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<DAILY TROUBLE>
Tuesday, September 7, 1999

Skechers USA, Inc.
(NYSE: SKX)
Phone: 310-318-3100
Website: http://www.skechers.com
Price (9/3/99): $6 1/4


HOW DID IT FIND TROUBLE?

Skechers has made a name for itself by designing and marketing colorful sneakers and clunky, big-soled fashion footwear mainly to teens looking for something a little extreme. What's been really extreme, though, is just how fast this newly public stock wiped out.

Lead underwriter Deutsche Banc Alex. Brown and respectable sidekick Prudential Securities priced Skechers' 7 million share initial public offering (IPO) at $11 a share. But the stock started trading on June 9 at just $10 1/2 and closed the day at $10 5/8. The shares briefly skated to $12 3/8 two days later, but by mid-July had tripped below $7.

Swirling interest rate fears throughout the summer have hurt many companies that depend on continued consumer spending, but Skechers has also shown signs of a creeping downturn in what has been a robust growth story.

Deutsche Banc analyst Marcia Aaron started coverage of the company July 6 with a lukewarm "buy" rating. She indicated that while the company would hit her Q2 estimates, sales would fall a few million dollars short of her initial expectations. The company's backlog of future orders at the end of March dropped 16% year-over-year to $136.5 million, and Aaron predicted more of the same for the June period.

Investors rightly feel taken when a newly public company immediately disappoints. In fact, that's about as uncool as it gets. Industry experts started wondering if Skechers had rushed too fast to saturate its market as it bumped its product line to 900 styles last year from just 600 in 1997.

That's a scary possibility because fashion brands tend to lose their cachet with youthful consumers when they become too big too fast. We know that partly because Skechers Chair/CEO Robert Greenberg basically made that very mistake a decade ago with his star-crossed L.A. Gear, one of the decade's great collapses.

BUSINESS DESCRIPTION

Based in Manhattan Beach, California, Skechers describes itself as a "global lifestyle company," but it's mainly a designer and marketer of fashion-oriented shoes for men and women ages 12 to 25. It operates 38 company-owned Skechers stores, including 16 outlet stores.

It sells its products in more than 110 countries and territories worldwide. For FY98, international operations accounted for 9.1% of sales.

In 1992, after Greenberg left L.A. Gear, he started Skechers as a distributor for Dr. Martens shoes, but the company also launched its own brands. By 1995, it had focused on the Skechers brand and, by 1996, started broadening its line to include shoes for women and children.

For FY98, its top five customers accounted for 34.8% of sales, with the troubled Venator Group (NYSE: Z), operator of Foot Locker, responsible for 11.8% of revenue. Skechers are also sold in department stores such as Nordstrom (NYSE: JWN) and specialty teen retailers such as Pacific Sunwear (Nasdaq: PSUN).

Competitors include Timberland (NYSE: TBL), Steve Madden (Nasdaq: SHOO), Vans (Nasdaq: VANS), and giants such as Nike (NYSE: NKE), Reebok (NYSE: RBK), and adidas.

Chair/CEO Robert Greenberg owns 65.% of the Class B supra-voting stock, giving him control of the company. Greenberg and his son Michael (the company's president) collectively own 60% of the stock and 73% of the voting rights. The company also employs Robert's other sons: Jason, Jeffrey, and Scott.

On June 14, R. Griggs Group, manufacturer of Dr. Martens and other footwear, filed a lawsuit against Skechers alleging, among other things, unfair competition pertaining to Skechers use of certain footwear trademarks. Skechers has counter-sued.

FINANCIAL FACTS

Income Statement*
12-month sales: $425.4 million
12-month income: $18.0 million
12-month EPS: $0.58
Profit Margin: 4.2%
Market Cap: $217.6 million
(*Income on a pro forma basis assuming 40% tax rate as C corporation. Based on 34.8 million shares outstanding, which doesn't account for certain in-the-money options.)

Balance Sheet
Cash: $0.2 million
Current Assets: $140.7 million
Current Liabilities: $82.4 million
Long-term Debt: $3.4 million

Ratios
Price-to-earnings: 10.8
Price-to-sales: 0.5

HOW COULD YOU HAVE SEEN IT COMING?

