Accounting 712 Financial Statement Analysis Professor Russell James Lundholm Skechers USA, Inc. Analyst Report Dec 8, 2003 by Kenneth Chan Alfonso Chang Carlos Enrique Perez Peter Smith Business Description and Strategy Skechers U.S.A., Inc. designs and markets a full product line collection of branded contemporary footwear for men, women and children, as well as a designer line for women branded separately. While the core customers groups are 12- to 25-year old consumer, substantially all of the lines appeal to the broader range of 5- to 40-year old consumers, with an exclusive selection to infants and toddlers. Business Sells contemporary, progressive and comfortable products at reasonable price Strategy by building brand equity. Functional R&D - Recognize lifestyle trends and translate it into designing reasonably priced Strategy footwear with comfortable, contemporary and progressive styles. Production – Use independent manufacturers with proven track record to increase production flexibility and capacity while at the same time substantially reduce capital expenditures and avoid the costs of managing a large production work force. Inventory – Keeping stocks to fill customers orders but estimating demand to reduce risk of overstocking. Distribution - Products are packaged in shoe boxes bearing barcodes and are shipped to distribution centers in California and Belgium or directly to other international customers. Sales channels include a network of wholesale accounts, in company-own retail stores and company website. Company owned retail stores are organized in three formats — concept stores, factory outlet stores and warehouse outlet stores. Marketing – Maintain and enhance recognition of the Skechers brand name as a casual, active youthful brand that stands for quality, comfort and design innovation, through heavy but efficient spending (8%-10% of annual sales) on advertising, sponsorship to celebrities, in-store promotions, cooperative marketing, public relation, licensing and others Services – Work closely with wholesalers to ensure the style and inventory levels of products carrying at each store are correct. Then utilize such information to forecast sales and determine production and inventory level. 1.1 Sustainability of Profitability However, Skechers’ strategy did not work well in the past 12 months. They overestimated their sales, kept excessive inventory and opened a lot of stores. Furthermore, due to increased competition and fast change in fashion, and Skechers inability to follow, the accumulation of excessive inventory had to be liquidated at clearance price leading to much thinner margins. Compared Q3 2003 to Q3 2002, sales dropped 15% and margin dropped 5% (Q3 2003) but SG&A and depreciation and amortization remained at the same level, leading to a drop in operating margin from 9.2% to -2.5%. Based on the factors in the table on the next page, we expect Skechers’ stock price and performance not to improve significantly unless there is solid evidence that management will be able to increase sales by differentiating their products effectively or cut costs significantly by streamlining their retail stores. We believe that Skechers’s will be able to improve their negative ROE of the LTM, and will revert to a positive ratio near their approximate cost of capital of 20%. This is based on our assumption that general economy improvements will pull sales up and the firm will improve margins once they stop selling lower priced excess inventory. However, the days of 30% ROE ratios are over for this firm. Management Team Given the recovery in the economy in the first three quarters of 2003 and shown improvement by their competitors while Skechers’ performance was declining, we think the management was either unable to execute its strategy or chose an ineffective strategy. Branding The decline in margin reflects the fact that Skechers’ brand was not as appealing to customers as other brands. Therefore the margin will continue to be under pressure given the fierce competition. Product Differentiation Unfavorable Factors Skechers have seen more competition at their basic price point and an increase in clearance price product purchase versus full retail merchandise. Skechers believe this will continue to be a factor in the fourth quarter. Skechers’ competitors are faster in following fashion trends and delivering new differentiated products Manufacturing and Logistics Cost The weakening US dollar caused unfavorable currency translation and increased production costs Oil price is still relatively high (around $30). High electricity bill in California increased their distribution operating cost and current economic situation (i.e $38B deficit) might increase operating expense Customer Demographics From 1990 census conducted by US Department of Commerce, Population Series P. 25, the population between 5 to 24 years old will decrease from 28.3% in 2003 to 27.4% in 2010 to 26.7% in 2015. Such a decline in population for the core customers will reduce the market size. Macro Environment 2003 Q3 US GDP annual growth was 8.2%. November Consumer Confidence Index was up to 91.7 from 81.7 in October. November Michigan's index of consumer sentiment is expected to 94 Favorable Factors November ISM index rose to 62.8 percent from 57 percent in October. The U. S. Conference of Mayors has released a report that an economic expansion will end the "jobless recovery" with job growth of 1.3 percent in 2004 and 1.7 percent in 2005. Distribution Due to wholesalers’ conservative approach, Skechers has excessive inventory which hurt margin due to clearing. Once the clearing is finished, margin is expected to improve. Skechers plans to cut cost by opening fewer stores (four) in 2004, and has no plan for new international expansion. This move is good for improving the margin and harvest the investment in the new 28 stores opened in last 12 months. New Product Development Launch of new product line, Michelle K, Mark Nason, 310 footwear and Marc Ecko footwear 2. ACCOUNTING In general the firm’s accounting reflects the underlying business reality. However, we believe two adjustments needed to be made to fully represent the liabilities and contingencies the company faces and to assess more accurately the company’s future earnings: The company has a strong outflow commitment in operating leases for each of the following five years that is not reflected in the balance sheet. If we discount the future minimum operating lease payments at the average interest rate of their Capital Lease Obligations of 8.42% (comparable secured debt), we get a PV liability of $129.7M as of December 2002, which represents 1.08X their 2002 Total Debt. To consider this liability we restate the company’s Balance Sheet, by increasing PP&E $90.8M (applying a liability multiplier of 0.7), increased Other Liabilities by $129.7M and reduced Retained Earnings by $38.9M. Capital Operating Leases Lease Year ending December 31; 2003 3,065 23,634 2004 3,065 23,461 2005 2,714 22,237 2006 4,721 20,630 2007 1 18,692 Thereafter 19,667 Assuming their $78.6M thereafter will be paid in four 19,667 equal payments. 19,667 19,667 13,566 187,320 Less inputed interest 2,180 PV of minimum lease pmts 11,386 Operating Leases PV as of 12/2002 129,689 rd 8.42% 7.25% -9.59% Capital Lease Obl As well, future contingencies through stock options can make significant impact in their earnings. In December 2002, the number of options outstanding and exercisable below the closing market price as of December 31, 2002 of $8.49 were 1,852,078 and 668,121 respectively. To consider this contingent liability, we compared the weighted strike price of the options ―in the money‖ with the Stock Price as of Dec. 5, 2003 ($7.20), and multiplied the difference by the number of outstanding stock options ―in the money‖ to get a liability of $1.907M, which we consider a contingent claim on equity (see below). Table 1 Number of Outstanding Stock Pr Dec 05, Contingent Range of X Price Dec. 31, 2002 Weighted X 2003 Liability $2.78-$9.28 1,852,078 $ 6.17 $ 7.20 (1,907,640) Number of Exercisable Range of X Price Dec. 31, 2002 Weighted X $2.78-$9.28 668,121 $ 5.14 $ 7.20 (1,376,329) 2.1 Summary of Significant Accounting Policies: Revenue Recognition Recognizes revenue when the products are shipped Revenues from royalty agreements are recognized as earned Inventories Stated at lower of cost (FIFO method) or market Estimated losses from obsolete or slow-moving inventories Income Taxes Accounts for income taxes through the asset and liability method Depreciation and Amortization Using the straight