden distribution into marginal clearance channels (remember Goody’s?)
3) Now SKX goes ahead and bids for none other than Heelys? The brand with the distinction of having more injury-related lawsuits per-pair than just about any other street shoe brand in recent memory? The same brand that grew to $188mm from almost nothing in 2 years – but in a real market size closer to $100mm?

This is just so wrong in o many ways.

How do acquisitions create value for a company in this space? Give leverage with 1) the consumer, 2) the retailer, 3) the manufacturer in Asia making the goods, and 4) the combined cost structure. Let’s evaluate those…
1) Consumer: Will either product be any better being part of the same parent? Probably not. Skechers is all about knocking product off other brands. They don’t do any R&D. It’s all about marketing. Could HLYS use Skechers’ marketing prowess? Yes. But first it needs a better product. That’s a problem.
2) Retailer: Not meaningful overlap here with retailer customers especially with HLYS’ more technical-based retail base. It’s nice that they don’t step on each other’s toes, but this gives no added leverage whatsoever.
3) Asia: Factories are closing left and right (over 3,000 thus far in China this year alone). Capacity is tightening, and manufacturers want to be aligned with the winners. Heelys? Nah.
4) Cost structure: HLYS was already extremely lean with SG&A at 27%, which is not a ‘cut-able’ rate. EVERY acquisition I can find in this space going back 20 years where a brand with SG&A below 32% has turned out to destroy shareholder value.

Is the price right? Yes, I can see why HLYS seems cheap at $143mm in equity value and $100mm in net cash. But there’s a difference between low-priced and cheap. This thing has negative EBITDA, and not many levers to pull to get margins higher. SKX said it would consider raising the offer price after due diligence. The best margin rate I can envision is 5% -- which is 6.5% on the offer. The problem is that the market is already pricing HLYS at 8x EBITDA under the assumption that SKX’s 7% premium is not enough.

If there’s one punchline I want to make clear, it is that I could care less if this deal goes through or not. The simple fact that the offer is on the table is affirmation that the underlying strategy is misaligned with the margin challenges coming down the pike. This one remains on my ‘least favorites’ list.