FOOL ON THE HILL
Oakley: Staring Into the Sun

After a record year in 2001, Oakley's stock has been on a tear -- but so have receivables and inventories, which have outgrown sales for most of the past two years. As a result, cash flow has been meager and the company is now looking to issue debt in order to pursue expansion opportunities outside its core sunglasses business. At a rich P/E multiple, the stock looks vulnerable.

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By Matt Richey (TMF Matt)
April 23, 2002

One of the red flags I watch for as an investor and sometimes take advantage of on the short side is when a company's earnings quality is deteriorating and yet its stock continues to rocket upwards. That was what happened at Lucent (NYSE: LU). I see a similarly disturbing trend developing now at sunglasses and apparel designer Oakley (NYSE: OO).

Oakley has been one hot stock to trot. With record sales in 2001 and a renewed three-year agreement in December with its largest customer (Sunglass Hut), the company's shares have shot up 26% over the past quarter and 75% over the past half-year. Last Wednesday, the company kept the crowd cheering with estimate-beating first-quarter earnings. Sales of $109.6 million were a first-quarter record and represented growth of 16.8% over the prior year. Also, management boosted full-year 2002 guidance to $0.81, up a penny from the prior forecast. This is generally the stuff of a stock market applause -- and the stock has in fact edged up slightly since the report -- but I see no reason to cheer given the strikingly poor quality of earnings.

The most evident problem is growth in accounts receivable, which have dramatically outpaced sales (on a year-over-year basis) for six straight quarters:

              Q1 02  Q4 01  Q3 01
Sales Growth  16.8%  -3.3%   6.5%
A/R Growth    36.6%  16.8%  39.1%

              Q2 01  Q1 01  Q4 00
Sales Growth  31.2%  48.7%  40.7%
A/R Growth    48.5%  60.9%  63.1%

From another perspective, days of sales outstanding (the average number of days to turn a sale into cash) increased from 52.9 in the fourth quarter of 2000 to 65.2 today. The only way to interpret such a long string of increasing receivables is that Oakley is offering more lenient sales terms in order to boost sales growth. This is a telling sign about the balance of power between Oakley and its retail store customers (Sunglass Hut, Galyan's, Champs, etc.). Oakley products may be popular, but apparently not so popular that the company can dictate sales terms to its best advantage.

A second and similar problem has been taking shape in Oakley's inventory. Until the most recent quarter, inventory had outgrown sales for seven straight quarters. The average length of time that Oakley held its inventory increased from 116 days in 1999 to 124 days in 2000 and on up to 144 days in 2001. Given the fashion risk of Oakley's radically styled sunglasses and trendy apparel, this growing inventory load is a liability. The company did, however, manage to bring its days in inventory down to 135 in the most recent quarter.

As a side note, W.R. Hambrecht issued a seven-page research note on Oakley's first-quarter results in which the analyst, who rates the stock a "buy," pointed out the inventory improvement and called it "impressive." The analyst didn't, however, explain that improvement came on top of seven straight quarters of worsening inventory levels. Nor did this analyst make any mention of the break-neck pace of receivables growth that continued through the first quarter. Obviously this analyst is paying attention to the balance sheet, and yet only the praiseworthy aspects are noted.

While we're on this tangent, I'll point out a couple other interesting tidbits. This same analyst initiated coverage on Oakley last week with a 30-page report that chronicled the business in tremendous detail. And yet nowhere in that report did the analyst discuss the glaringly negative trends in receivables and inventory. The analyst did, however, happen to point out that the company expects to attain $50 million in long-term debt financing (read: investment banking business) during the upcoming quarter. The analyst also had some very complimentary words to describe management: "exceptionally creative," "unconventional thinkers," "unparalleled in the development of sports technology products," "cohesive," "fresh." I'll leave it to you to determine this analyst's true motives.

Moving on, there's one final very negative consequence of Oakley's rapidly growing receivables and inventory: It's a vicious drain on cash. Oakley wouldn't need to be issuing $50 million of long-term debt if it had kept its receivables and inventories in check. In 2001, Oakley reported $50 million in net income, but actually only generated $30 million in cash from operations. It's never a good sign when cash from operations is less than net income, and that's been the case for Oakley each of the past two years. The culprit is the additional investment in working capital (e.g., receivables, inventory, and other current assets, net of current liabilities), which reduced cash from operations in 2001 by nearly $60 million. The working capital investment cost Oakley $33 million in 2000. After capital expenditures, Oakley's free cash flow was negative in 2001 and barely positive in 2000.

Not only is Oakley being forced to fund its business expansion through debt, but worse than that, its growth opportunities are into less economically attractive businesses like apparel, athletic footwear, and sports watches. These segments have lower gross margins and greater competition. Already Oakley is feeling the pinch on gross margins, which declined 540 basis points year-over-year in the most recent quarter, from 58.0% to 52.6%. That marked the fourth consecutive quarter of sequential and year-over-year gross margin erosion.

Let's review: Rapidly increasing receivables signify weakness vis-�-vis customers and are a drain on cash; increasing inventories pose risks of obsolescence and/or future mark-downs, and are a drain on cash; at least one analyst has a suspiciously rosy view on the stock in advance of a debt offering; and the company is using debt to expand into lower-value businesses. For this, investors are currently paying 29 times trailing earnings and 24 times forward earnings (based on management's guidance). Oakley owners need to take off the rose-tinted shades.

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Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.