line method Trademarks are amortized on a straight-line basis over ten years Advertising Costs Advertising costs are expensed in the period in which the advertisements are first run or over the life of the endorsement contract Product Design and Development All costs of product design and development are expense when incurred Stock Option Plan For pro forma purposes, the fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model. A contingent claim on common equity of these stock options must be adjusted. Leases The company leases facilities, equipment and automobiles under operating lease agreements. The PV of the future minimum payments was adjusted in the B.S. The company also leases certain property and equipment under capital lease 3. FINANCIAL ANALYSIS Although Skechers USA Inc’s (―SKX‖) had very high ROE ratios in the past (30+%) due to their high Asset Turnover ratios, their sales volume has decreased substantially and when combined with their low cost / low margin strategy, their ROE became negative the Last Twelve Months ―LTM‖. NIKE INC CL B K-SWISS INC CL A TIMBERLAND CO SKECHERS USA INC 2001 2002 2001 2002 2001 2002 2001 2002 LTM Basic Dupont Model Net Profit Margin 0.062 0.067 0.099 0.099 0.090 0.080 0.049 0.050 (0.010) x Total Asset Turnover 1.625 1.614 1.484 1.685 2.413 2.283 2.702 1.923 1.830 x Total Leverage 1.761 1.672 1.301 1.305 1.451 1.425 2.134 2.340 1.734 = Return on Equity 0.178 0.181 0.191 0.217 0.316 0.260 0.284 0.224 (0.031) Advanced Dupont Model Net Operating Margin 0.066 0.070 0.099 0.099 0.091 0.080 0.058 0.056 (0.007) x Net Operating Asset Turnover 2.025 2.032 1.922 2.199 3.502 3.254 3.595 2.882 2.184 = Return on Net Operating Assets 0.134 0.143 0.190 0.218 0.319 0.261 0.209 0.161 (0.016) Net Borrowing Cost (NBC) 0.027 0.026 0.000 #DIV/0! #DIV/0! #DIV/0! 0.086 0.047 0.017 Spread (RNOA - NBC) 0.106 0.117 0.190 #DIV/0! #DIV/0! #DIV/0! 0.124 0.113 (0.033) Financial Leverage (LEV) 0.413 0.328 0.004 0.000 0.000 0.000 0.604 0.562 0.453 ROE = RNOA + LEV*Spread 0.178 0.181 0.191 #DIV/0! #DIV/0! #DIV/0! 0.284 0.224 (0.031) The driver for Skechers’ ROE is its high Net Operating Asset Turnover 3.1 Return in Net Operating Assets Net Profit Margin (―NPM‖) of 5.0% is low compared among its peer group. Moreover, its optimistic forecasts in the 1Q’03 (when inventories balloon up) force Skechers to lower its prices in order to decrease its high inventory levels. This caused its gross margin to decline 220bp from 2001 to the LTM gross margin of 41.7%, for these same LTM its Net Profit Margin is -1.0%. NIKE INC CL B K-SWISS INC CL A TIMBERLAND CO SKECHERS USA INC 2001 2002 2001 2002 2001 2002 2001 2002 LTM Margin Analysis Gross Margin 0.413 0.421 0.422 0.453 0.458 0.454 0.439 0.429 0.417 EBITDA Margin 0.129 0.136 0.164 0.166 0.156 0.135 0.108 0.106 EBIT Margin 0.107 0.108 0.156 0.160 0.138 0.117 0.092 0.087 (0.003) Net Operating Margin (b4 non-rec.) 0.068 0.071 0.094 0.097 0.091 0.076 0.058 0.054 Net Operating Margin 0.066 0.070 0.099 0.099 0.091 0.080 0.058 0.056 (0.007) Skechers, through its fast growing sales until 2001, had one of the highest Net Operating Asset Turnover (―NOAT‖). Yet in the past two years, due to inefficient management of some assets (e.g. receivables, inventory) and declining sales its NOAT came from an industry high 3.595 in 2001 to 2.184 in the Last Twelve Months (―LTM‖). Further, its NWC turnover has decrease from an industry high 5.166 in 2001 to a 2.864 ratio in the LTM. NIKE INC CL B K-SWISS INC CL A TIMBERLAND CO SKECHERS USA INC 2001 2002 2001 2002 2001 2002 2001 2002 LTM Turnover Analysis Net Operating Asset Turnover 2.025 2.032 1.922 2.199 3.502 3.254 3.595 2.882 2.184 Net Working Capital Turnover 3.699 3.597 1.963 2.306 4.608 4.230 5.166 3.661 2.864 Avge Days to Collect Receivables 61.369 63.247 43.266 42.434 36.770 40.589 42.053 44.155 51.737 Avge Inventory Holding Period 94.025 89.142 117.348 111.732 73.671 70.065 91.222 103.519 104.399 Avge Days to Pay Payables 31.842 29.574 27.420 30.095 25.424 20.710 55.667 55.256 42.155 PP&E Turnover 5.926 6.119 28.618 35.023 15.797 15.923 12.301 7.253 Combining its Net Operating Margin and NOAT, Skechers has a Return in Net Operating Assets in 2002 (―RNOA‖) only higher than Nike among its peer group. Yet it shows the most rapidly declining RNOA, reaching a negative RNOA of 1.6% in the LTM. 3.2 Spread and Financial Leverage Its Borrowing Spread (RNOA – NBC) is lower than Nike (K-Swiss and Timberland did not have a debt as of December 2002). Furthermore, in the LTM its spread turns to be negative as its RNOA declines. Among peer group, SKX has the highest financial leverage. In 2002 its Financial Leverage of 56.2% allows them to boost up its RNOA to achieve a higher ROE. Yet in the LTM, because of the negative spread, the high Financial Leverage caused SKX’s ROE to deteriorate even further. 