It's been a wild 24 hours for Motley Fool Hidden Gems recommendation DeckersOutdoor
Check that -- it's been a wild ride since I recommended Deckers as a guest analyst in September 2004. I picked the stock when it traded for $29. It subsequently surged to $49, then fell back to $21 after the company twice reduced its financial estimates. Deckers now sits about 6% below my recommended price.
Despite the serious challenges this company faces, I remain confident it's a good long-term investment. Let's take a look at Deckers' second-quarter results, released this morning.
After the report, Deckers shares jumped 12% to $29.90 in pre-market trading. I usually don't pay attention to this, but trading volume was relatively high. Once the market officially opened, it dropped to around $25.50 before rallying to over $27. Like I said, things have been wild.
So what's all the hubbub?
Sales came in at $40.3 million, down a hair vs. last year's second quarter, but per-share earnings came in at $0.21, beating the average analyst estimate by a nickel. I think pre-market traders concentrated too much on the $0.21 and didn't read the rest of the report carefully. Sure, management boosted the low end of its full-year earnings target by $0.03 and reaffirmed its sales estimate. But that's no reason to get all wild and crazy.
You've got to dig deeper.
Inventories went nuts, surging by 240%. As Fools know, it's generally a bad, bad thing when inventories rise by more than sales. Deckers' attempt to reduce its inventory of Teva products cut into gross margins (click here to see key highlights of Deckers' quarter). This was expected, but it's still not a good thing. Ugg inventories increased in order to take care of retailers, but that required an added $45 million in working capital as compared with last year's quarter. That's some serious dough.
I don't believe this company's products are fads, but they do have a fashion element to them. Regardless of brand strength, fashion trends can change quickly. Should that happen (and I think the probability is low), there's now $56 million of Ugg inventory on the books. We have to remember the lesson from Teva: Discounted inventory kills gross margins.
In addition, the company continues to reposition its brands, a risky proposition. Deckers Chairman Doug Otto called the last six months a "wake-up call." That's refreshing, but it doesn't reduce the uncertainty facing this company. New CEO Angel Martinez has a big job as he repositions Teva as a performance brand, a la Nike
Deckers is trying to expand its Ugg product line, which diversifies its revenue stream but could dilute the brand's value. The company's Simple brand is making good progress in its turnaround. What does the future hold for both situations? Investors don't handle uncertainty too well. That's why we invest in businesses, not stocks. If a company is run by excellent managers -- and Deckers is -- we have good reason to stay confident in its prospects.
Deckers aims to grow annual sales to $500 million, and management is making savvy strategic decisions to reach that goal. For instance, the company is expanding its distribution network. Management is also investing in new products and using more marketing dollars to support them. Without the right products to generate a great experience for customers and retailers, shareholders will lose out.
Lastly, Deckers continues to experiment. With all of the current challenges, the company still plans to open a new outlet store in California. And distributors in Japan are planning to open an Ugg store. Retail stores would provide a new sales channel, new inventory-control mechanisms, and more branding opportunities.
Remember, this is not a short-term play. It will take time; years, in fact. But take comfort: This company generated a 34.7% return on net tangible assets in 2004. (Net tangible assets are defined as total assets minus the sum of goodwill, other intangibles, current liabilities, and long-term debt.) That's considerably more than the company's cost of capital, and Deckers is on track for similar performance this year.
That's what Hidden Gems is about: making long-term investments in companies that fly under that radar. I still think Deckers has a bright future ahead of it.
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