They say you can tell a lot about a person by the shoes they wear. Assuming you can also learn a lot about a man from the shoe stocks he buys, then clearly, I love brands on sale with big ol' upside potential. Hence today's Rising Star purchase of Skechers
Obviously, the market doesn't share my taste in foot fashion. Skechers' stock has been sold off roughly 60% from its 52-week highs. The company is having a hard time dealing with a combination of slowing sales, growing inventory, and a host of negative publicity surrounding its once widely popular "Shape-Ups" toner shoes. However, at current prices, I believe the market has unduly punished Skechers, and that today's the time to buy.
The opportunity to own a widely recognized brand with 19 years of operating history, 14 out of 16 years of profitability as a public company, and a host of growth opportunities -- ranging from international expansion to non-footwear licensing – is simply too attractive to pass up. I'm therefore opening a 3% position (roughly $500) in the ALOHA Portfolio for some snazzy new shares of Skechers.
While Skechers isn't the most fashionable footwear company in the world, it's pretty darn ubiquitous. Amazingly, Skechers is the second-largest footwear brand in America, after Nike
Asymmetric: Are we being appropriately compensated for the risk we're taking?
On almost every revenue and earnings metric, Skechers looks undervalued, especially when compared to some of the competition:
Source: Capital IQ as of May 13.
Then, after looking at Skechers' balance sheet -- with a net cash position of $108 million (roughly 12% of its market capitalization) and a tangible book value of $19.23 -- the stock at $18.31 just looks plain cheap. However, this does assume that its piles of shoes can translate into cash money. However, I'm willing to bet on its ability to monetize its rising inventory. First of all, the company works with foreign contract manufacturers who produce these shoes for a song. Second, the company has an enviable network of retail, outlet, wholesale, and international distribution points that it uses to liquidate excess inventory at relatively competitive prices, compared to its production costs.
Given these factors, I've estimated an intrinsic value range for Sketchers of between $15 to $30. The low end represents my asset valuation of the company with no consideration of the brand or the company's long-term earnings power. The high-end number assumes that between salvaging some portion of the "Shape-Ups" business, and the company's international expansion, Skechers can resume high-single-digit EPS growth (which they've been able to do on average over the last five years). Given today's price, this value range provides us with an attractive reward-to-risk ratio of 3.5-to-1.
Leveraged: Is there a natural edge or strategic advantage embedded in this investment?
Skechers' brand, distribution network, low-cost manufacturing capabilities, and licensing opportunities are all levers the company can use to continue scaling. Skechers has successfully leveraged these elements to grow revenue from $675 million in 2000 to more than $2 billion in 2010. Hence, owning America's second-best-selling shoe brand for less than tangible book value gives us all the intangibles and international expansion for free.
Opportunity: What's the variant perception, why does it exist, and can we capitalize on it?
The market hates broken growth stories, but I actually love them. Over the last year, Skechers has gone from a growth story to a bloated-inventory fad fiasco. What I see is a trusted, value brand that has a core business that isn't going away. All we have to do is be patient, buy cheap, and allow management to work through the current inventory problems.
Has a catalyst: What crucial tipping point will affect this stock, and how soon?
The biggest catalyst for Skechers is the inventory issue. Management says it's excited about new styles and products that it wants to push through the pipeline later in the year. To do so successfully, it needs to deal with the older toner inventory. To that point, management says it hasn't been as aggressive as it could be, since it hasn't wanted to flood the market and put undue pressure on its retail partners. Fair point.
However, the stock will remain depressed until the company shows it can successfully cycle through a slowing product line, while simultaneously refreshing the pipeline with new, desirable designs. The company claims it'll have made significant progress by the third or fourth quarter. However, based on management's past track record, I think we'll really know after the holiday season, which puts us into the first or second quarter of 2012. At that point, the future of "Shape-Ups" and their bloated inventory – one way or another – will have played out.
Allocation: How big a position does this investment warrant?
Don't get me wrong -- while Skechers' stock appears cheap, I can see it getting cheaper. As a matter of fact, I can see it trading well below my value range, if a complete inventory purge causes margins to meaningfully contract. So for now, I'm comfortable taking a nibble on the stock, and potentially adding more on a pullback. While a 3% position is good for now, that stake could potentially grow to 6%-8% of the ALOHA portfolio.
The Foolish bottom line
It's a bit rare to find well-known brands selling for less than tangible book value that also have a fair amount of growth potential in their future. Skechers, while being far from a "shoe-in" investment, definitely merits a spot in the ALOHA portfolio.