3.3 Default Risk Although highly leverage compared with its peers, in 2002 Skechers had a low default probability of 3.1%. But as sales and earnings have decreased Skechers’ Cash from Operating Activities, of $116.8M in 2002 decreased in the last 9 months of 2003 to ($22.6M) increasing its Average Implied Default Probability in the LTM to 4.7% (see table below.) 3.4 View Skechers has come to be a company of low net profit margins (among its peer comparison group) with declining sales and operating asset turnover. In the past, although having a low NPM, Skechers had high operating assets turnover and growth in sales, putting it as high growth company. However, as of the third quarter of 2003, Skechers did not stand out from its peers in operating margins or in operating asset turnover. Thus we believe, Skechers is at a crossroads between continuing to invest in high growth with the risk of not generating an acceptable return to its investors, or investing to grow slightly above the economy and focus in reducing costs and improving its operating margins. Its 1.04 (7.20/6.95) Market Price to Unadjusted Book Ratio reflects the market view of a Skechers as a company, worth only its Book Value that lacks positive NPV projects in which to invest. NIKE INC CL B K-SWISS INC CL A TIMBERLAND CO SKECHERS USA INC 2001 2002 2001 2002 2001 2002 2001 2002 LTM Analysis of Leverage - Short-Term Liquidity Current Ratio 2.029 2.264 6.423 5.305 3.156 2.836 1.783 3.687 4.924 Quick Ratio 1.078 1.298 4.197 3.389 1.855 1.755 0.775 2.155 2.652 EBIT Interest Coverage 17.278 22.435 #DIV/0! 493.234 104.547 157.042 6.410 9.146 (0.255) EBITDA Interest Coverage 20.925 28.246 #DIV/0! 513.819 118.718 182.498 7.515 11.170 Analysis of Credit Risk Net Income to Total Assets 0.101 0.103 0.145 0.156 0.212 0.177 0.116 0.082 -0.018 implied default probability 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 4.5% Total Liabilities to Total Assets 0.400 0.404 0.227 0.240 0.288 0.308 0.512 0.616 0.418 implied default probability 3.0% 3.0% 2.2% 2.2% 2.5% 2.5% 3.5% 4.5% 3.0% Quick Ratio 1.078 1.298 4.197 3.389 1.855 1.755 0.775 2.155 2.652 implied default probability 4.0% 3.5% 1.5% 1.5% 2.5% 2.5% 5.0% 2.0% 1.8% EBIT to Interest Expense 17.28 22.43 #DIV/0! 493.23 104.55 157.04 6.41 9.15 (0.26) implied default probability 1.5% 1.5% 1.0% 1.0% 1.0% 1.0% 1.8% 1.8% 8.5% Inventory Holding Period 93.31 87.54 117.59 122.34 72.32 68.73 106.78 100.24 112.23 implied default probability 5.5% 4.9% 5.5% 6.0% 4.9% 4.5% 5.5% 5.5% 5.5% Annual Sales Growth 5.5% 4.3% 6.5% 23.0% 8.4% 0.6% 42.3% -1.7% -14.0% implied default probability 3.0% 3.2% 3.0% 3.2% 3.0% 3.2% 5.0% 4.2% 5.0% Average Implied Default Probability 3.2% 3.0% 2.5% 2.7% 2.7% 2.6% 3.8% 3.3% 4.7% Forecasting Assumptions: Income Statement: Revenue: The revenue is modeled using three equally weighted scenarios to capture the uncertainty surrounding the future of Skechers’ revenue stream as a result of its recent 15% drop in revenues. In the first scenario, which most closely corresponds to company guidance and equity analysts, the revenue is expected to increase by 10% the first year, erasing just over half of the drop off from this year, and then grow at a fairly steady 5%. This reflects the belief that the company has become relatively mature, is encountering new pressure in its chosen segments, and will be able to maintain its market share, but will only grow at the rate of the overall economy. This rate of growth (5%) closely matches the forecast for GDP growth over the coming 10 years (the forecast horizon). Even more importantly, there is a clear relationship between the change in GDP and the change in expenditures on goods such as shoes (see Exhibit 1 below). In scenario 2, we have taken a more conservative