I've long been bearish on Motley Fool Hidden Gems recommendation Deckers Outdoor (Nasdaq: DECK ) . I first warned that the stock was overvalued in February 2004, when it was climbing past the $25 mark. As it continued its rise, my skepticism only increased.
When the stock rose above $40, I became particularly interested in shorting the stock, but I wanted to make sure that I timed my short to avoid getting too badly exposed to a continued run-up. So I started watching Ugg boots on eBay (Nasdaq: EBAY ) , and when their prices started to fall in March, I took it as my cue to short.
The investment has paid off. Though I closed my position when the stock had fallen back into the low $20s, the stock has fallen even further as the company's results continue to disappoint. Shares are now trading at around $19 a share, with a trailing-12-month P/E ratio of about 8.6 -- an indication that the stock market takes a dim view of Deckers' prospects.
My investment philosophy is strongly influenced by Warren Buffett's "Mr. Market" creation -- the manic-depressive figure that BerkshireHathaway's (NYSE: BRKa ) (NYSE: BRKb ) chairman uses to represent the behavior of the stock market. The idea behind this character is to illustrate that while intrinsic values of companies generally move slowly, the market tends to overshoot with either excessive enthusiasm (as was the case with Deckers for most of the past 18 months) or excessive pessimism. Now, the key questions for me are whether the market will overcorrect on Deckers by becoming too negative in its outlook as Ugg suffers, and when the stock will become attractive for a long position.
What is Deckers worth?
To answer my questions, I thought about Deckers' intrinsic value. The company has three primary brands -- Ugg, Teva, and Simple. According to its most recent press release, the company expects net sales for 2005 to be about $154 million for Ugg, $85 million for Teva, and $8 million for Simple. In my mind, the only brand that has any real, sustainable long-term value is the Teva brand. I see Ugg as a passing fad with minimal staying power. With less than $10 million in sales and no growth, Simple is too small to matter. That leaves the real value of the company in Teva, which outdoor enthusiasts recognize as a premier brand.
According to the company's 2004 10-K, Teva generates about $25 million in cash flow on $88 million of sales, which are essentially flat. This is a stable, healthy business that spins off significant cash. Roughly speaking, we can value that brand at eight times cash flow (a typical multiple for this kind of business), or about $200 million. To me, this is what the brand would be worth to a competitor like Timberland (NYSE: TBL ) or Reebok (NYSE: RBK ) , companies that could simply roll the business into their existing infrastructure. That figure would also be close to what the brand would be worth to a private equity firm, which could run Teva as a standalone business with minimal corporate overhead.
Ugg is the key
To unlock this value, the strategy would be to milk the Ugg brand. In 2004, Ugg generated about $32 million in cash flow on just more than $115 million in sales. Going forward, I would very conservatively expect the brand to be able to generate at least that much as sales drop off over a couple of years.
According to its 10-K, Deckers today spends about $20 million in corporate overhead, and it is not allocated to any product line. This amount is probably for executive salaries, corporate accountants, corporate advertising and promotion, and a host of other costs to support the three product lines. Most, if not all, of these expenditures would not be required if a competitor or a private equity firm bought Deckers and ran it as the Teva brand. However, shutting down these corporate offices would require a one-time cash outlay for restructuring costs.
When would Deckers become attractive?
So at what point does Deckers become attractive as a takeover candidate for the Teva assets? If we make the simple and conservative assumption that the cash generated from Ugg would be adequate to cover required restructuring costs, and we ignore Simple because it is too small to matter, the value of the company is about $200 million. If I were doing the deal, I would want a solid margin of safety -- I would start to become interested at $150 million, and my interest would grow from there as the price fell. With about 12.5 million shares outstanding and essentially no debt on the balance sheet, Deckers has an equity value of about $12 a share, given the $150 million figure. At anything below $10 per share, this company becomes a prime takeover candidate.
Though the stock appears to have temporarily stabilized at around $18 per share, I'm watching this one closely. Three years ago, the stock was trading below $5 per share. If it gets back down anywhere close to that level, I may again take a position in Deckers. Mr. Market's behavior opens up opportunities on both the long and short sides of a stock. I've been successful with Deckers on the short side, and I'm hoping an opportunity will soon arise on the long side.
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