My head hurts.
I've been thinking about what to do with my former Motley Fool Hidden Gems recommendation Deckers Outdoor (NASDAQ:DECK) for the last few weeks following its year-end earnings release.
Pain, pain, go away
Here's what's causing the pain. I love the company's products, I love the company's returns, I love the company's management, and I love the company's prospects. But I can't get the market's current expectations and the company's guidance to line up. That's because I think the stock market, as it is prone to do, has discounted too much future value to the present.
As I look forward, I see lots of good things. I see UGG as a growing brand -- Nordstrom (NYSE:JWN) and other retailers continue to rave about its products. I see Teva turning around; its new sandals and shoes, and the supporting marketing investments, should help it regain market share from Keen, Merrell (owned by World Wide Wolverine (NYSE:WWW)) and Chaco. It will still take a while to feel the full effect, but I am confident that CEO Angel Martinez and his team can get the job done. Simple is a wild card, but it's gaining some traction at interesting sales channels like Whole Foods (NASDAQ:WFMI).
Look forward, solve backwards
The bright future and excellent management make me think I should hold. But that rising stock price makes me wonder if I should sell. It's time to take a page out of mathematician Carl Jacobi's book and invert the problem, so let's work backwards from the current stock price and the new information from the company's latest press release to find out if future expectations are too high.
From the latest press release, management says it can grow sales by 15% and EPS by 5% in 2007. It also believes gross margins will shrink back down to 44%.
The company did not include a cash flow statement in the press release. From some quick calculations using the changes in working capital on the balance sheet, I estimate that Deckers generated about $41 million in free cash flow in 2006. That's because working capital changes worked out to about $0 and I assumed the company spent $4 million in capital expenditures.
Using a stock price of $70 and $41 million in free cash flow as my starting point, I can calculate that Deckers needs to grow its free cash flow by 14% over the next five years. That means that it will have to generate $46.7 million on free cash flow in 2007. Can it do it? Let's work backwards even further.
From the EPS growth estimate, management expects to generate $44.8 million in net income next year. Working backwards from the free cash flow result above, the company has to generate about $49 million in net income in 2007 to justify the expectations built into the price. As a benchmark, 2006 net income was $42.5 million, so with the 5% growth, the company expects 2007's to be around $44.6 million. This tends to confirm my suspicion that the market's expectations are out of synch with the company's and it may be a good time to sell some shares.
It's happened before and it will happen again. In the short-term, the market is a voting machine. In the long-term, it's a weighing machine. The market has correctly weighed Deckers' prospects and performance over the past two years. However, I think cheery voters have taken over today.
What to do
The stock still appears to be overvalued, even with new (and excellent, I might add) performance information. Admittedly, my gut is telling me to sell. But I want to make sure I think about it correctly, so I'll break down how I'm thinking about it.
Option 1: Buy
Believe it or not, I could actually buy more shares if I am underestimating the growth potential of the company and what it can do with that $100 million war chest sitting on its balance sheet.
Option 2: Hold
Holding could be a prudent option here as there are a few wild cards. The first is that the benefits of the Teva turnaround could arrive faster and/or higher than expected. The second is that $100 million sitting there waiting to be used to buy and nurture a new brand. The company has its hands full right now, so I would call this a low probability event.
Option 3: Sell
The company is overvalued relative to my estimate of its intrinsic value (your mileage may vary), and the aforementioned catalysts won't cause my intrinsic value calculation to rise fast enough to close the gap.
This decision could also be influenced if there was another bargain opportunity to put the cash in after the sale.
Give a Fool some feedback
What do you think? I really want to know. So I've set up a poll here at the Deckers Outdoor discussion board. Share your opinion and I'll post the results in a QuickTake along with my final decision. And if you're really passionate about your analysis, then don't forget to bring your opinion to Motley Fool CAPS, our community intelligence database.
Here's some background material on the Deckers Outdoor saga.
Deckers Outdoor is a former Motley Fool Hidden Gems recommendation. To learn about other small cap companies that can boost your portfolio, sign up today for your 30-day free trial.
Whole Foods is a Motley Fool Stock Advisor selection.
Retail editor David Meier loves his new Teva sandals. Even his dogs won't go near them, he's worn them so often. He owns shares of Deckers Outdoor but does not own shares in any of the other companies mentioned. David is currently ranked 494 out of 24,252 investors in the CAPS rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.
