In my last post, I created a shortlist of companies for further consideration. Near the top of that list was Skechers (NYSE: SKX). Skechers reports returns on equity in excess of 20% and analysts are projecting a 20% growth rate for the company for the next five years. The reason I am starting with Skechers is that the company looks to be trading at a significant discount to their intrinsic value. In this post, I’ll take a closer look at this business to determine if I can understand it, if management is capable, and if it is indeed trading at a significant discount.
Skechers is on my radar in the first place because my daughters love Skechers. They prefer their shoes over any others. During back to school, we went to a Skechers store at the local outlet mall, and it was packed. I was interested to see that the store offered a full range of shoes, from the casual footwear and kids shoes that they are more known for to hiking boots, dress shoes, and sandals. Being sensitized to the company, it is surprising to see how many adults wear Skechers as well.
Skechers is in the business of selling shoes, but you might be surprised to know that they are the second largest footwear company in the United States. They are a distant second behind Nike, who has 62% of the market. Skechers passed Adidas to achieve 5% of the market, while Adidas is now third at 4.6%. Nike is truly a behemoth in the footwear space with significant advantages, including brand and distribution. Still, Skechers’ growth has been impressive as of late, and they have made some investments that may continue to pay off.
Skechers doesn’t make any of their own shoes. They outsource production to factories in China and Vietnam. They focus on the design, marketing, and distribution aspects of the value chain. They have a dizzying array of designs, to the point where one could argue that they lack focus. Still, they use their success in certain segments of the market as leverage to expand their market acceptance in other areas.
From a marketing perspective, Skechers uses a multi-channel approach. They use print, television, online, outdoor, trend-influenced marketing, public relations, social media, promotions, and celebrity endorsements. Their list of celebrities is a little more under-the-radar than what brands like Nike or Under Armour might pursue. Their list of celebrities includes Demi Lovato, Brooke Burke-Charvet, Kelly Brook, Joe Montana, Joe Namath, Pete Rose, Ringo Starr, Sugar Ray Leonard, and Mariano Riviera. If you’re like me, you may know who half of these people are.
Traditionally, Skechers was focused on distributing their goods to retailers, but they have made great strides in expanding their direct-to-consumer strategy. Most of the capital investments Skechers has made recently are in broadening and expanding their supply chain and their company-owned stores. Their reach has expanded to more than 160 countries. They have distribution centers in Rancho Belago, California (1.8 million square feet), Liege, Belgium (780,000 square feet), company-owned and third-party distribution centers in Central America, South America, and Asia. International expansion both in terms of distribution and direct-to-consumer stores are a critical piece of Skechers’ growth strategy.
The expansion of company-owned retail stores provides greater margins and higher returns than the more traditional wholesale model. The retail market in more traditional domestic locations has been contracting, but same store sales in company-owned stores continues to expand. As of the end of their second quarter, they had 546 company-owned stores, including 404 domestic stores and 142 international retail stores. In the first two quarters of 2016, the company opened two domestic concept stores, five domestic outlet stores, 10 domestic warehouse stores, 10 international concept stores, and 5 international outlet stores. They also closed three domestic stores.
Skechers’ management consists of many seasoned veterans in the footwear industry. Many of them were managers of the footwear company L.A. Gear. Since filing bankruptcy in 1998, that company has never really recovered. Skechers’ Chairman and CEO, Robert Greenberg had been forced to resign from L.A. Gear well before they went bankrupt and founded Skechers soon thereafter in 1992. Mr. Greenberg is now in his mid 70s, which could raise some concerns about succession.
The President and Director of Skechers is Michael Greenberg. He is Robert Greenberg’s son. The star of press releases and conference calls these days is David Weinberg. He has a plethora of titles that includes Chief Financial Officer, Chief Operating Officer, Executive Vice President, and Director. This is another concern. There is a lot of responsibility tied up in this position. It is difficult to tell, but it certainly seems like David Weinberg is effectively running this company.
Overall, Skechers has the feel of a family-run business. This can be concerning, but their track record over the last several years has certainly been strong as we shall see later. Robert Greenberg effectively controls the company. He holds 45% of the outstanding Class B common shares. Members of his family own another 15%, and family trusts set up by Mr. Greenberg own 38.7% of the Class B shares. Class B holders have 10 votes for every one vote cast by Class A holders. This is a roundabout way of saying that if you’re not in the family, you are just along for the ride as a shareholder. This could be structured this way based on how Mr. Greenberg got forced out of L.A. Gear. That can’t happen again here.
