Deckers Outdoor a Step Ahead of Crocs

by Will Ashworth | October 20, 2011 6:00 am

Tuesday wasn’t a great day for Crocs (NASDAQ:CROX[1]) shares, which dropped 39% on lower guidance. The obvious question many investors will ask themselves after the dip is whether the stock is a bargain at $16 and change. It’s not. While Crocs’ business mode has dramatically improved from its heyday in 2007, it still has a lot of work ahead of it. Don’t be tempted to take the deal. Instead, replace it with Deckers Outdoor (NASDAQ:DECK[2]). Here’s why.

Awful Timing

Crocs dropped third-quarter guidance from 40 cents per share to between 31 and 33 cents. At the low end, it’s a 29% downward revision. It’s still making good money, so the drop itself is not really a concern. What’s more troubling is the fact that the company released this information one week before its Q3 announcement. Either it felt compelled to spill the beans now in an effort to limit the downside or it’s completely unaware of what’s really going on in its business.

Obviously, shareholders hope it’s the former and not the latter. On the surface, it seems clear that this move was nothing more than damage control because in the previous four quarters, the company has had positive earnings surprises of 17%, 150%, 20% and 39%, in that order. A 30% miss without any warning would be devastating to any stock in this type of trading environment, but especially so for one with a checkered past.

A 39% decline today probably translates into a 50% drop or more on the day of its announcement. Management averted a firestorm by talking down its stock. That’s classic Investor Relations 101 stuff. Is it enough?

What’s Really Happening?

The above assumption hinges on the notion that management knew far in advance that its business wasn’t going to hit its margins in the third quarter and most likely the fourth as well. According to Robert Samuels of WJB Capital, Crocs’ goal to hit a 15% operating margin for the year is now likely unattainable. Making a quick calculation, working backward from its third quarter EPS estimate of $0.31 a share, I come up with an operating margin of 11.4%, 130 basis points lower than in the third quarter of 2010.

What exactly does this mean? For starters, the company is growing revenues at the expense of profits. Even with the revision, third-quarter revenues will increase by 26% year over year, which is higher than the 21% growth it experienced in the third quarter of 2010. If this margin compression continues into the fourth quarter, year-end earnings won’t be nearly as impressive. Samuels cut his 2011 estimate by 25 cents, and the consensus before the guidance was $1.38 a share. Therefore, let’s assume it does $1.13 per share in 2011. For the first half of the year, its earnings per share were 85 cents.

Add 31 cents for the third quarter and you have a 3-cent loss in the final quarter. This compares to a profit of 5 cents in the fourth quarter last year. Sales are moving ahead while profits are falling behind. Until Crocs can demonstrate it has its expenses under control, its stock is not a bargain.

Gradual Change

In many ways, Crocs and Deckers Outdoors are similar. They both made it big by leveraging a single brand, grew quickly and eventually opened their own retail stores. But that’s where the similarities end. Crocs got its start in 1999. By then, Deckers had been in business for 26 years. It really got going in 1995, when it acquired the UGG Australia brand. While UGG boots still account for 70% of its overall business, its revenue diversification is ongoing.

Deckers might appear to be an overnight sensation, but it has taken almost four decades to get where it is today, which is at the pinnacle of footwear success. Gradual change is at the heart of its business. For instance, as of the end of the second quarter, it had 30 retail stores open in the U.S. and elsewhere. Meanwhile, Crocs has 397 stores or kiosks open worldwide, 10 times more than Deckers.

We all know the story of the tortoise and the hare. If you sell products people truly want, they’ll wait for you to open more stores. In the second quarter, Deckers opened 11 stores and converted its European business from a distributor model to that of a true wholesale business. As a result, it lost money in Q2. However, it is on course in 2011 for a 17% increase in earnings per share, to $4.72, and a 26% boost in revenues, to $1.26 billion. It has loads of cash, and on July 1 parted with some of it to acquire the Sanuk brand of sandals and apparel for $126 million, or three times sales.

Jeff Harbaugh’s Market Watch blog suggests Deckers got itself a great brand with impressive 60% gross margins and an entrée into the independent skate and surf shops it doesn’t currently serve. Forget P/Es for a moment — this is a company with a true vision of its future.

Bottom Line

Successful business has everything to do with execution and little to do with financial formulas. When choosing between two businesses, always go with the better company. That’s Deckers Outdoors.

As of this writing, Will Ashworth did not own a position in either of the stocks named here.

  1. CROX:
  2. DECK:

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