It’s been a rough year for my holding in Deckers Outdoor (NASDAQ:DECK). After buying early in 2012 for around $63 per share on the news of a large increase in raw material costs the share price continued to dive to a low of $28. I managed to average down at $30 so my average buy price now is about $50.

A few days ago Deckers announced its full year 2012 results which were a little disappointing to me if I am honest, the effects of the raw material cost increases had a much larger impact than I had estimated, and the global financial crisis has also started to take its toll on the business. At the beginning of the year they said they expected revenue to increase by 15% and profits to be flat. In the end profits were down 35% and sales were almost flat. On the flip side, how much worse can things get!?

The business

I view this business in a variety of different segments which I have chosen as these different areas seem to perform differently.

1. UGG wholesale, which is the major driving force behind profits and revenues

2. Other brands wholesale

3. E-commerce – large increases in sales over the years and allows them to sell at retail prices

4. Retail outlets – were a lot of cash flow is being spent so important to evaluate separately in my opinion.

2012 results

1. UGG wholesale sales were down, from $915m to $820m in 2012. This was not totally offset by increases in sales through other channels. They also experienced some resistance to price increases by consumers and have to retrospectively scale back their 2012 price increase later in 2012. They blamed lower UGG sales to carryover inventory by customers due to 2011’s warm winter. Operating income was down 31% to $268m.

2. Excluding the acquisition of Sanuk, other wholesale sales were down around 8% and operating income was down around 40% to $6m, but this paints a rosy picture as they ceased a loss making brand in 2012.

3. E-commerce sales increased from $106m to $127m excluding Sanuk. Both UGG and Teva saw increases but their much smaller brands showed decreases. Operating income was up 23% to $30m.

4. Retail store sales increased from $189m to $246m excluding Sanuk. Retail sales increased across all brands except Teva. Same store sales however decreased by 3.4%. Operating profits decreased 19% to $26m.

Besides the reduction in gross margin due to higher sheepskin costs, there was a large increase in selling, general and administrative charges of  $140m to $394m. This was explained due to

– $36m extra from new retail stores
– $25m expenses for Sanuk brand
– $14m extra on marketing
– $7m extra on e-commerce marketing
– $16m LESS in performance based compensation
– $10m LESS on legal expenses

Cash flow

Several things affected cash flow this year. Firstly sales didn’t increase so their rapid expansion of inventory has slowed and freed up more cash from operations. Secondly, accounts receivable has decreased due to their European switch from a distributor model (selling to distributors) to a wholesale model (selling direct to retailers). This switch also means they need to hold higher levels of inventory to be ready to ship to retailers.

Sound management action

There were a couple of things that management did throughout the year that I felt were wise moves. The first was the reduction in their UGG selling price, retrospectively. This was based on consumer feedback that the large price increases (driven by increased costs) were having a negative affect on sales, and had gone over a point were customers thought they were getting decent value. Based on this they decided to reduce prices (still higher than 2011 though) which I think is the right move.

Secondly, upon the large weakness in the share price they massively expanded the planned share buyback to $220m. Seizing the opportunity they used short term borrowings to fund the purchases, which may have sounded worrying to investors at first, but by the end of the year only $33m is still outstanding on the loan, the rest has been repaid. Even this $33m is easily covered by cash on hand.

Sanuk

It’s also been a full year for the Sanuk brand so a good time to evaluate how good this acquisition has been. Operating income was $15.5m however this includes amortisation of $8.8m related to the acquisition, removing this gives $24.3m. The acquisition cost is quite complicated. They are contractually obliged to pay 50% ($25m) of the gross profit as part of the purchase agreement in 2012. In 2013 they must pay 36% of gross profit, and in 2015 will pay 40% of gross profit. On aggregate I estimate this acquisition will have cost up to $225m once all contingent payments have been made. With operating profits of $24.3m that looks like decent value and has reduced seasonal pressures somewhat on the business.

Free Cash Flow

I think the last three years are particularly harsh for measuring free cash flow. Firstly they’ve had a difficult couple of years. Secondly their switch from a distributor model to a wholesale model, and more direct sales has meant much greater levels of inventory are required. Cash was pumped into working capital to fund expansion and went up because of rocketing costs, so we can only get a good idea of the cash this business generates in hostile conditions. Net income totalled $491m in the last 3 years. If we assume $20m a year of capital expenditures are for new retail stores and exclude this, free cash flow totalled $225m, lets call it 50%. That’s under extreme conditions. If we look from 2003 to 2009 that figure is more like 85%. So the business generates large amounts of cash in any situation. What is this spent on?

Share buybacks – as discussed before, management seems to be willing to commit to large share buybacks when the time is right

Retail stores – They are increasing their retail stores greatly, and with a return on assets of 19% last year for this segment, this is a good investment for them to make.

Acquisitions – The Sanuk acquisition was the largest recent acquisition and looks to be a fair deal. Their Teva acquisition back in 2002 also has generated good returns on the amount paid.

So their cash is still being spent wisely. I would expect cash generation to return to more normal levels, say 80% of net income in the next few years as cost increases have slowed and inventory levels aren’t expected to expand further (beyond necessary for any increases in sales). Can they grow? In the current market conditions sales have been lagging, however a lot of sales are being converted from wholesale to retail and E-commerce. Retail has much lower margins than wholesale, whereas e-commerce has higher. Overall I would expect margins to decrease as they expand their retail presence. They need to be careful however that they don’t simply displace sales from wholesale to retail, although they can sell for retail prices, they make better margins on wholesale. What is good however, is for their E-commerce sales to increase given the large margins they make on this.

If conditions return to more normal I can see a strong future for their brands. They have new mens lines being introduced for UGG, opening up a whole new market to them although they don’t have the same brand strength among men in my opinion but they have shown they can develop a brand.

I would say growth of 5% a year isn’t unreasonable given profits they have grown at 22% per annum over the last decade, and they could sustain that for quite a long period. Also if sheepskin demand falls over the next few years then gross margins could improve. Using my PE ratio tool, a multiple of 16-22 seems appropriate. Factoring in around only 80% of profits are free cash flow this reduces to 13-17.6. With the 35% fall in profits, I feel my margin of safety has diminished, but that is what it’s there for!

I still feel this is a good investment with lots of growth potential left so I will hold. At current valuation it is predicting modest growth and any return to the growth they experienced in the last few years will surely see this stock selling at far higher multiples, especially given the huge amount of free cash flow it generates for a growing business. With plenty of cash to buyback shares this should also support the share price as it did last year.

Disclosure: Long DECK