Skechers Balance Sheet Analysis
Looking at Skechers’ balance sheet, the first thing that jumps out at me is that the company has a lot of cash and relatively little long-term debt. As of their most recent quarter, they reported $629 million in cash and long-term borrowings of $68 million. As I write this, Skechers has a market capitalization of $3.6 billion, priced at just under $23 per share. Cash is equivalent to $4.06 per share, and total shareholder equity is equal to $10.27 per share. The current ratio is 2.89. In one sense, you could say that this company maintains a conservative balance sheet. In another sense, they are retaining more cash than they need to operate the business. One other quick check on inventories and it looks like inventory is down slightly over the past quarter, so no ballooning inventory risk appears to be occurring.
Sticking with the balance sheet for a minute, one of the most important measures of growth for a company is book value per share growth. I like to look at it because it factors in share dilution that might be occurring while also measuring the growth of the enterprise. Skechers does not pay a dividend or repurchase large amounts of shares. Cash is either retained or invested in new initiatives. Looking back to 2005, Skechers’ book value per share was $3.24. At year end 2015, the book value per share was $8.92 per share. This represents a 10.6% compound annual growth rate.
Skechers Income Statement Analysis
In regards to the income statement, there are some changes underway. From a domestic point of view, a greater percentage of sales are coming from direct to consumer lines. These segments have greater margins than the traditional wholesale business. Domestically, revenue growth is somewhat limited as the market is more mature, but the mix of revenue is changing. Internationally, Skechers is getting quite a bit of traction and driving strong growth.
These drivers show up in the most recent press release (2nd Quarter, 2016). Net sales for the first six months of 2016 grew from $1.57 billion in 2015 to $1.86 billion this year, 18.5% year over year growth. Margins were 45.7% as compared to 45.1% last year. As far as second quarter growth, there was a 34.6% increase in their international subsidiary and joint venture businesses and a 40.5% increase in their international company-owned store sales. Company owned domestic sales growth was 15.4%, but the wholesale business shrank by 5.4%. For the first six months of 2016, the domestic wholesale business grew by only 3.2%.
The most recent quarter resulted in a miss of analyst sales estimates. Their traditional domestic wholesale business is struggling to gain additional market share this year. This is likely the reason the stock continues to trade down this year. International sales growth is robust, but it is also more risky. In one sense, Skechers should be rewarded for going where the growth is, but in another sense their business model is in transition and subject to more risk. Growth is slowing, but from a high level. Yet growth continues. Shares seem to be priced as if growth has stopped altogether. Below is a table of their ten-year history of sales, earnings, and earnings per share growth.
Looking at this table, you can see the volatility in growth rates that the company has experienced. Big drops in earnings occurred both in 2008 and 2011, only to be followed by snapback-type recoveries. The 2008 drop was recessionary, but the 2011 drop was related to a miss in their business. Remember the shape-up scandal? Skechers had to pay $50 million to settle charges of false advertising. They claimed wearing their shoes helped strengthen leg muscles. The claims proved to be to good to be true. Another red flag for management judgment, though no such claims are being made now.
Despite the recession and the shape-up scandal, the company has grown revenues at a compound rate of 10.1%, earnings at a compound rate of 12.6%, and earnings per share at a compound rate of 11.4% over the past 10 years.
Skechers Cash Flow Analysis
Finally, on to the cash flow statement. It shows how the company is allocating capital. In 2015, The company had operating cash flow of $232 million, which was a reasonable amount less than their net income of $261 million. The company is using up some of their net income in the purchase of inventory and the growth in receivables. This is offset slightly in cash offsets in payables. This is a sign of growth. If inventories were ballooning well beyond earnings growth, that would be a sign of problems ahead. It would mean that they weren’t moving their inventory.
In 2015, the company had operating cash flow of $163 million on net income of $152 million. That was a really good sign as it demonstrated that inventory had shrunk relative to earnings during the year.
Capital expenditures totaled $118 million and investments totaled $8.4 million in 2015. This represents what the company is investing back into the business. You can see this growth in land, buildings and improvements, furniture and fixtures, and leasehold improvements on their balance sheet. This is land for buildings, new buildings and improvements to expand distribution, and furniture and fixtures for their new stores around the world. Below is a snapshot from Skechers annual report indicating their store openings worldwide.
They expanded from 553 stores to 649 stores in 2015. In addition to this, they have expanded distribution capabilities in Europe and Asia, which required capital expenditures as well. Keep in mind that they also license their brand and establish partnerships internationally to sell direct as well. I’m just noting their capital expenditures here. Skechers is investing significantly in the expansion of their company-owned stores. They expect an additional 330-340 stores to be added in 2016. They note in their letter to shareholders that they expect company-owned and licensed storecounts to total 1,650 by year-end 2016. Of this total, they expect 575 will be entirely company owned.
