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Is Skechers Channel Stuffing?

June 25, 2011 | About:
It has been a wild ride for Skechers USA Inc (SKX) these last few years. They had a wonderful run following the release of their Shape-Up brand – those funny looking shoes with the rounded bottoms that have a wide range of supposed health benefits (though some researchers suggest the benefits are illusory, and a class action lawsuit alleges the industry is committing false advertising). Revenues teetered around $1 billion between 2001 and 2005, and then shot up into the $1.4B range through the recession before peaking at $2 billion this last year. But the tide appears to be turning, as the Shape-Up line (the “toner” category) proves to be a fad which has run its course. The company reported its quarterly earnings April 27, and shares declined 7.5%. Since the release, shares are down 32.8% (as of the time of writing – June 10th). Several people have emailed me asking my thoughts on SKX now, since the stock is so much cheaper than when I wrote about it in the fall. I took a closer look, and didn’t like what I saw.

First, let’s take a look at the headline numbers from this last earnings release. For Q1 2011 and as compared to Q1 2010,

  • Net sales declined 3.4% from $492.8m to $476.2m
  • Gross margin declined from 48.2% to 40.4%
  • Operating income 82% declined from $81m to $14.7m
  • Earnings declined 79% from $56.2m to $11.8m
Clearly, this was a rough quarter. Unfortunately, I am not convinced this shows the full extent of the damage. Let’s dig deeper and look at the company’s performance by segment. From the company’s 10-Q:

skx-performance-segment1.jpgSkechers Performance by Segment

From this, we see that the decline in sales and gross margins is almost wholly due to their domestic wholesale segment, which suffered a 23% decline in revenues and a 46% decline in gross profit. The company says this is the result of a dramatic decrease in the average selling price per pair, which decreased 16% to $19.83 from $23.64 year over year. The company is trying to move its excess inventory of Shape-Up shoes and it is heavily discounting in order to accomplish this.

However, if we turn away from the negative aspects of the above charts, and look to the apparently positive aspects, we see that the international wholesale division is really the only bright spot in the organization. Sales increased 37%, and margins held steady (43.7% in 1Q 2010 and 43% in 1Q 2011). Not a bad performance, and it gives management a success that it can point to. But are these sales legitimate or are there some financial shenanigans going on?

Let’s first look at the company’s receivables, where we see a massive jump from $266m at December 31, 2010 to $320m on March 31, 2011, a 20% increase in just three months. This seems to suggest that the company is extending its wholesalers more favourable sales terms. How does this relate to the international division? According to footnote 11 of the company’s 10-Q,

Domestic accounts receivable, which generally do not require collateral from customers, were equal to $163.3 million and $164.4 million before allowances for bad debts, sales returns and chargebacks at March 31, 2011 and December 31, 2010, respectively. Foreign accounts receivable, which in some cases are collateralized by letters of credit, were equal to $180.1 million and $121.4 million before allowance for bad debts, sales returns and chargebacks at March 31, 2011 and December 31, 2010, respectively.

Thus, the domestic wholesale division accounts receivable held steady, while international wholesale accounts receivable increased by 48%, or $58.7m. So the international wholesale division, which is the only shining light in an otherwise extremely bleak quarter, improved revenues predominantly as a result of improved trade terms.

Here’s the company’s statement on revenue recognition (emphasis added):

The Company recognizes revenue on wholesale sales when products are shipped and the customer takes title and assumes risk of loss, collection of the relevant receivable is reasonably assured, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. This generally occurs at time of shipment. The Company recognizes revenue from retail sales at the point of sale. Allowances for estimated returns, discounts, doubtful accounts and chargebacks are provided for when related revenue is recorded. Related costs paid to third-party shipping companies are recorded as a cost of sales.

For wholesale sales, revenue is generally recognized at the time of shipment. SKX is hardly unique in this regard, but this allows for changing assumptions regarding estimated returns, doubtful accounts etc. Since SKX’s only area of improved performance achieved this improvement without getting cash from its customers, one is left to wonder whether the improvement is real or whether it is the result of more liberal assumptions, or worse still, the result of purposeful channel stuffing. Unfortunately, there is little opportunity for investors to discover the truth, so we are left to simply wait and see whether returns occur en masse in coming quarters. In the meantime, this is a red flag for me, and I will stay away.

To learn more about channel stuffing and other financial shenanigans check out this in-depth review of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports

Author Disclosure: No position

Talk to Frank about Skechers

About the author:

Frank Voisin
Frank is an entrepreneur who owned four restaurants by the time he was twenty. He sold his businesses and returned to school, completing a concurrent Law / MBA degree. At the same time, he successfully completed all three levels of the CFA exams. He now invests full time with a focus on value investing. Frank Voisin writes about value investing topics at http://www.frankvoisin.com.

Visit Frank Voisin's Website


Rating: 2.9/5 (12 votes)

Comments

RaymondCSmith
RaymondCSmith - 3 years ago
Should I buy more skx here? or should i sell out my position (a loss of 40%) or hang tight to see what happens next: Thanks
c12mintz
C12mintz - 3 years ago
As part of a recently established 24 stock portfolio, SKX is my worst performer- down 25%. My 2nd worst performer is ARO also down 19%. I personally am holding my SKX, but upon reading this article I'm a bit more nervous. Shape-Ups were a fad, yes, but I don't think a return to 04-09 trend #s is unreasonable..

On a side note, ARO is looking like a super buy right now. I'm considering double my position in this company... Frank any thoughts on ARO?

Disclosure: Long SKX and ARO - Short ANF
Adib Motiwala
Adib Motiwala - 3 years ago
I am waiting out on SKX. I have seen long recommendation for it as well. I would like to see update in the next quarter on their inventory and A/R situation. In general, I did not find SKX to be a high quality well run business....but that does not mean you cannot make money on it.

JBUDDYBOY
JBUDDYBOY - 3 years ago
I have owned Skechers over the years and made some money. It's a family run company and as I look at the numbers recently, I am disturbed by the increase in their SG&A expenses, while everything else is going down. This indicates to me the people running the company are much more interested in paying themselves (salaries) than they are in building shareholder value. If the trend continues, I am selling, before they just let the company rot from the inside.

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