When it comes to publicly traded companies, shares can be overvalued, fairly valued, or undervalued relative to future return potential. And the more I examine official Motley Fool Hidden Gems recommendation Deckers Outdoor (NASDAQ:DECK), the more I think that at around $45 per share, the company's shares do not reflect the strong possibility of an earnings shortfall this winter -- a dip that could easily come in the wake of a challenging retail environment and weaker demand for the UGG brand.
Torrid growth or just growth?
Shares of Deckers Outdoor are, according to the most recent EPS forecast of $2.39 to $2.45 for 2006, currently trading at a P/E multiple of about 18.5, which is near the top of its recent historical valuation. A P/E multiple of 18 may seem attractive when compared with the company's growth rate over the past couple of years (a heady 200% since 2003), but it's no bargain in light of the company's forecasted five-year growth rate of 15% per annum. (Other companies with such growth prospects currently sport P/E multiples in the range of 17.)
The current valuation is also no bargain next to fellow shoemakers Columbia (NASDAQ:COLM), Timberland (NYSE:TBL), and Nike (NYSE:NKE), all of which are forecast to grow earnings at slightly lower rates (12 to 14% over the next five years) but also sport trailing P/E multiples of only 14 or 15. Nike in particular also pays a 1.6% dividend, sports almost the same long-term growth rate, and offers one of the most powerful global brands. So those who are currently long Deckers Outdoor shares are either unaware of other investment opportunities in the same industry, very optimistic about the company's long-term growth rates, or riding the stock's momentum and hoping to unload their shares at an even higher price after the holiday season numbers come in. Neither of these possibilities is comforting.
As we dig further into Deckers Outdoor's historical growth rates, it's worth discussing how the company managed to increase net annual sales and diluted EPS from 2003 to 2005 by 118% and 220%, respectively. One word, three letters: UGG.
Although the company consistently talks about how it markets its products under three proprietary brands, at the moment Deckers might as well call itself UGG Australia. The Simple brand is currently inconsequential; it contributes less than 3% of net sales and is unlikely to rise above a 10% contribution to revenues for at least a few years. Teva sport sandals, meanwhile, account for one-third of revenues, but sales in this brand have grown by only 7% per year since 2001.
Indeed, the real driver of growth in the past few years has been the UGG brand's explosion from net sales of $19 million in 2001 to $150 million in 2005. What makes the rise impressive is that UGG isn't even a true year-round brand -- almost 80% of sales occur in the second half of the fiscal year.
Thus, what remains to be seen is whether this is a company that has temporarily hit the jackpot with an extremely popular brand and is capable of around $125 million in annual sales over the long term, or whether it's on its way to posting top-line revenues of half a billion bucks in 2010. If the latter, that future is still far off. At the moment, it's no stretch to say that owning shares of Deckers Outdoor is largely a bet that consumers will keep spending money on footwear with $100-plus price points in the second half of 2006. And that could be a problem for investors.
Getting ready for a miss?
Currently, management has forecasted 2006 sales to come in somewhere between $272 million and $278 million and diluted EPS to land between $2.39 and $2.45. The average forecast from seven analysts who cover the stock is for 2007 total sales of around $308 million and diluted EPS of $2.79, with a range of $2.59 to $3.00. The company will likely issue guidance for fiscal 2007 with its third-quarter earnings release, and the adjustments to analysts' 2007 EPS estimates will be crucial. Even if the company meets EPS expectations for 2006, it will probably have to top the forecasted EPS of $2.79 per share for 2007 to satisfy the expectations built into the current price. And if you ask me, I'd say the company's next earnings report will disappoint those who buy at the current price.
