Deckers’ Quarter: More Sanuk Travails and the Public Company Conundrum.

I’ve reviewed Deckers’ 10Q for the three months ended December 31, 2016 and their conference call.  The company earned $41 million on sales of $760 million in the quarter, which isn’t bad.  But that’s down from net income of $157 million on revenues of $796 million in the same quarter last year.

The problem?  I’m sure regular readers already know.  Yup, it’s mostly Sanuk again.  But’s let start at the company’s top line.

Total revenues fell by 4.47%.  The gross profit margin rose from 49.1% to 50.5%.  Now we get to the fun part.

SG&A expense rose $142 million from $188.5 to $330.4 million.  $113.9 million of that was writing the Sanuk brand’s goodwill down to zero.  Why did they decide that was necessary?  It “…was primarily the result of lower forecasted sales for the Sanuk brand, lower market multiples for non-athletic footwear and apparel, and a more limited view of international and domestic expansion opportunities for the brand given the changing retail environment.”

Oh- I see.  I thought it might have had something to do with how they managed the brand after they acquired it.  Guess not.  But CEO Dave Powers does state in the conference call, “We are confident that Sanuk will continue to be an important brand in the sandal and casual canvas category. And with new leadership now in place, we have been able to reduce costs and also improve product design and marketing through leveraging innovation and collaboration across our brand.”  I applaud some of the changes they are making- I just wonder what took them so long.

There was another $4.1 million charge to write down the utility of Sanuk’s Sidewalk Surfer patent which they determined “…had very limited value in the marketplace because of its limited ability to exclude others from creating similar products.”  Turns out, in our industry, customer perceptions and brand positioning are more important than patents.  What a surprise.

Let’s go a little deeper into the numbers before we move on to more strategic issues.  There’s no need to discuss the balance sheet (except maybe inventory- I’ll get to that).  It’s in good shape.

The decline in revenues “…was primarily due to decreases in UGG and Sanuk brand wholesale sales, which were partially offset by increases in other brands wholesale and DTC sales, while Teva brand wholesale sales remained relatively flat. The overall decrease in wholesale sales was primarily driven by a decrease in weighted average selling price per pair (WASPP) for the UGG brand.”

Sanuk’s total revenue for the quarter was $13.87 million, down 18.4% from $17.0 million in last year’s quarter.  Wholesale was responsible for the drop, falling from $13.47 to $10.26 million.  DTC (direct to consumer) rose just a bit from $3.53 to $3.6 million.  “Wholesale net sales of our Sanuk brand decreased primarily due to a decrease in the volume of pairs sold and a decrease in WASPP. The decrease in the volume of pairs sold had an impact of approximately $1,300, primarily driven by lower international wholesale sales. The decrease in WASPP had an impact of approximately $2,600, which was attributable to an increased impact from closeout sales.”

Sanuk reported operating income of $2.94 million in last year’s quarter.  In this year’s quarter, with the big write down, there was an operating loss of $119.97 million.  If we ignore that write down of $113.9 million, we find that the operating loss in this year’s quarter was $6.07 million.  So the trend is negative even ignoring the write down.

I want to remind everybody that back in February 2016, Deckers started a restructuring program that included “…the implementation of a retail store fleet optimization and office consolidation that is intended to streamline brand operations, reduce overhead costs, create operating efficiencies and improve collaboration, and includes the closure of facilities and relocation of employees.”  In addition to the Sanuk charges, there were $10.9 million in charges for the quarter associated with this program.

Deckers has identified 24 stores that are “candidates for potential closure” and they’ve closed 12 of those as of December 31.  They have also opened 16 stores this fiscal year.  They ended the quarter with 172 stores worldwide.  These are mostly UGG stores.

In the online age, closing and opening at the same time makes perfect sense.  Retailers with legacy brick and mortar are finding they need stores.  However, some of the ones they have are of the wrong configuration, in the wrong place, or of the wrong size.  And as they figure out the dynamics of online, and as some malls close, they are finding opportunities for new stores in locations they might not have previously considered.