Skechers had sketched out a tremendous growth story, with sales increasing at a compound annual rate of 42.4% between 1994 and 1998. Last year, sales shot up 102.7%, pumping earnings from operations up by 117.4%. For the first quarter of FY99, sales skated ahead 59.9% while earnings from operations soared by 90.8%.

Still, there were reasons for skepticism. First, Skechers had filed to go public in July 1998, then hoping to raise $115 million. The IPO markets shut down shortly thereafter, but the revived offering didn't inspire much enthusiasm either.

This time out, the company hoped to sell 10.7 million shares (8.9 million owned by the company) at $15 a piece. The fact that both the offering size and price were dropped indicated lame interest in the offering, which was immediately reflected in the first day trading. If a company can't sell its story on a pre-IPO roadshow to get that first-day lift, then there's almost always something wrong with the story.

In this case, investors may have feared that history might repeat itself. L.A. Gear didn't file for bankruptcy until January 1998, some six years after Robert Greenberg and other top Skechers officials left the company. Yet, the major elements of L.A. Gear's decline began in late 1990, on Greenberg's watch, as the stock fell from $50 to $12 in a year's time.

That company had paid pop superstar Michael Jackson $20 million to promote a casual shoe line that ultimately flopped. A basketball line promoted by Kareem Abdul-Jabbar also failed to make the company a contender in the performance-shoe category because the shoes were so poorly constructed that, in one highly publicized case involving a Marquette University basketball player, they literally fell apart on the court.

Soaring inventories led to massive discounting into clearance channels, which irritated the firm's department store customers. L.A. Gear found itself in repeated technical violation of its debt agreements, and one lawsuit alleged the company was stuffing its sales channel and even reporting as revenues products that were still being stored in its warehouses. And the Securities and Exchange Commission at one point did force the company to restate its results to indicate a loss rather than a small profit.

Given this history, Skechers' declining backlog at the end of March should have been reason enough to worry. But the company's marketing spending also showed an effort to keep sales afloat.

Skechers' marketing expenses during Q4 FY98 hit 18.3% of sales, pushing total FY98 marketing costs to 11.3% of sales -- well above the stated target range of 8.0% to 10.0%. That trend continued in Q1, when marketing spending hit 13.3% of fast-growing sales versus just 9.1% in the year-ago period. A skeptic might have read desperation in such spending.

WHERE TO FROM HERE?

Second quarter sales rose 19.3% to $104.6 million while fully taxed pro forma earnings per share (based on 31.5 million shares) increased 25% to $0.20 beating the $0.18 estimate. However, gross margins dipped to 40.9% from 41.1%. Selling expenses rose to 11.1% of sales from 10.6% a year ago, more than making up for a modest improvement in general and administrative expenses, which ran at 18.0% of sales versus 18.2% a year ago.

The latter half of the year, particularly the current back-to-school period, accounts for the majority of Skechers' sales and operating profits. And Greenberg said on July 28 that "sell through at retail remains robust, fueled by the popularity of our lifestyle products, and aggressive marketing campaigns."

Skechers has also introduced a new urban brand called Sity. And even going into this more robust season, inventories are down $6.7 million from where they were in December and up just 8% from a year ago, a definite positive.

However, management used the $69.7 million in cash from the IPO to pay down part of its revolving credit facility, to repay notes held by early shareholders, and to make certain distributions to those shareholders. Interest expenses haved dropped, but the company has used cash to fund the fast-rising and potentially worrisome trade accounts receivable, which are up 60% from December.

So Skechers has got little cash sitting in the coffers today despite the recent offering.

The underwriters are now calling for Skechers to turn in earnings of $0.82 per share for this year and $0.98 per share for FY 2000. So the stock is trading at less than 8 times projected earnings just 4 months out. If you assume Greenberg has learned some lessons from L.A. Gear, then the stock is cheap.

Yet, the market for fashion-oriented footwear is fickle enough to present major challenges, especially for such a fast-growing company. Trouble signs would include continued high levels of receivables, continued above-plan marketing spending, continued declines in the backlog, or upticks in inventories.

The market is pricing in fears that Skechers could become another L.A. Gear, and perhaps rightly so.

-- Louis Corrigan
(TMFSeymor@aol.com)

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