view of the future growth and eliminated the 10% rebound in 2004, and simply utilized the GDP growth forecasts to project growth from the current expected 2003 revenues of approximately 800MM. Finally, we created a third scenario that captures the domestic versus international component of revenue growth in the firm. Domestic revenues are forecasted as a percentage of the US retail footwear market (mean of 2.1% with a standard deviation of 0.32% based on SKX’s share from 2000 to 2003). The retail market is forecasted based on GDP using linear regression analysis (1990 to 2001) and GDP forecast (2003 to 2013) provided by CBO (Exhibit 1). As used by Tucker Anthony Sutro Capital Markets, the retail market is assumed to have a 45% mark up to manufacturer’s prices (i.e., SKX’s domestic wholesale prices). International revenues are forecasted based on the percentage of international revenues of total revenues. This percentage for 2013 is based the penetration of the international market by SKX and its competitors and has a triangular distribution of 17% (2002 SKX estimate), 33% (2002 Timberland estimate), and 50% (2002 Nike estimate). The percentages for years 2003 to 2012 are linearly interpolated from 2002 SKX estimate to 2013 assumption from Nike, SKX, and Timberland. Exhibit 1: US Regression Analysis US Domestic Footwear Industry Fo 60 Fo 70 0.6% ot Actual Forecast ot Ma we we 60 60 57 rke ar 50 ar 54 0.5%t Ex Ex 52 49 50 as pe pe 50 46 47 a ndi 40 45 0.4%Pe ndi 42 tur tur 39 40 rce es es 40 37 34 36 nt ($ 30 ($ 32 31 33 0.3%of US US 30 No , , mi Bill 20 Bill 0.2%nal ion y = 0.0038x + 9.0682 ion 20 2 US s) R = 0.9967 s) GD 10 0.1%P 10 0 0 0.0% 0 5,000 10,000 15,000 1990 1993 1996 1999 2002 2005 Nominal US GDP ($US, Billions) Year , Bureau of Economic Analysis, and American Apparel & Footwear A Sources: Congressional Budget Office, US Department of Commerce ssociation Revenue Forecast 1.6 Scenario 1 Scenario 2 Scenario 3 Expected Value 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 2003 2005 2007 2009 2011 2013 COGS: The COGS for Skechers has historically been near 57% of the gross sales. However, in 2002, this figure approached 63% as Skechers disposed of an inventory backlog and suffered competition at its price points for sales. The factors when combined contributed to the worst gross margin in the recent history of the firm. For future forecasts, we assumed one of two scenarios would take precedence. First, we believed that COGS, as a percent of Sales, would remain elevated from their previous levels due to the increased competition at the Skechers price points, but would decrease from the previous high in 2002. Therefore, we decided to start the COGS at 60% and allow it to decrease over the 10 year horizon back to the historical average of 57%. The source of this decrease is the increased presence of retail outlets that increase the average sales price of Skechers goods, thus reducing the associated COGS percentage. Our second methodology is a conditional formula that essentially captures the same data as above, but specifically allows the COGS percentage to float with the revenues for 2004. Thus, if revenues return to their historical levels (1Bn in sales), then it is assumed that the retail outlets have allowed the ASP to increase and the COGS percentage is allowed to decline faster toward 57%. SG&A: The SG&A for Skechers is composed of both fixed general and administrative changes and variable selling / marketing charges. Historically it has run at approximately 32% of sales. However, in 2003, this figure has increased to 38% of sales since the fixed expenses have increased with the opening of new stores and revenues have fallen to three year lows. Therefore, we forecast SG&A based on a fixed component tied to general and administrative expenses and a variable component tied to 10% of revenues, or the typical selling / marketing expense of Skechers. Recently, management has made comments that it will attempt to reduce costs in the coming quarters to reign in SG&A expense and reduce the current rate of 38% of SG&A. We believe that many of the expenses were due to the opening of new stores and that the company should be successful in trimming half of the expense in the coming year, returning to approximately 35%. Thereafter, the firm