First, there's reason to believe that demand for the company's products has actually fallen from last year. While UGGs generally come out when the first cold wave hits, last year they were pretty ubiquitous even in early autumn. So far, I have seen very few girls wearing UGG footwear of any kind at the affluent college campus where I work, and I have yet to overhear anyone talking about the boots or see them featured prominently in a local storefront. More importantly, I invite you to search on eBay for the UGG products that are marked as back-ordered on UGGAustralia.com, the official UGG brand website. You'll find that these UGG styles change hands for about 10% less than their retail price, a stark contrast to the same period two years ago, when UGGs often sold for as much as 25% higher than retail.
Second, Deckers' treatment of its return customers could use some work, especially when compared with other luxury-brand companies. At Jos. A. Bank, you receive an email thanking you for your business the day after your purchase, as well as intermittent emails that alert you to upcoming specials and sales. Buy something from RedEnvelope, and you'll be inundated with specialized catalogs, discounts, promotions, and even suggestions for repeat gifts online and offline for years afterwards. Tiffany sends you a catalog regardless of whether you've even shopped there. Yet despite having made multiple purchases of UGG products in the past two years, both directly from the company and Nordstrom (NYSE:JWN), I've received only a single postcard inviting me to sample the new styles, all of which were clearly geared toward women.
Don't get me wrong. It's not that I feel snubbed. But from a business perspective, I have doubts about how quickly the UGG brand can grow without more robust advertising and better cultivation of the existing customer file.
Third, even though luxury-brand purveyors are likely to weather the twin impact of higher energy costs and interest rates better than the discounters can, the high-end sellers are by no means immune. Though Coach (NYSE:COH) and UGG's primary sales channel, Nordstrom, have done well recently, their strength has come in large part from consumers who favor accessory purchases over apparel -- an area to which UGG has limited exposure. Other concepts that cater to Deckers' customer base have all found it difficult to grow recently -- Urban Outfitters (NASDAQ:URBN) being one example.
I know. You've heard a similar story before, several times. But just because UGG has proved resilient to such pressures in previous winters, that does not mean it possesses any special immunity. Note that last year's performance surprised even the management team as many retailers cancelled their orders in October, only to come back and rebook the orders in December. During last year's third-quarter earnings release, CEO Angel Martinez forecast 2006 EPS of $2.00 to $2.15 on the basis of, among other things, the retail climate. Ultimately, his prediction proved to be too conservative, but the fact that things looked so bleak last year should be taken into account, since the underlying drivers of such underperformance seem to again be in place.
Fourth, given how much this company is currently driven by its UGG brand, I'm worried that these boots are getting a bit long in the tooth as far as their fashion appeal and buzz factor are concerned. From Sarah Jessica Parker and Demi Moore to Kate Hudson and Cameron Diaz, lots of celebrities have been wearing these boots, but it's hard to imagine that many more will, or that the company will get any more free publicity from tabloids, or that a higher-profile celebrity than Oprah Winfrey could be recommending the brand to her viewers. Even ignoring the odds that the boots could become this winter's fashion faux pas, sales could also fall short of expectations if Oprah merely neglects to mention them. That stores were canceling orders last year until Oprah featured the boots on her show in November makes me further question whether Deckers can grow as quickly as expected without Oprah's help.
Right now, I see plenty of short-term risks in owning Deckers Outdoor shares but little chance of outsized returns. If you're thinking of opening a position, consider taking a wait-and-see approach until after the holiday season or until the P/E ratio falls to at least 15 times 2006 earnings, which, at current estimates, would be about $36 per share. At that price, the valuation would be more in line with other shoemakers, and future growth wouldn't be priced in as much.
For more Foolishness on Deckers, check out:
Deckers Outdoor and Columbia are both Hidden Gems recommendations. RedEnvelope is a past Hidden Gems pick. Interested in other small-cap values? Then come and take a free trial to find out what Tom Gardner and Bill Mann are finding.
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Fool contributor Marko Djuranovic does not have a financial position, long or short, in any company mentioned in this article. He does, however, own several UGG products and welcomes any constructive comments, criticism, and suggestions. The Motley Fool has a disclosure policy.