The general trend for Deckers’ retail stores, however, appears to be down.  “…while we believe our retail stores remain an important component of our Omni-Channel strategy, in light of recent and continuing changes in the retail environment, we also believe it is prudent to consider further reducing our global brick and mortar footprint, which we have begun to do through the implementation of our retail store fleet optimization.”

When I write about Deckers I tend to focus on Sanuk.  Two reasons; first, it’s an industry brand we’re interested in.  Second, there’s an important cautionary tale here about paying a big price for a brand you don’t understand and, for whatever reasons, can’t manage effectively.  Probably because you don’t understand it.

Ignoring Sanuk, Deckers has been a successful and generally well-managed company.  Did they delay a bit longer than they should have in undertaking some of the changes they are implementing?  I think so, but they have lots of company.  Are they confronting the same issues everybody else in their space has?  Yes.  When you read through their 10Q and conference call, you find these include changes in consumer behavior, a strong dollar and weak economies, wholesale customers purchasing differently (including carrying over inventory), changing weather, and the ever popular and really annoying problem of how to build your online presence without cannibalizing your brick and mortar sales.  As CEO Powers puts it, “Unfortunately, brick-and-mortar traffic remains challenging and we expect our stores will continue to face headwinds for the foreseeable future.”

Deckers is responding appropriately.  They are trying to reduce closeout sales (which explains an inventory that’s higher than they ultimately want it to be) and are using the UGG Closet as one tool to do it.  They are also working to “optimize” their wholesale distribution though at the same time they have opened Amazon.  Can’t ding them for joining that not so exclusive group.  Other channels new this quarter include Macy’s and Footlocker.

They are reducing expenses and “…realigning our organization to better engage and service our global omni-channel consumers.”  To continue to quote CEO Powers, “The contraction will help us realign organizational costs against the rapidly changing environment, aligning the company’s skill set and better positioning it to confront the challenges of the current environment, and the evolving consumer preferences in distribution and digital marketing.”  All good things to be doing, though it’s hard to distinguish between Deckers’ actions and its competition.  That seems to be the case no matter who I’m writing about.

Meanwhile, an analyst asked, “How do you think about what the long-term distribution model has to look like for this company?”  Here’s part of Dave Powers answers.  I’ve edited it down a bit.

“I think the results of the quarter indicate the urgency that we need to shift our distribution strategy both in the short and long term…Some of the testing that you saw in new channels this past quarter, i.e., Macy’s, into Foot Locker and going into Amazon, we’re anticipating a broader shift in the distribution long term.”

“For me, it comes down to controlling our distribution as best we can, so continuing to work with the partners who are going to continue to win, continuing to work with partners that are going to showcase and present our brand in a quality way, and then bringing on even more so partners that are working closer to the consumer, and most importantly, our e-commerce business.”

“As we’ve talked about over the last couple calls, we’re also cleaning up and right-sizing our distribution in North America, so closing unproductive accounts and creating more opportunity for our top key accounts to do business with us in a quality way.”

“So I think longer term you are going to see us control more of our distribution. You are going to see more distribution done through online channels, whether it’s through our online channels or our top partners, and we’re right-sizing the organization to be able to help them be successful that way. But really, the ultimate goal for us is fewer key accounts across the distribution marketplace, more through online, and more through direct channels.”

Later on, in a related question, another analyst asks, “Does that mean that you need to be – that you need to shrink the ultimate market-size opportunity for the brand? Is that what we’re kind of moving into here?”

Dave’s answer? “Not necessarily. We’re still focused on driving growth, but we want it to be healthy, more profitable growth in the right channels. We’re optimizing every turn in every sale.”

He didn’t say yes or no.  He said maybe they’d be able to grow if the growth is healthy, profitable and in the right channels.

Here we have another company, then, that may be finding itself with a conflict between being a public company and having the required growth on the one hand and managing their brand and distribution to maintain their competitive position on the other.  This isn’t Skullcandy or Quiksilver because the company is profitable and the balance sheet is strong.  But the analysts and the company executives recognize the potential conflict between revenue growth and distribution that’s in the interest of the brands and the bottom line.

Unlike Skull or Quik, Deckers has the resources to try and make this work as a public company.  We’ll see how they do.