In this week's small-cap spotlight, we take a close look at Skechers (SKX) - Get Report. The stock has fallen hard recently to $21.90 after its quarterly results fell short of estimates, but was this just a bump in the road or a sign of more bad times to come?
Frank Curzio and Larsen Kusick debate whether Sketchers can still jump back into the game. Read below, or
watch the video.
Curzio: Things May Not Be As Bad As They Seem
Skechers' quarterly miss on July 24 left investors and analysts with egg on their face. Last April, management's guidance was upbeat, and just weeks before the report (which was presented at a conference), management reiterated that business was strong.
With such high expectations heading into the quarter, it came as no surprise when shares dropped over 20% when earnings fell short of estimates. However, despite management's miscues, a closer look at the quarter indicates that shares could have high price-appreciation potential over the next 12 months.
Breaking down the quarter, Skechers' earnings miss was caused by higher expenses, which included increased warehousing costs to meet rapid demand, an increase in marketing and new store openings. Also, the company is launching Cali Gear, a new brand of shoes that is a knock-off competitor to
These expenses, which were seen as a negative and which led to a sharp selloff in the stock, can actually be interpreted as positives, since they are clear signs of growth. This was indicated by a 20% jump in revenue year over year despite the earnings miss. Also, on the basis of huge demand for Crocs' colorful summer footwear, which we
outlined here, it's obvious why management is increasing its efforts to quickly establish this brand.
On the international front, Skechers' potential could be enormous. As of last quarter, sales grew by 65% year over year, and management's goal is to double sales abroad from 15% of total revenue last year to 30% over the next five years. On the basis of Crocs' huge success internationally, which includes a revenue surge to 32% from 8% from 2005 to 2006, I believe management's goal of 30% is very conservative.
On the basis of valuation, shares are attractive, trading at just 12 times next year's earnings estimates, which is lower than the industry average of 17 times, and are expected to grow at more than 17% annually over the next three years, according to Capital IQ. Also, Skechers has a healthy balance sheet with over $218 million in cash and just $17 million in total debt.
After the huge decline in the stock, mostly caused by management's poor communication skills, most analysts have reduced estimates that could result in an earnings beat next quarter. With Sketchers huge growth potential, particularly in the international markets, and the fact that shares are trading at a discount compared with its peers, I believe shares could trade north of $27.50 a share, some 25% higher than the current price in the short term.
Kusick: A Weak Brand That Looks Like a Value Trap
Following the 21% gap down on July 25, I'd use the same word to describe both Skechers' stock and its shoes: cheap. But in my opinion, this stock deserves to be cheap because of its weak brand and misguided attempt to generate additional revenue growth by increased spending on advertising and the Cali Gear initiative that Frank mentioned.
Footwear companies are notoriously vulnerable to shifts in consumer taste. For this reason, it's imperative that a shoe company keep its brand fresh and appealing to even moderately fashion-conscious consumers.
Skechers had a nice run in 2006 due in part to its successful marketing of stars such as Carrie Underwood and Ashlee Simpson. Its shoes were also lined up exactly right with the shift in consumer taste toward "lifestyle" footwear -- a style that I would best describe as consisting of a number of lower-profile variations on the traditional sneaker.
But competitors have jumped into the mix, leading to an increasingly crowded lifestyle footwear space, while consumers are looking to a number of other retailers, trying to find the next trend.
The reaction by Skechers' management has left investors uninspired.
Rather than focusing on its strength by forging ahead of the competition with a variety of fashion options that leverage its status as being near the front of the fashion pack, the company has decided to ride the coattails of Crocs by introducing its own line of rubber-shoe knockoffs. Hasn't this strategy been tried by a number of companies over the past two years, only to result in a resounding victory for Crocs? To me, this looks like a desperate and unoriginal attempt that shows the company's confusion about what to do next.
The other key driver for Skechers' disastrous second-quarter earnings miss was the company's rapidly rising advertising costs. In spite of the strong growth in revenue, Skechers is spending a higher percentage of its revenue on advertising than it did a year ago -- 9% of sales in the second quarter vs. 8.4% during the second quarter of 2006. This is a huge red flag for investors, as it indicates that management is essentially sacrificing earnings to maintain revenue growth. This is completely the opposite of what investors want to see at any company.
It's understandable why management is desperate to right the ship. A look at gross margins shows that year-over-year gross margin comparisons turned negative for the first time during the recently announced second quarter. As the table below illustrates, what used to be an attractive metric of Skechers' increasing profitability is now showing that the company has "hit the wall," so to speak.
I don't expect Skechers' revenue growth to tail off in the near future. Rather, I expect its brand to move further down toward the cheap, "has-been" end of the spectrum.
The best comparison I can offer is
Old Navy brand, which had success in the late 1990s and earlier this decade, thanks to an aggressive marketing push. But in the end, Old Navy's styles were too easily replicable, and now the brand sits at the bottom of the spectrum, attractive only for customers who are looking for something cheap.
Without a new fashion trend to capitalize on, Skechers' brand appears headed toward a similar fate, and I see little reason for the stock to command a higher multiple with shrinking gross margins and increased operating expenses.