Will these investments pay off? That is the real question for Skechers moving forward. One of the best measures of past performance is return on invested capital. I have combined the past 10 years of returns on invested capital with operating cash flow growth in the table below. Return on invested capital consists of net operating profit after tax divided by shareholder equity plus debt. Debt is minimal for Skechers, which will cause this calculation to line up pretty close with return on equity. Also keep in mind that one could argue that there is more cash on Skechers’ balance sheet than is needed for the business. That will drive down returns a bit as well.
One of the important things that Skechers lacks is consistency. Some of this is due to the recession of 2008-2010 and some of it is due to the shape-up issues. Still, Skechers has demonstrated that they can produce returns on invested capital above 10% over the long term and that some of their recent investments have really paid off.
To create a reasonable value for a company, you need to have some estimation of earnings and then discount those earnings back at some discount rate. I’m really looking out 10 years. I want to have some estimate of earnings 10 years from now and then apply some reasonable market multiple to those earnings and then discount that price back. Below are a couple of tables that I produced to track growth rates over the past 10 years plus returns on invested capital.
If the future is like the past, Skechers could be expected to grow at around 11%. Analysts still project earnings growth over the next five years to be 20%. Again, the past was pretty rough, but there could also be volatility in the future. A conservative but reasonable estimate going forward would be 12% growth. If we project 12% growth starting from 2015 earnings per share, the next ten years of earnings would look like this.
This growth is pretty conservative, especially when you consider that earnings per share through the first six months of 2016 have been $1.11. To get a future value of shares, I am assigning 2x the estimated growth rate, or a P/E ratio of 24. That would be fairly aggressive for a company growing at 12%, but not beyond belief. I am only going to sell if a good price is offered after all. At 24x year 10 earnings, the value of shares would be $112. If I want a 15% return, I would use this as my discount rate and get a value of $28 today. Why 15%? Doing this sort of research needs to result in a payoff well above market. Otherwise, I would just buy an index fund and forget it.
Once you build a model, you can start to play with the numbers a bit. If Skechers is trading at only 12x earnings in 10 years, your returns would still be between 9% and 10% based on the current price. We are still talking positive numbers. It looks like as long as Skechers is growing, the downside for a long-term investment is fairly limited.
What about the upside? If we want to project analyst growth numbers forward 10 years, meaning Skechers grows at 20% for 10 years, the numbers start to look pretty amazing. This feels unlikely, but it would mean that they continue to expand market share in the U.S. and that the traction they are getting internationally continues for the next decade (especially in Asia). If you make these assumptions, Skechers is worth $372 per share in 10 years and its current value should be somewhere around $92 assuming a 15% discount rate. Investors obviously don’t believe this story, but it represents the potential upside.
Using my estimates for a range of values, $1,000 today can buy you about 44 shares. We’ll round up and call it 50. 50 shares today would cost $1,142. In 10 years, it could be worth $5,600 at 12% growth or $18,600 at 20% growth. I don’t believe the upside, but the middle range of 12% growth is reasonable. Chances are, though, that Skechers continues to growth at the 15% to 25% range for the next several years and then levels out. If the market started to price in continued growth, it would be time to exit. That would be my approach anyway.
There are definitely some positives and negatives with regard to this company and its management. The positives include really recognizing how to grow their business given the weaknesses in their traditional wholesale model. They are expanding their direct to consumer category and reaping the rewards domestically while internationally they are getting traction with their brand and expanding distribution. They are currently the second largest footwear company by sales in the United States.
Do the positives lead to a competitive advantage? Their advantages are in their brand and their distribution. As far as their brand is concerned, they are no Nike. They do not have the same brand recognition. However, they continue to invest in their brand in more subtle ways. They also continue to expand their store base and their distribution.
There are concerns long term. Current management is fairly experienced, but aging. Will a legitimate successor be found that can continue to drive growth? That will be up to the Greenberg family and their trusts as they have complete voting control.
Despite the questions, there appears to be some value in Skechers’ shares, especially in the short to intermediate term. For the next several years, they could continue some fairly strong growth. Investors should watch their domestic market share and the traction that they gain internationally, especially in China. If their brand gains traction there, shares are super-cheap. Early indications are that consumers there appreciate Skechers’ value and style.
I currently hold shares of Skechers through my fund. I do not have shares in any other accounts. I am willing to let the story play out over the next three to five years as the downside seems limited and the upside could be significant.
A lesson in all of this is that when you find a good investment, look for a better one. Skechers looks to be a good investment, but they are not a buy it and forget it, hold forever-type investment. They are a fair to good company at a really attractive price. I question the durability of their advantages. If they miss on style, their sales could suffer. When sales are based on popularity, there are risks. Larger and even smaller competitors could compete in their space as barriers to entry are not insurmountable. Is Nike a better long-term investment? I definitely want to take a look.
Disclosure: I hold shares of Skechers. This is not a recommendation to buy. I hope it serves as a starting point for further research.
You can see my update on Skechers here.