should be able to slowly return to it’s historical norm of 32%. Finally, as a sanity check, we compared our results with industry statistics for projected growth in net income and found that Skechers in our model will grow Net Income at approximately 13% per year, or slightly less than the expected industry Net Income growth of 13.7%. Balance Sheet: The balance sheet assumptions are not altered from their 2002 ratios. Skechers took on 90MM in debt in 2002 to finance its expansion and has stated that they will slow that growth substantially to digest the store openings. The company has become a more mature firm that has begun to see attacks in their ―low cost‖ niche. As a mature firm their growth is expected to be relatively constant in the coming years and substantial changes in their balance sheet are unexpected. They may pay down some of the debt that they took on, but with their high cost of equity, retaining the additional debt will keep their WACC lower and will thereby increase their overall firm value. Therefore, we expect the debt to equity ratio to remain relatively constant. VALUATION: By adding Monte Carlo analysis with @Risk into eVal and utilizing the above assumptions, the potential value for each share of SKX common stock ranges from $2.99 to $7.65 (Exhibit 2) by both residual income and discounted cash flow valuation techniques with an expected price of $5.05. Thus, with a current price of $7.20 (as of Friday, December 5, 2003), SKX’s share price does lie in the range of calculated values. However, it is currently trading at a 42.6% premium over the expected value, leading to the conclusion that it may be over-valued presently since there is only a 5% chance that the ―true‖ value of each share lie at least $6.55. Distribution for Forecast Price/Share / Exhibit 2: Distribution of SKX Share Price SKECHERS USA INC/B26 1.000 0.800 Prob of Value 0.600 >= X-axis 0.400 Value 0.200 0.000 2.50 3.00 3.50 4.00 4.50 5.00 5.50 6.00 6.50 7.00 7.50 8.00 The differences between the expected value and the current value may be explained by examining the valuation drivers in Exhibit 3 and Table 1 below. Exhibit 3: Valuation Drivers Correlations for Forecast Price/Share / SKECHERS USA INC/B26 5 -.785 Enter Cost of Equity Capital:/J9 4 -.485 Cost of Goods Sold (2004) / Actual/B36 3 Rev Scenario / Actual/F16 .104 2 -.023 Intl Sales as a % of Total Sales (2013) / Actual/B34 1 Corr Coeff calculated at end of bars -.004 US Retail Footwear Market Share / Actual/B26 0 -1.00 -.50 .00 .50 1.00 Coefficient Value Table 1: Driver Assumption Revenue Forecast 34% scenario 1, 33% scenario 2, 33% scenario 3 COGS (% of net revenues) Uniform distribution between 57.1% (2002 value) and 60.1% (average of 2002 and 2003 values) Intl Sales as a % of Total Sales Triangular distribution with min of 17.7% (2002 value), most likely of 33% (2002 Timberland value), and max of 50% (2002 Nike value) Market Share of US Retail Footwear (2013) Normal distribution with mean of 2.1% and standard deviation of 0.3% (based on 2002 to 2003 values) Cost of Equity Capital Uniform distribution between 15.1% (equity premium of 5.2%--all publicly traded companies between 1964 to 1994) and 20.1%(equity premium of 7.6%--S&P between 1926 to 1998) As seen in the above exhibit, the two main valuation drivers are SPX’s cost of equity capital and COGS assumptions. Investors may be using lower cost of equity capital and/or lower COGS assumptions to value SPX. These lower figures may be driven by investors’ believes that the SPX is less risky than expected and that SPX’s COGS will be lower due to several cost cutting initiatives launched by the company. Additionally, investors may be more optimistic about SPX’s revenue growth. In summary, Skechers is at a difficult point in its life cycle and is transitioning from a growth stock to a mature one that needs to be more efficient in its delivery of a product to the market. As additional competition arrives in Skechers’ price points, Skechers ability to enhance margins where possible is critical to its long term survival. However, even if Skechers is able to make this change and grow with the broader economy as a whole, its stock is overvalued at this time and should adjust downward in the coming months.
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