Deep Dive – From the Bottom of the $DECK

Deckers was one of the “Back-from-the-Dead” stocks of 2013 (NFLX, GMCR, BBY, etc.).  DECK had declined from a high of $118.90 in November 2011 to a low of $28.53 in November 2012, quite a descent in just 1 year.  However, the stock more than doubled in 2013, moving back above the prior $70 support level from 2011 and 2012 after its recent October earnings report:

Amazingly, throughout the stock’s move higher in 2013, its short interest has remained above 30% of flat (it was below 15% of float for most of 2010 and 2011).  Even more recently, short interest is higher today than it was in July, despite the fact that DECK is up more than 50% since then:

DECK is primarily a shoe company, with its popular UGG brand.  Yet, the stock trades like a tech startup, and the high short interest suggests more than a simple shoe business as well.  With that in mind, I wanted to take a deeper look at the fundamentals.

Deckers is a $3 billion footwear company that has been around for decades, but really took off in 2006 with its UGG brand.  The stock’s successes and failures since then have generally been tied to sales of those sheepskin boots.  Here’s the revenue and income breakdown by division, from the company’s most recent 10-Q:

UGG wholesale (sold to third party retailers) made up about 51% of revenues in the first nine months of 2013 (vs. about 56% of revenues in 2012, 66% of revenues in 2013, and 67% in 2010).  The proportion has decreased due to the acquisition of Sanuk, as well as an increase in the e-Commerce and Retail divisions, whose primary revenue sources are from UGG shoes.

Moreover, the fourth quarter is the seasonally most important quarter for DECK by far (about 50-95% of earnings from holiday season selling over the past 4 years), which is dominated by UGG sales.  In short, Deckers still relies primarily on the UGG brand for the bulk of its financial performance.

So why have UGG sales stagnated over the past few years?  

First, the overall consumer excitement about the boots was probably hard to sustain given its fad nature when UGGs first got big.  Google Trends shows the decline in interest since the 2010 holiday season (the stock actually peaked in October 2011, and really declined as the results of the 2011 holiday season became apparent):

Following up on the decline in customer interest, management has embarked on a strategy of customer diversification and business investment in order to build a more sustainable, multi-product footwear company.  Here’s what management said about its overall UGG strategy in the most recent release:

We believe the luxurious comfort of UGG products will continue to drive long-term consumer demand. Recognizing that there is a significant fashion element to UGG footwear and that footwear fashions fluctuate, our strategy seeks to prolong the longevity of the brand by offering a broader product line suitable for wear in a variety of climates and occasions and by limiting distribution to selected higher-end retailers. As part of this strategy, we have increased our product offering, including a growing spring line, growing year-round collections and an expanded men’s line, a fall line that consists of a range of luxurious collections for both genders, an expanded kids’ line, as well as handbags, cold weather accessories, home, and apparel. We have also recently expanded our marketing and promotional efforts, which we believe has contributed, and will continue to contribute, to our growth. We believe that the evolution of the UGG brand and our strategy of product diversification also will help decrease our reliance on sheepskin, which is in high demand and subject to price volatility. Nonetheless, we cannot assure investors that our efforts will continue to provide UGG brand growth.

We remain constructive on management’s stewardship of the UGG brand but question whether the margin recovery will ever live up to increasingly lofty market expectations. At 13% guided for 2013, DECK’s operating margins remain well below the 25% peak set in 2010. As weather trends normalize and product costs deflate, the case for mean reversion is loud and clear. However, we remind investors of the SG&A ratio, a line that has de-levered 900 bp since 2010. Investments in retail, marketing and international have come with the intention of building a sustainable long-term model, a philosophy that is unlikely to change until 2015, at the earliest. In summary, we take management’s mid-teens margin target at face value and do not expect a return to 20%.

Selling, General and Administrative (SG&A) Expenses.  The change in SG&A expenses was primarily due to:

·                  increased retail costs of approximately $12,000, largely related to 37 new retail stores that were not open as of September 30, 2012 and related corporate infrastructure;

·                  increased recognition of performance-based compensation of approximately $6,000 as a result of our belief that the achievement of at least the threshold performance objective of certain awards is probable; and

·                  increased expenses of approximately $2,000 for the Hoka brand which we acquired on September 27, 2012.